As the value of cryptocurrencies plummeted in 2018 after hitting a high in late 2017, crypto investors began to look for options they could use to convert their investments to cash – for example, providing cryptocurrency as collateral for loans. This alternative, however, comes with several potential tax consequences for both borrowers and lenders.
The IRS on cryptocurrency
The IRS last weighed in on cryptocurrency – or, as the agency dubbed it, “virtual currency” – in March 2014 when it issued Notice 2014-21. This guidance describes how existing general tax principles apply to transactions involving virtual currency.Notice 2014-21 defines such currency as a “digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” It cites bitcoin as an example of “convertible virtual currency” that “can be digitally traded between users and can be purchased for, or exchanged into, U.S. dollars, euros, and other real or virtual currencies.”1 According to the notice, virtual currency is treated as property for federal income tax purposes.
Despite the lack of additional formal guidance, the IRS has intensified its scrutiny of transactions involving cryptocurrency.
The growth of crypto-based loans
Cryptocurrency investors are turning to lending primarily for liquidity reasons – by putting up cryptocurrency as collateral, they can continue to invest in the crypto market while also obtaining access to cash. Thus, their investments need not sit idle.This strategy generally also allows them to avoid taxation because borrowing against an asset does not constitute a sale, so no taxable event occurs. And, of course, simply selling their crypto investments could generate substantial capital gains liability.
Potential taxable events on crypto-backed loans
That is not to say that crypto-backed loans are without the risk of taxation. For example, a taxable event could occur in the case of a margin call. The value of cryptocurrencies is notoriously volatile, and a drop in value could lead to foreclosure if the borrower cannot meet a margin call by depositing additional collateral or paying down the loan to meet the requisite loan-to-value ratio.A collateral swap also might trigger a taxable event. Some crypto lenders receive collateral and then relend it. If the original borrower does not recover the same pledged collateral it submitted, the transaction could be considered a taxable sale.
General tax consequences for lenders and borrowers
Crypto-based loans largely resemble traditional loans in terms of general tax treatment, as follows:
Interest income and expense
Lenders: Interest income on crypto-based loans is deemed ordinary income for the lender. The lender will need to determine the fair market value (FMV) of the cryptocurrency in U.S. dollars as of the date of receipt, which can prove challenging. Notice 2014-21 allows any “reasonable manner” for determining FMV, but the IRS has provided little additional guidance. Moreover, the value changes depending on the market index – no uniform price is available. Ultimately, the most important consideration for lenders is to select a measure and use it consistently.
Borrowers: For the borrower, the deductibility of the interest expense will depend on how the loan proceeds are applied:
- If the loan proceeds are used by individuals to purchase investments such as stocks and bonds, the interest is deductible to the extent of net investment income. Any excess is carried forward and offset against net investment income in the future tax years.
- If the loan proceeds are used to produce tax-exempt income, the interest generally is not deductible, although certain exceptions might apply if the borrower is a financial institution.
- If the loan proceeds are used as part of a trade or business, the deduction generally is limited to 30% of earnings before interest, taxes, depreciation, and amortization per IRC Section 163(j). Certain exceptions apply for businesses with floor-plan financing income.
Foreclosure
Lenders: When a crypto-based loan is foreclosed, the lender likely can claim a bad-debt deduction on the loss as an uncollectible loan, subject to reporting on Form 1099-A, “Acquisition or Abandonment of Secured Property.” Again, the lender will need to determine the FMV of the collateral in U.S. dollars as of the date of foreclosure.
Borrowers: For the borrower, the foreclosure will be treated as a sale for tax purposes. The nature of the gain or loss depends on how the pledged asset was held in the hands of the borrower. If it was held as an investment, the gain or loss is capital; if it was used in a trade or business, the gain or loss is ordinary.
Risks remain
Although crypto-based lending has become more prevalent, it is not without risks. The IRS has not provided any guidance on the activity, and lenders mostly are unregulated. Hackers could attack a lender, causing a permanent loss of collateral, and price volatility could prompt margin calls. Parties interested in exploring the area – whether as lenders or borrowers – must keep these concerns in mind.
1 Notice 2014-21, IRS, April 14, 2014, https://www.irs.gov/irb/2014-16_IRB#NOT-2014-21
