By: Tatum Perez, Esq. and Nick J. Richards, Esq
As digital assets like Bitcoin and Ethereum become more widely adopted, taxpayers and financial advisors must navigate a complex and rapidly evolving regulatory environment, particularly regarding investing and collateralizing crypto portfolios. Below is a high-level overview of key tax considerations related to cryptocurrency, the implications of borrowing against cryptocurrency portfolios, and current developments in legislative and regulatory frameworks.
Tax Treatment of Cryptocurrency:
Under current IRS guidance, cryptocurrency is treated as property for federal tax purposes (IRS Notice 2014-21 ). This means that most transactions involving cryptocurrency, including sales, exchanges, and use in lieu of cash, trigger capital gain or loss recognition, similar to stocks or other investment assets.
Key points include:
Disposition Events: Selling cryptocurrency for fiat currency, trading one form of cryptocurrency for another, or using cryptocurrency to purchase goods or services are taxable events.Character of Gain/Loss: Capital gains may be short-term or long-term depending on holding period. Losses are generally deductible, subject to capital loss limitations.Receipt as Income: Cryptocurrency received in exchange for services (e.g., by contractors, miners, or stakers) is included in gross income at fair market value as of the date received.Recordkeeping: Taxpayers must maintain adequate records to establish cryptocurrency basis, holding period, and fair market value.
Borrowing Against Crypto Holdings
(Crypto-backed loans or Crypto Collateral Loans)
Borrowing against cryptocurrency through platforms such as Coinbase, BlockFi, or Celsius has become a popular strategy for investors seeking liquidity without incurring taxable gains. The mere act of borrowing is not a taxable event, provided there is no transfer of ownership.
However, if collateral is liquidated to satisfy a loan (such as in a margin call), that liquidation will trigger a taxable disposition. Additionally, interest payments on such loans are generally not deductible unless the borrowed funds are used for investment or business purposes, subject to applicable limitations under IRC §163(d) and IRC §163(h) .
Well-known cryptocurrencies include Bitcoin (BTC), which functions primarily as a store of value, and Ethereum (ETH), which powers smart contracts and decentralized applications.
How the Strategy Works:
Collateralization: The borrower pledges a certain amount of cryptocurrency (e.g., BTC or ETH) as collateral.Loan Disbursement: In return, the platform issues a loan based on a loan-to-value (LTV) ratio typically ranging from 25% to 60% of the collateral’s market value.Repayment Terms: The borrower repays the loan over time, often with interest. If the value of the collateral drops significantly, a margin call may require the borrower to add more collateral or face liquidation.
Tax Implications:
Non-Taxable Event at Inception: The act of borrowing itself does not trigger a taxable event, because the ownership of the cryptocurrency remains with the borrower. This is analogous to taking out a mortgage or a securities-backed line of credit.Taxable if Liquidated: If the lender liquidates the crypto collateral (e.g., due to a margin call or default), the borrower is treated as having sold the asset. This results in a taxable disposition, with gain or loss calculated based on the difference between the cryptocurrency’s cost basis and its fair market value at the time of liquidation.Interest Deductibility: Interest paid on the loan is generally not deductible for personal expenditures. However, interest may be deductible if the loan proceeds are used for investment or business activities, subject to limitations under IRC §§ 163(d) (investment interest) and 163(h) (qualified residence interest).
Risks and Considerations:
Volatility and Margin Calls: The price volatility of cryptocurrency can lead to forced liquidations and unintended tax consequences if collateral values decline quickly.Custody and Platform Risk: The borrower must trust the lending platform with custody of the assets, which can expose a borrower to platform-specific risks such as hacks, insolvency, or regulatory shutdown.Regulatory Uncertainty: The legal treatment of cryptocurrency backed loans, especially in DeFi protocols , remains fluid. Certain jurisdictions may treat wrapped assets, interest payments, or liquidation events differently for tax or securities law purposes.
Current Legislative and Regulatory Developments:
The Infrastructure Investment and Jobs Act (2021) expanded reporting requirements for “brokers,” broadly defined to potentially include decentralized exchanges and wallet providers. These 1099 reporting obligations are expected to take effect in 2025.
Ongoing litigation and regulatory action by the SEC and CFTC center on whether certain tokens are investment contracts under the Howey test . This classification has far-reaching implications for both issuer obligations and tax treatment.
Proposed legislation, including the Lummis-Gillibrand Responsible Financial Innovation Act , seeks to provide clarity on the classification, taxation, and reporting of digital assets.
Cryptocurrency remains an area of heightened IRS focus and legal uncertainty. Taxpayers engaging with digital assets whether through direct investment, DeFi participation, or collateralized lending should proactively assess reporting obligations, basis tracking, and risk exposure.
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