Crypto Loan Tax Regulation Overview — For those with brass balls
Note: If you like paying your taxes and funding the state, read no further.
This is not the place for you.
In DeFi, it is common practice for users to deposit cryptocurrency to a lending platform and use that as collateral to take out a loan in a different cryptocurrency, or in some cases, in the same cryptocurrency as the collateral.
The objective of taking out a loan in the same currency as the collateral will depend on the specific situation and may include, among others, liquidity mining (i.e. depositing collateral and taking out a loan on a platform with the objective of acquiring tokens or other forms of economic return).
Whatever the user’s objective may be, the economic substance of such a lending/loan transaction is clear; it is a loan and not a sale of a cryptocurrency.
Whether the U.S. Internal Revenue Service (IRS) or other tax authorities will agree with this treatment is unclear.
Tax authorities have not issued any guidance on how cryptocurrency loans should be treated for tax purposes.
In the absence of clear guidance, one needs to take a tax position considering the substance of the transaction, which should reflect the intent of the parties involved in the transaction with reference to relevant tax codes or precedence on similar transactions.
In the following sections, we will present an argument that we believe reflects the intent of most DeFiers using lending platforms.
If you want to play it safe and pay taxes on your crypto loans, stop reading this article.
This is not for you.
If you are looking for professional tax advice, this is where you should close the screen.
This is also not for you.
If you are sick and tired of ridiculous tax regulations, whose only objective is to take money out of the hands of hard working citizens.
If you believe that crypto loans should be treated the same as a dollar loan.
If you have balls of brass to stand up for what you think is right and put that on your tax return, read on!
What is a taxable event?
A taxable event is an action that triggers a gain or loss for tax purposes. The following are listed as taxable events in the IRS guidance of 2014:
- Trading cryptocurrency for fiat currency like the US dollar
- Trading cryptocurrency for cryptocurrency
- Using cryptocurrency for goods and services
What is not a taxable event?
The following are listed as not being a taxable event in the IRS guidance:
- Donating crypto to a qualified tax-exempt charity or non-profit
- A wallet-to-wallet transfer
- Buying cryptocurrency with USD
How about taking out a loan in crypto?
The IRS guidance does not state or infer that taking out a loan in crypto is a taxable event.
In most situations, taking out a loan in fiat currencies is not considered a taxable event.
Some tax professionals and legal experts take the view that a crypto loan would be deemed a sale or exchange of property and not a loan.
However, most in the DeFi space would agree that this is absurd.
If one takes this position (that crypto loan is essentially a sale or exchange of property), all crypto loans taken out on BlockFi, Compound, MakerDAO, and other DeFi platforms would all be considered a sale or exchange of property, triggering capital gain taxes on unrealized gains.
We believe that this treatment does not represent the intention of the users nor the economic substance of the transaction.
They should be treated for what they are — just simply a loan.
If you agree, continue reading!
Short quiz
Just to confirm we are on the same page so far:
Q1: I converted ETH to BTC, would this be considered a taxable event?
A1: Yes, this would be considered trading a cryptocurrency for a different cryptocurrency and therefore a taxable event
Q2: I converted WBTC for BTCB, would this be considered a taxable event?
A2: Yes, this would be considered trading a cryptocurrency for a different cryptocurrency and therefore a taxable event. WBTC and BTCB are both representations of BTC. However, because they are technically different cryptocurrencies (i.e. different blockchains) and have different risk and return attributes, in our view, they are different cryptocurrencies.
Q3: I borrowed stable coins using ETH as collateral using a DeFi lending platform, would this be considered a taxable event?
A3: As mentioned above, there is no clear answer. Our current view is that this is a loan transaction and hence NOT a taxable event. Having said that, each and every case is unique and should be evaluated accordingly.
For example, in the case of Compound, when you deposit ETH to Compound, you receive cTokens. In other words, an exchange of tokens (ETH to cToken) has occurred. If you focus on the technicality of the transaction, this could be viewed as a “trade,” a taxable event.
How about in the case of MakerDAO? It gets a little more complex.
In the case of ETH, when ETH collateral gets deposited to the contract, it is converted into WETH. Though the risk attributes of ETH and WETH are pretty much identical, they are technically different tokens. Therefore, one could argue that a trade has occurred and therefore a taxable event.
In the case of ERC20 tokens, there is no conversion of tokens when depositing collateral. This case is analogous to a normal fiat currency loan, and therefore should be treated as such (i.e., not a taxable event).
In the case of Tax Heaven, there is no conversion of tokens when depositing collateral to the platform. This is the case for all tokens (ETH, ERC20, BNB, BEP20). There is an accounting entry that is recorded on the blockchain that represents your right to the collateral and also a numerical representation (i.e., units) of how much of the collateral is redeemable.
