Thanks to DeFi platforms and Stablecoins, more people are lending and borrowing using some form of cryptocurrency. Blockchain platforms like Chainlink that uses smart contracts have helped with cryptocurrency loans. But can you be taxed on a cryptocurrency loan? That depends.
Fiat Currency Loans And Cryptocurrency Loans
When you borrow or lend in fiat currency, it does not trigger what is known as a taxable event. But cryptocurrency is considered property by the IRS. When you lend or borrow using a cryptocurrency, it could result in what is deemed to be taxable income. So, what is the difference?
Fiat loans are non-taxable because of the fungibility of the American dollar and the fact that you get your collateral back when the loan is settled. Every dollar bill is equal and interchangeable to the next dollar. When you take out a property-backed fiat loan – such as a car title loan – you get the same collateral back that you put up for the loan when the loan is paid off. So, if you use your 2010 Dodge Ram as collateral on a $5,000 title loan, you get your 2010 Dodge Ram (or its title as typically titles are held instead of the physical truck) back when you pay off the loan. The same goes for personal, credit card, and student loans. They are tax neutral and do not trigger a taxable event.
Cryptocurrency loans, however, do not meet the fungibility requirement and they do not return the same collateral as fiat loans. Cryptocurrency is considered property and each unit is different from the other. Since the borrower is not getting back the same currency as they deposited at the initiation of the loan, it triggers a taxable transaction.
For example, a borrower purchases one ether (1 ETH) for $200 in January 2020. In April, 1 ETH is worth $1000. They use it as collateral for a loan on a DeFi platform and receive $500 USDC. The 1 ETH worth $1000 was used to provide liquidity to other users during the life of the loan. The IRS looks at that 1 ETH as if had been sold and the borrower didn’t receive the same 1 ETH back when the loan was repaid.
Cryptocurrency Borrowing And Lending
What makes borrowing and lending using cryptocurrency interesting is that all parties involved tend to use the cryptocurrency in loans, as if they were fungible assets. It is still up to the IRS to determine whether or not they can be treated this way, and if the money is considered taxable. So far, the IRS has not issued any guidance on how cryptocurrency loans should be taxed if they are taxable.
Anyone involved in a cryptocurrency loan should follow best practices to ensure that the loan is considered fungible and non-taxable. Those best practices include:
• Clear documentation stating that both parties view the transaction as a loan and not a sale
• Requirements that the collateral be returned to the borrower in the same cryptocurrency provided to the lender to preserve fungibility and not be considered a sale