The idea of holding onto your cryptocurrency to watch its value rise is not new. However, a lot of investors understand that holding cryptocurrency in a cold wallet while awaiting the day it orbits the moon offers some advantages.
What if, instead, you used the assets you now own to expand your portfolio and generate passive income? What if, alternatively, you could make further investments by using your assets as collateral?
Investors can accomplish that through crypto loans. DeFi crypto lending eliminates the need for a middleman, although centralized exchanges like Binance have long provided crypto loans, providing investors more authority over their assets.
But what about crypto loan taxes? Your tax office will inquire about your participation in crypto loaning as well as any earnings or income, as they do with all crypto transactions.
A crypto loan is a form of peer-to-peer lending where a lender makes a loan to a borrower in exchange for regular payments with interest. When you take out a loan, you are lending someone else money that they promise to pay back with interest.
A crypto loan works much the same way, but with a few twists. The borrower borrows cryptocurrency from a lender and promises to pay back the same amount of cryptocurrency plus a set interest payment. When you take out a loan with cryptocurrency as collateral, you are loaning someone money that you promise to pay back with interest.
Crypto Loans: An Alternative to Selling Off Crypto
The distribution of crypto among its investors is unequal. There are a number of crypto investors who have a large portion of their assets as cryptocurrency. However, most of these investors are hesitant to sell off their holdings and incur long or short-term capital taxes.
So rather than selling and incurring taxes, they use the crypto as collateral and apply for a loan. Doing so can let them use the assets to get money and can use it for anything.
Why Should You Take Crypto Loans?
You may use part of your cryptocurrency as collateral and borrow money through crypto earning platforms at an interest rate that is typically far cheaper than what you'd have to pay to a financial institution for personal loans.
With cryptocurrency loans, you may still raise money if you think Bitcoin or some other crypto will increase in value over the long term. As a consequence, you are able to hold onto your cryptocurrency for a long time and profit from long-term capital gains taxes later on.
Nevertheless, taking out a cryptocurrency loan has additional consequences. For instance, if the valuation of the cryptocurrency committed as security falls, the exchange may sell off some of it to keep the necessary loan-to-value (LTV) ratio. If you're thinking about getting a loan backed by cryptocurrency, you should not ignore the possibility of such scenarios considering the volatility of the crypto market.
Custodial Loans Vs Non-Custodial Loans
Who Offers Crypto Loans?
A number of centralized and decentralized platforms offer crypto loans. These include centralized platforms like:
- Compound: Any user who adds cryptocurrency to the Compound pool is instantly qualified to borrow using their cryptocurrency holdings as collateral without needing to undergo a credit check or fulfill any other additional conditions. The rate of interest for stablecoins ranges anywhere from .6 to 1.3%.
- Crypto.com: Crypto.com provide a greater variety of cryptocurrencies with higher interest rates (ranging from 8.5% to 14%), particularly with stablecoins (such as Dai, Tether, TUSD, and Paxos), and charge 12% interest on crypto loans.
- AAVE: Users of Aave can move between two distinct sorts of rates using its rate-switching feature. By selecting between "fixed" and "dynamic" interest rates, consumers may achieve the best rate of interest on their loans. Lenders to the network deposit their money in return for aTokens that earn interest. Stablecoin rates of interest range from .5% to 1.3%.
- BlockFi: BlockFi has announced a 4.5% APR for cryptocurrency loans with Bitcoin as security. BlockFi provides interest rates ranging from 5.25% to 8.6%, based on the cryptocurrency you have to stake with; the higher rates apply to deposits made using stablecoins like GUSD or USDC.
Crypto Loan Taxes
Most of the crypto transactions in the US are considered taxable events — barring a few, such as donations and gifts (you can check out our crypto tax guide).
According to the IRS, cryptocurrency is taxable as “property” similar to other tangible assets. But, taking out a loan is often not taxed. Lending money in fiat currency or cryptocurrency is also not taxed.
Loaning crypto on DeFi platforms may be subject to either income tax or capital gains tax, depending on the exact platform you’re using and how it works. When you utilize the loan funds to acquire cryptocurrency and then sell that coin for a profit or loss, the situation becomes more complicated.
Crypto Loan Taxes: Interest Expense
Although the IRS hasn't issued guidelines on the subject, it's likely that interest payments on crypto loans will be regarded similarly to those on conventional loans.
You are charged a yearly interest rate of 5% by bitcoin lending sites when you borrow money using your cryptocurrency. If you utilize the loan proceeds for investment or for commercial reasons, you can deduct the interest charge from your taxes.
The loan proceeds may be used to buy additional cryptocurrencies, or they may be invested for investment reasons in more conventional assets such as bonds and stocks. If this is the case, the interest paid on your crypto loans is deductible as an investment expenditure on Form 4952.
It's crucial to remember that, depending on the deal, any earnings you make from investment loans will either be taxed as capital gains or as personal income.
Keeping track of all the paperwork related to your loans is a crucial part of preparing your crypto taxes. This is essential to correctly estimate your taxes and might save you a tonne of time.
It's crucial to remember the dates and amounts associated with each payment you make. Include the dates of any sales or other events that have an impact on your material, as well. By preserving such records, you can reduce the chances of an investigation and simplify the tax filing process.
Note: Keep in mind that interest costs would not be tax deductible if you used the revenues from the crypto loan to pay for personal expenses.
Suppose Jim takes a loan on his bitcoin. He earns about $1000 of staking rewards via his loan proceeds but pays $300 of his interest expenses. He recognizes $1000 of his income from investment and writes off $300 of investment expenses.
Crypto Loan Taxes: Paying Off
In general, the loan repayment and receiving the collateral back are not taxable events.
Suppose you returned the collateral with the principal amount to the platform you took a loan from. Even if the price of Bitcoin increased during the time it was locked as collateral, this is not a taxable event for you.
Taxes on Crypto Loans
There are a few circumstances in which a crypto-backed loan might result in tax liability for you.
The platform will first sell your collateral to offset its losses if you don't repay the loan, which will result in an unexpected tax obligation for you.
So what happens if you fail to repay your debt?
The lender will have the option to sell your collateral, and then you’ll have to pay capital gains taxes on your profit. Thus, failing to repay your crypto loans is not a way to cash out, you’ll have to end up paying capital gains taxes.
The Bottom Line: Reporting Crypto Loan Taxes
All in all, it is now clear that when executed right, loans secured by cryptocurrencies do not incur taxes. All you have to do is simply keep track of your assets across exchanges, wallets, and decentralized protocols — thanks to crypto tax reporting software, and you’re good to go!
Disclaimer: This material has been prepared for informational purposes only, and is not intended to provide tax, legal or financial advice. You must consult your legal, tax, and accounting advisors before you engage in any transaction.