If you are sitting on appreciated crypto with large unrealized gains, taking out a crypto loan could be a very lucrative way to get some cash while avoiding taxes on capital gains, however, you must understand the risks before you take out a crypto loan.
Imagine this scenario, you purchased 10 Bitcoin back in 2020 for $6,000 each ($60,000 total), and today that is worth about $650,000. You know that Bitcoin is the best store of value, and as such, you don’t want to sell your Bitcoin because you know that it will keep increasing in value. Suppose you also want to buy a house. If you sell your Bitcoin you will have a $590,000 capital gain to pay tax on – depending where you live and on the rest of your tax situation, you will be paying anywhere from $100,000 to over $200,000 in income taxes, which means you’ll already have much less. Not only that, but what if Bitcoin does go to $1 million in the future as many are predicting? Well, hope you bought some more!
If you take a loan on your Bitcoin on the other hand, you could buy the house, pay the loan back (similar to how you would pay back the mortgage) and once the loan is paid back, you have your Bitcoin back. Not only did you not pay taxes on the loan, but now if Bitcoin does go to $1 million, you still have your Bitcoin! Obviously you’ll have to overcollateralize the loan, so you won’t be able to get 100% of the value in your loan, but you also only pay back what you borrowed.
Another advantage is due to the inflation that we have seen around the world. Since most loans are denominated in fiat currency (or stablecoins), as fiat currencies continue to see inflation, each payment is getting cheaper in terms of real value. This is while the Bitcoin that you still own continues to appreciate – you don’t pack back anymore on the loan but once you repay the loan, you get the rewards of the appreciation of the asset. Because of today’s highly inflationary environment, this type of transaction makes a lot of economic sense provided that Bitcoin and other cryptocurrencies continue to act as inflation hedges.
We are all assuming that we get to pay no income taxes on the Bitcoin loan. But what if the IRS or other tax authorities decide otherwise? You see, lending of crypto assets, depending on how the loan is structured, could be viewed as a sale. Why? You are technically exchanging one asset for another asset, and currently cryptocurrencies are treated as property, which complicates the matter as established law recognizes a loan for tax purposes as an obligation to pay money, not property. Is this likely? Depends on what happens next with crypto tax law, which is still under construction.
If you are extremely risk averse and don’t want the possibility of taking a loan that a tax authority says is taxable, you should stay away from crypto lending. However, if you understand the risks associated with taking a tax position in uncharted territory, then the outcome is certainly a lucrative one providing the cash flow and letting you keep your crypto. But remember, keep enough cash on hand in case tax authorities decide they will go after lending. This would be a highly unpopular policy within the crypto community which continues to grow and bring more smart money with a voice, so perhaps that will suffice to ensure the future of crypto tax policy. However, remember that we are in uncharted territory and understand the risks.