Are you considering obtaining a crypto loan or lending your crypto to generate interest, or have you already engaged in such activities? Regardless of whether you are borrowing or lending, it is crucial to comprehend the tax consequences associated with crypto loans to avoid confusion regarding your tax obligations at the end of the year.

Receiving a crypto loan

When you receive funds by using cryptocurrency as collateral, this transaction is not subject to taxation. This is akin to securing a loan by offering equity shares as collateral.

Utilizing crypto loan proceeds

Using the cash obtained from crypto loans is also not taxable. However, if you fail to repay the loan, this situation will trigger a taxable event due to the emergence of cancellation of debt (COD) income.

Lending crypto to generate income

The tax implications of lending cryptocurrency differ based on whether you do so on a centralized or decentralized exchange.

Lending crypto on a centralized exchange such as Fulcrum does not incur taxes, as there is no disposal of crypto assets involved. When you lend your cryptocurrency, you do not receive any tokens in return, which contrasts with the process on decentralized exchanges.

In contrast, decentralized exchanges have tax implications because the loan results in a crypto-to-crypto exchange. For instance, if you lend your cryptocurrency on a DeFi platform like Aave or Compound, your crypto becomes part of a liquidity pool. Upon depositing your cryptocurrency into this pool, you receive a distinct token that signifies your ownership stake. The IRS considers crypto-to-crypto transactions as disposals, meaning that the act of receiving aETH in exchange for lending ETH on Aave may be taxable. Additionally, lending cryptocurrency on a decentralized exchange may incur either income tax or capital gains tax, depending on the specific platform and its operational mechanics.

Interest on crypto loans

Interest payments made on the loan can be deducted as an expense on your tax return if the loan proceeds are utilized for investment or business activities.

Repayment of the Crypto Loan

When an investor repays the loan amount and retrieves their collateral, this transaction is not classified as a taxable event and therefore does not incur any taxes.

Failure to Repay the Loan

If the loan is not repaid within the designated timeframe, the platform has the authority to liquidate your assets to recover the outstanding loan amount along with any accrued interest. This liquidation will be regarded as a disposal of assets, resulting in a capital gains tax obligation.

Collateral Liquidation

Liquidation takes place if the value of the collateral drops below a threshold established by the platform. In such cases, the liquidation will be considered a disposal of assets, triggering capital gains tax. For instance, if the price of Bitcoin falls below $12,000, the platform will liquidate Andrew’s collateral, leading to a capital gain of $11,000 ($12,000 liquidation price minus $1,000 purchase price). Consider that liquidation is a rare event and it is advisable to maintain sufficient collateral to prevent liquidation events.

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