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Bitcoin-backed loans and taxes : What you need to know

Unchained
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First published: 09/11/2018
| Last updated: 02/22/2023
| -- min read

Recent years have seen significant growth in the prices of bitcoin. If you’re like a lot of investors, you’ve both bought and traded, and hopefully gained from each strategy. But with gains come taxes. Paying taxes on your bitcoin gains can be a frustrating and confusing process. The lack of clarity from the IRS has left investors, as well as CPAs and other professionals, in “tax limbo.” In fact, there has been no new guidance on how taxes on cryptocurrency will be treated since 2014.

One tool that can help manage bitcoin tax liabilities is a secured loan. Borrowing against your bitcoin provides you with the cash you need now while allowing you to postpone realizing potential gains in the future. Tax attorneys Robert Wood and Dashiell Shapiro of Wood LLP say they have seen an uptick in clients asking about bitcoin loans as a way to generate cash without triggering current taxation. But they stress that the details and documentation are really important.

To promote the distribution of good information related to taxes and lending, we have built relationships with bitcoin tax experts throughout the United States to answer some of the most common questions.

Deadline approaching

With the tax and extension deadlines right around the corner, we wanted to lay out some of the questions you should be considering regarding lending and taxes.

What tax questions should I be considering?

Why should I take a bitcoin-backed loan instead of selling my bitcoin holdings?

To answer this question, we consulted with Daniel Winters of Global Tax, LLC.

“Crypto investors have unique challenges concerning their taxes, especially long time HODLers. For an early investor interested in generating USD from their assets, selling highly appreciated crypto at the preferential long term capital gains rate seems an obvious choice.

However, this is a complex decision. At higher income levels, the federal long-term capital gains rate is 20%, plus an additional 3.8% for total 23.8%. When you add state income taxes, the total tax bite can easily reach 30% or higher. In this scenario, an investor with $1,000,000 long term capital gain may end up with only $700,000 after taxes. In essence, the bitcoin HODL investor has a 30% cost of capital to cash out to USD. That is huge.

Even worse, in some cases, the investor may actually need to sell additional bitcoin assets to cover the cash USD taxes due on the original capital gain. Now the investor has even more tax to pay, because they have new capital gains from selling bitcoin to pay the taxes on the original sale. Madness!

So, what’s the good news? Well, borrowing against bitcoin assets is not a sale, thus no tax is due on the transaction. The investor can therefore borrow USD against their bitcoin, continue to HODL and pay less in interest than the taxes on the capital gains.”

What are my tax liabilities when taking out a loan backed by my bitcoin?

In traditional lending, if you use an asset (like your home) as collateral for a loan, the IRS does not claim that you have “sold” your asset, so you are not subject to capital gains that a sale might trigger. This is why taking out such a loan is “tax neutral” with respect to the collateral. Even if the value of your home has increased, using it as collateral for a loan is not a “sale,” and you therefore are not required to pay capital gains taxes at the time of the loan. (However, if a lender relieves you from the obligation to repay your principal balance, you would be required to pay income taxes on the amount of the relief.)

In the bitcoin lending space, the IRS has not given explicit guidance, but the treatment of bitcoin-backed loans will likely be analogous to traditional lending. In March 2014, the IRS stated that virtual currencies should be treated as property for tax purposes. As with traditional lending, the use of property as collateral should not be considered a sale. Therefore, borrowing against your bitcoin would not trigger capital gains taxes.

Are my loan interest payments tax-deductible?

The IRS has yet to issue specific guidance surrounding interest payments in bitcoin lending. However, we can begin to get a better idea for how they may be treated by once again looking at traditional lending. To understand whether 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. For more information on whether an investment interest expense is tax deductible, consult this article.

What are the tax implications if Unchained sells my collateral, such as during a margin call?

During a margin call, borrowers can choose to either deposit additional collateral, pay down their principal with a wire transfer or submit a request to surrender collateral to pay down principal (liquidation) to re-adjust their collateral-to-principal ratio to required levels.

In the case of a forced liquidation event, which occurs when a borrower has not responded to a margin call and the value of their bitcoin collateral has fallen below the required minimum collateral-to-principal ratio, Unchained would be forced to foreclose, take possession of and sell your bitcoin to restore the collateral-to-principal ratio. This would be treated as a property sale for income tax purposes, and you may be liable for capital gains tax.

What if the bitcoin I put up as collateral is not the same the bitcoin I receive back at the end of my loan?

This is an important question that bitcoin investors may fail to consider, as many view bitcoin to be a fungible currency. the IRS has classified digital assets as property, not currency. In a property loan, if the property you receive at the end of the loan is not the same as the property you pledged as collateral, a taxable event may have occurred. For example, suppose you borrowed money using your real estate property as collateral, and at the end of the loan, a different property was returned to you by the lender. Even if the property that you pledged and the property returned were of the same value, the sale or exchange of the property during the loan may trigger capital gains for you.

When Unchained makes a loan, we create a unique and dedicated collateral address for each customer. We do not mix deposits made by customers, and we do not use your bitcoin for any other purpose than as for collateral for your loan. Since these dedicated addresses can be monitored on the blockchain, a borrower can verify that the bitcoin deposited as collateral is the bitcoin returned to the borrower at the end of the loan term.

For additional information on your bitcoin taxes, see this letter put out by the American Institute of Certified Public Accountants to the IRS that provides some answers to bitcoin investors’ frequently asked questions.

Contact a tax professional

Have more questions? You should contact a tax professional. Below is a list of tax professionals we know and trust.

If you are a tax professional looking to connect with us, we’d love to hear from you! Reach us at hello@unchained.com.

Unchained Capital does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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