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How Are Crypto Loans Taxed?

How Are Crypto Loans Taxed?

Getting a fiat loan on your appreciated crypto is a great way to withdraw money without paying capital gains tax. This article will analyze several transactions associated with a cryptocurrency loan and understand their tax implications.

Receive loan funds with cryptocurrencies

Receiving money for depositing cryptocurrency as collateral is not a taxable event. It's like getting an equity line of credit, in which you collateralize your house in the bank and get money against the appraised value of the property.

For example, John bought one bitcoin (BTC) in 2017 for $1000. It is now worth $60,000. John decides to place this BTC as collateral on a credit platform and get a loan. The loan platform offers a loan of $40,000. This $40,000 is not taxable for John. You do not need to enter this amount in any tax form, although it will require you to select "yes" for the virtual currency question on page 1.

Spending the loan proceeds

Spending the money received is also not a taxable event. You can spend your money on anything you want. However, remember that if you don't pay the loan, it will lead to a taxable event.

Interest charges on cryptocurrencies

Crypto lending platforms impose an annual interest rate for lending money against your cryptocurrency. This rate is around 5%. Tax interest charges may be waived if you use the loan income for business or investment purposes.

Investment objectives include investing in loan funds to buy other cryptocurrencies or invest in traditional assets, such as securities and stocks. In this respect, the interest expense on the cryptocurrency loan is deductible from your tax return as an investment interest expense on Form 4952.

A business purpose would be a situation where the loan proceeds are invested in a rental property or a going concern to make a profit. Here, the interest charges on the crypto loan are deductible from the corresponding company's tax return.

Please note that if you are using crypto loan funds to cover personal expenses, such as food, furniture, or a car, the interest will not be deductible.

Repaying the cryptocurrency loan

Generally, loan repayments and guarantees are not taxable. Continuing with the example above, suppose John returned $40,000 to the lending platform and received 1 BTC, which he deposited. This is not a taxable event for him, even though the price of BTC has increased in value while it was blocked as collateral.

As you can see, when handled as properly, crypto loans are tax-free. That being said, the IRS could technically argue that cryptocurrency loans are taxable because cryptocurrencies like bitcoin are not considered fungible like fiat. However, the chances that cryptocurrency loans will be treated in this way are out of the question.

When should you pay the crypto loan tax?

There are certain situations in which you could have a tax debt related to a crypto loan. First, if you don't repay the loan, the platform will put up your collateral to cover your losses, thus creating an involuntary tax account for you. Suppose John decides not to pay off the $40,000 loan, and on this day, BTC is trading at $41,000 per BTC. If so, the platform can liquidate John's BTC by subjecting him to a capital gain of $40,000 ($ 41,000 - $1,000). Therefore, defaulting on a loan with cryptocurrencies is not a way to withdraw money without paying capital gains taxes.

Secondly, you could also face a collateral deal if the price of bitcoin falls below a certain limit set by the lending platform. To avoid taxes and liquidation, you will need to add additional collateral or cancel the loan.