As you borrow from the platform, units of redeemable collateral decreases. As you use up your credit line, your collateral units will eventually reach zero, however, your right to the collateral is not eliminated in the system.
This would be the case if you took out a traditional loan; your right to collateral is effective, as long as you have not violated the terms of the loan agreement. As you repay the loan, the units of the redeemable collateral increases.
If you violate the terms and conditions of the loan and your collateral factor should exceed 100% at anypoint, Tax Heaven will liquidate your entire collateral and apply that to your outstanding debt. This is a faithful representation of the terms and conditions of a loan between the user of Tax Heaven and the Tax Heaven protocol.
It is clear that this is analogous to a normal fiat currency loan, and therefore should be treated as such (i.e. not a taxable event).
Q4: I bought a non Binance Smart Chain (BSC) token on Binance.com and withdrew them to BSC as a BEP-20 token. Is this a taxable event? How about if I had the same non BSC token in my wallet, sent them to Binance.com and then withdrew them to BSC?
A4: If you used cryptocurrencies to buy that token on Binance.com, that will be considered a taxable event. At this point, you do not own a cryptocurrency. What you have is an IOU against Binance to deliver that cryptocurrency to you. If you buy a non BSC token and withdraw that currency to BSC, all you are doing is withdrawing what is yours. The act of withdrawing that token to BSC should not be considered a taxable event. On the other hand, if you already owned a non BSC token in your wallet, sent that token to your Binance.com account, and then withdrew that to BSC, what you have done is converted a non BSC token to a BEP-20 token. This would likely be considered a taxable event.
Q5: I converted ETH to WETH, would this be considered a taxable event?
A5: To be consistent with the rationale that we’ve been applying so far, this would technically be considered a cryptocurrency to cryptocurrency trade. ETH and WETH are technically different token contracts and have different risk attributes (the difference is immaterial however). Therefore, this would likely be considered a taxable event.
Can I segregate “borrowed” assets from the rest of my portfolio when selling?
Segregating borrowed assets from the rest of your portfolio when calculating the cost basis of your assets might pose a challenge.
After all, an asset in your control would constitute part of your inventory, whether you borrowed it or not.
This would not be an issue if you didn’t have existing inventory of the token you are borrowing.
If you have existing inventory of the token you are borrowing, you would adjust the cost basis of your token inventory to reflect the market value of that token when you borrowed it.
There may be two ways to circumvent this situation.
One is to eliminate the existing inventory of the token you are going to be borrowing by lending the entire token balance to the Tax Heaven protocol and then borrowing.
Technically from a cost accounting perspective, that should bring the cost basis of the token in your possession to the current market value.
Selling that token immediately in the market would be considered a taxable event but your cost basis would closely resemble that amount, resulting in minimal gains or losses.
Another possible solution is to use specific identification where permitted.
By specifying which specific token is subject to a transaction, one should be able to designate the borrowed token as the token applicable to the sale.
How is Tax Heaven different from Compound or MakerDAO?
If you’ve made it this far and agree that crypto collateralized loans should be treated as loans and not as a taxable transaction, let’s take it one step further.
Compound and MakerDAO are both effective ways of monetizing a crypto position without triggering a taxable sale.
However, both platforms have a relatively low collateral ratio that has to be maintained in order to carry the loan position.
This is where Tax Heaven shines.
With Tax Heaven, the collateral ratio is set at 100%.
Interest is paid upfront as a loan origination fee and the cost to carry the loan is currently 0%, considering the zero/negative interest rate policies of governments and central banks around the world, actual bond yields, among other things.
In short, you can monetize a larger amount of your collateral compared to using Compound or MakerDAO.
And as a bonus, you can get TAX tokens!
Summary
You think it is a loan, we think it is a loan.
The technicality of the transaction that occurs on the blockchain is analogous to that of a loan.
All parties involved in the transaction agree that it is a loan.
The tax treatment should be of one that honors the spirit of the transaction, not the pockets of the tax man.
We have done our best to document the rationale behind the tax treatment that we think best represents the objective characteristics of a transaction on Tax Heaven.
We are not tax experts and can not state that we have complete knowledge of the tax regulations (it is so convoluted and scattered all over the place, in other words dirty) .
If you think there is faulty logic, rather than to criticize, let us know how we can improve it so that the argument becomes more robust.
Just stating that the argument won’t fly is not adding value to anyone, and the only assessment that we can make of you is that you are in favor of tax treatments that benefit the state and not the average Joe.
Let’s fight this uphill battle together!
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