Cryptocurrency lending and borrowing have become popular as a result of the rise of stablecoins and DeFi platforms. From the fiat world, borrowing and lending dollars don’t typically result in any taxable events.
How Fiat Loans Function
Before we dive into assessing crypto loans, it’s important to understand two important ingredients that make fiat loans non-taxable: fungibility of USD & yield of the same precise collateral in loan settlement.
Government-issued money like USD is considered fungible. This implies every dollar bill is equal, identical, and synonymous with any additional dollar bill. Because USD is fungible, you’re deemed to be paying the exact dollar bills you borrowed in the loan initiation. That is why receiving loan proceeds from a personal, credit card or student loan or repaying the loan in USD are tax neutral.
In the case of property-backed fiat loans (car title loans & gear loans), as long as the lender yields the exact same exact collateral debtor deposited in the loan initiation, there is absolutely no tax implication. This is actually true with almost all fiat asset-backed loans. For instance, if you receive a $5,000 title loan after collateralizing your 2005 Honda Civic, at loan repayment, the lender will give back your same exact vehicle. Obtaining anything other than your precise car could cause a taxable event.
Technically speaking, crypto loans don’t meet with the fungibility and yield of the specific same collateral standards which shield loans from taxation as stated above.
First and foremost, cryptocurrencies are treated as”land” an IRS 2014-21 and most land is not fungible, unlike the US dollar. Each unit of cryptocurrency differs from each other. Moreover, at the loan settlement, the borrower is not getting the exact same precise cryptocurrency he/she deposited initiation. Both of these factors could convert generally tax neutral loan trades into taxable sale transactions in the crypto world.
By way of instance, let’s say you bought one ether (1 ETH) for $200 in January 2020. In April 2020this 1 ETH is worth $1,000 in order to place this as security on a DeFi stage and get $500 USDC. Back in May 2020, once you repay the loan, you are not getting back the precise 1 ETH you deposited in the loan initiation in April because the land isn’t fungible such as the US dollar along with also the stage most likely has used this unit of ether to provide liquidity to other users. Therefore, this could be regarded as a sale of your original ether and result in $300 profits ($500 — $200).
Likewise, lending one house and getting anything else other than the original property in loan settlement might be considered a sale of the first property (as opposed to placing it as collateral, which is nontaxable)
That said, in the DeFI world, when you use cryptocurrency for loan transactions, the parties included a plan to use them as a fungible asset such as the US buck. However, if the IRS will agree with this therapy or not remains a question. In fact, the IRS hasn’t issued any guidance on how cryptocurrency loans should be taxed.
From the absence of crypto loan special advice, there are several best practices you can follow to make a solid case for fungibility and non-taxability. For starters, be sure that you record that involved parties are handling the transaction as a loan, not as a sale. Further, loan records could have a necessity to return the collateral in the exact same cryptocurrency (if possible) supplied to the creditor to maintain fungibility criteria and avoid getting taxed as a sale.