Do I Need to Pay Taxes on Crypto Loans?
Are you curious about how your cryptocurrency loan is taxed?
Even seasoned investors may find cryptocurrency taxes difficult to navigate. Because crypto is a new asset class, the IRS has yet to provide clear guidance on several typical transaction types, including loans.
In this article, we’ll go over everything we know about how cryptocurrency loans are taxed — whether you’re using a centralized or decentralized service. We’ll also discuss some gray areas in the tax code and break down several ways to report your debts.
What are cryptocurrency loans and how do they work?
Some investors hold a large portion of their net worth in crypto assets. Though they may need to withdraw some of their holdings for personal use, they are reluctant to sell their cryptocurrency and incur a taxable event.
Investors frequently use their cryptocurrency as collateral to borrow funds instead of selling their assets. They can get cash for personal use without having to sell their cryptocurrencies by doing this.
Is it true that crypto loans are tax-free?
By the IRS, loans have been considered nontaxable for years. It’s reasonable to assume that cryptocurrencies will be treated in the same way as other non-interest bearing financial instruments.
However, there are certain uncommon situations where borrowing cryptocurrency may result in a taxable event.
There are many gray areas in the tax code.
Some decentralized payment systems utilize crypto-to-crypto exchanges to help individuals obtain loans. If you put ETH as collateral for a platform like Compound, you’ll be given cETH in return.
Previously, the IRS has declared that crypto-to-crypto exchanges are a taxable occurrence. However, it’s unclear whether this exchange would be classified in the same manner.
Because this is a gray area in the tax code, some investors choose a conservative approach of reporting these kinds of loans on their tax returns, while others take a more aggressive stance.
A conservative approach would be to consider the swap as a taxable occurrence. Depending on how much your collateral has appreciated since you first acquired it, incur capital gains or losses.
Non-aggressive method: Treat this swap as a tax-free loan and do not submit it to the IRS.
Are crypto loans considered tax-deductible?
While the IRS has yet to issue regulations on whether crypto loan interest payments are deductible, they will most likely be treated similarly to conventional loans.
A loan repayment may be treated as a tax-deductible business expenditure if a firm takes one out.
If the loan is taken for personal reasons, interest payments are generally not deductible. Using loan funds to pay for tuition, food, or vehicle bills is an example of this.
In most cases, the interest paid as a result of taking out an investment loan is deductible. For example, if an investor uses the funds they receive from a loan to invest and deducts that amount from their total investment income in one year, the interest expense will be treated as investment interest expense and is deductible up to their total investment income that year.
However, it’s crucial to remember that any profits you make from investment loans are taxable as capital gains or personal income, depending on the nature of the transaction.
What are the tax consequences of crypto loan liquidations?
If the value of your collateral drops significantly, some protocols may liquidate it. In this instance, a disposal event is considered, and you will be liable for tax even if you do not receive the money from the sale.
How are self-repaying crypto loans taxed?
Alchemix and others provide “self-repaying loans.” These protocols keep your collateral in yield generation methods to generate money and pay back your loan over time. In this example, because your loan repayments would be seen as debt cancellation income, you will probably have to pay income tax on them.