By: Sharon Yip, CPA
More and more crypto exchanges, such as Coinbase, Binance, BlockFi, and Nexo.com offer crypto loans. You can borrow money at an interest rate usually much lower than what you would have to pay to a bank for personal loans, by using some of your cryptocurrency as collateral. That way, you can keep your crypto for long-term holding. But if the coin being used as collateral drops in value, the exchange may liquidate some of it to maintain the required loan-to-value (LTV) ratio.
Borrowing money is usually not a taxable event. If it’s a personal loan, the interest you pay for the loan is not tax-deductible unless it qualifies as investment interest. The situation gets complicated when you use the loan proceeds to buy crypto, later sell that coin for a gain or loss. It’s very important to understand the tax implication of each step in the sequence.
Example: Borrowing 9,000 USDC with 1 BTC as collateral when its price is $27,000
James borrowed $9,000 worth of USDC in December 2020 by using 1 BTC as collateral when the BTC price was $27,000. He bought the BTC 13 months ago and his cost basis in the BTC was $8,000.
James sold the 9,000 USDC in January 2021 for 10 ETH when the ETH price was $900. Since USDC is a stable coin, this is treated as if he’s using USD to purchase ETH, and no capital gain or loss needs to be recognized. His basis in the 9,000 USDC is $9,000 because he’s on the hook for repaying the USDC to the lender. He gets a basis from this liability.
James sells the 10 ETH in June 2021 for 18,000 USDC and repays his 9,000 USDC loan for a total of $9,360 (principal + interest at 8% per annual). He will need to recognize a short term capital gain in the amount of $18,000 – $9,000 = $9,000.
His tax liability = $9,000 x ordinary income tax rate (e.g. 35%) = $3,150
His total cost = $3,150 (tax) + $360 (interest payment) = $3,510
His reward = $18,000 – $9,360 = $8,640 USDC after loan repayment, plus his 1 BTC which is now worth $50,000.
As you can see, the USDC James ends up with is $8,640 and he has to pay $3,150 in taxes. That gives him a net benefit of $5,490 (= $8,640 – $3,150) in USDC, and he’s keeping his BTC intact the whole time.
This example illustrates the benefit of using crypto loan in a bull market. In a market downturn though, the situation will be completely different. Please do your research and proceed with caution if you decide to take out a crypto loan.