How Taxes Work - Crypto Loans, DeFi, and Margin Trading
Cryptocurrency lending markets and other “decentralized finance” (DeFi) services have exploded in popularity over the past couple of years. Cryptocurrency loans contain some unique features and have different tax implications separate from simply buying, selling, and holding cryptocurrency. This guide discusses the tax implications for these new types of cryptocurrency financial services.
For more information on how cryptocurrency taxation works in general, checkout our Complete 2019 Guide To Cryptocurrency Taxes.
What Is DeFi?
Decentralized finance—DeFi for short—is what the Ethereum community calls financial smart contracts, decentralized applications (DApps), and protocols built on Ethereum. Popular DeFi products include decentralized exchanges, lending and borrowing markets, tokenized physical assets such as gold, derivatives, prediction / betting markets, payment networks, insurance, etc.
Because DeFi seeks to eliminate many of the “middlemen” associated with traditional lending markets, users of these crypto lending and defi platforms typically see beneficial interest rates and borrowing options. Interest rates on a holders cryptocurrency can offer an attractive passive income stream for investors.
Some popular DeFi products and platforms include MakerDAO and its associated stable coin DAI, Compound, Uniswap, and Augur. All of these platforms operate using Ethereum smart contracts and do not require a central authority to run. Users of these products receive various benefits including interest payments from their cryptocurrency colateral. These interest payments are a form of taxable income. More on that later.
Outside of the world of DeFi and Ethereum, a number of centralized companies offering crypto lending products have emerged. Companies like Nexo, BlockFi, and Salt give cryptocurrency investors an easy way to deposit and earn interest on their crypto. They also provide a variety of options for taking out loans using your crypto as collateral.
Checkout our complete guide to learn about the best companies for crypto backed loans.
The Tax Implications of DeFi and Cryptocurrency Lending
Lending your crypto in return for interest
Any cryptocurrency that you have not expressly bought may be deemed as Income and be subject to income tax. This includes income earned from the interest on your cryptocurrency deposits/collateral. Such income should be reported under the “other income” section of line 21 of Schedule 1 — Additional Income and Adjustments to Income as part of your income tax return.
In this sense, receiving interest in crypto is treated similarly to mining cryptocurrency for tax purposes. You need to determine whether you are operating as a business or as a hobby and file your income accordingly. The amount of income to recognize should be the associated USD fair market value of the cryptocurrency interest at the time you received it.
Because cryptocurrency prices fluctuate dramatically, many miners, stakers, masternode operators, and cryptocurrency loan holders use cryptocurrency tax software like CryptoTrader.Tax to import all of their cryptocurrency income that they have received over the course of the tax year. CryptoTrader.Tax will automatically retrieve all historical USD prices and keep track of your cost basis across all of your crypto holdings.
Borrowing fiat against your cryptocurrency
Taking out a fiat loan or borrowing against your crypto assets is not considered a sale, and thus is not a taxable event. This means that you don’t pay capital gains taxes on the fiat you get from your crypto loan. Because of this, many long-term cryptocurrency holders use crypto loans to gain access to US dollars and avoid paying capital gains taxes on their crypto gains. Keep in mind, you will still be paying interest on this loan, but for many investors, the interest on their loans will be less than paying capital gains taxes.
Are my loan interest payments tax deductible?
The IRS has yet to issue specific guidance surrounding interest payments in crypto lending. However, you can get a better idea for how they may be treated by looking at traditional lending. To understand whether your interest payments are tax-deductible, it is necessary to consider whether a loan is used for personal, investment, or business-related purposes.
If a business takes out a loan for a commercial purpose, the interest is treated as a legitimate tax-deductible business expense.
If a loan is taken out for personal reasons, interest expense is usually not considered tax-deductible. However, if an individual borrows money to purchase a piece of real estate that will produce investment income, the interest they pay on their loan may be considered investment interest expense, which may be tax-deductible. This TurboTax help article discusses these investment interest deductions in more detail.
What are the tax implications if a platform sells my collateral, such as during a margin call?
It’s important to note than many crypto-backed loan agreements include a liquidation clause should the value of the collateral fall below a specific value. During a margin call, borrowers can choose to either deposit additional collateral or pay down their principal to re-adjust their loan-to-value ratio to appropriate levels.
In the case of a liquidation event, the liquidation of cryptocurrency collateral will be treated as a sale and will thus incur capital gains tax.
The Tax Implications of Margin Trading
What is margin trading?
Margin trading involves borrowing money from a cryptocurrency exchange to open a long or a short position. Once the price begins moving, you can opt to close your position and realize any gains. The difference between the opening and closing price will be your profit or loss.
Long vs. short positions
A long position is opened when you believe the price of a cryptocurrency will go up. For example, if you believe the price of BTC will go up, you borrow USD from an exchange like Kraken, use it to buy BTC and wait for the price to go up. Once the price goes up, you’d sell the BTC for USD, return whatever USD you originally borrowed, and pocket the difference.
A short position is the exact opposite and is opened if you believe the price of an asset will go down. For example, if you believe the BTC price will go down, you’d borrow BTC from the exchange and immediately sell it for its current price of USD. Once the price of BTC has dropped, you’d simply buy back the same amount of BTC that you borrowed for this new cheaper price. You’d then return that amount of BTC to the exchange and pocket the difference.
How do taxes work with margin trading?
From a tax perspective, margin trading with crypto is treated like taking out a loan from a bank to invest in property. Simply taking out the loan itself is not a taxable event. However, when you incur gains/losses when selling the property that you used money from the loan to purchase, you incur a taxable event. For margin trades, the 'selling' happens when you close a position. Any gains/losses made at that point will be realized capital gains/losses and declared in the same way as regular trades, on Form 8949.
If you paid interest on your margin trades, you can claim it as an itemized deduction. If the interest was paid using a cryptocurrency, it will also be subject to capital gains.
Using Crypto Tax Software to Automate Your Tax Reporting
Cryptocurrency tax software like CryptoTrader.Tax is specifically built to automate the entire crypto tax reporting process. Today, thousands of cryptocurrency users use the platform to import all of their cryptocurrency trades, income, and other transactions and auto-generate necessary tax reports with the click of a button. You can get started importing your transactions with CryptoTrader.Tax completely for free.
Importing Interest Income into CryptoTrader.Tax
As mentioned above, cryptocurrency received in the form of interest from your crypto loans or DeFi networks is typically treated as a form of ordinary income. The challenging part for crypto users is calculating the value of the cryptocurrency interest received throughout the year in US Dollars. CryptoTrader.Tax automatically retrieves all historical cryptocurrency prices in your home fiat currency at the time you received the income so you don’t have to.
To import your crypto interest payments info CryptoTrader.Tax, simply connect your DeFi or crypto loan platform or import a bulk CSV file of all of your interest payments into step 3 of the app (pictured below).
CryptoTrader.Tax will automatically retrieve the historical USD price at the time of each of these transactions and provide you with a complete income report for you to file with your tax return.
File Your Cryptocurrency Tax Report With Ease
Questions? Feel free to reach out to our team - we are happy to help!
Disclaimer - This post is for informational purposes only and should not be construed as tax or investment advice. Please speak to your own tax expert, CPA or tax attorney on how you should treat taxation of digital currencies.