Despite some early rumblings about zero percent capital gains taxes on digital assets, recent comments from President Donald Trump produced no such promises. For the time being, at least, crypto and other digital assets will retain their existing character as property under US tax law.
This may prompt long-term holders of crypto assets to review their options when it comes to raising capital. Borrowing against one’s crypto holdings is an alternative option to selling. An entire industry has grown around issuing such asset-backed loans, typically using Bitcoin as the collateral.
A Bitcoin-backed loan may be a good alternative for raising capital without incurring capital gains taxes. This is especially true in cases in which the taxpayer has held the Bitcoin for less than one year and would therefore pay short-term capital gains tax on the sale.
Asset-backed loans are nothing new. Borrowing against property such as stock or real estate has long been a strategy of wealthy individuals looking to minimize their tax bill. Such individuals often can borrow against the property at very favorable rates, as the lender often can rely on continued business in the form of refinancing as the loans come due or originating new loans (with fresh fees) in lieu of liquidating the collateral.
Bitcoin has become an attractive form of collateral against which private lenders are issuing loans. With roughly a $1.5 trillion market cap and multiple exchanges, brokers, and over-the-counter desks through which the lender can trade, Bitcoin is highly liquid compared with traditional forms of collateral, such as real estate.
Liquidations can occur when the price of the asset falls below an agreed-on loan to value ratio—or the percentage of the market price of the collateral that a lender is willing to loan, expressed in dollars.
Let’s say a Bitcoin lender agrees to lend $50,000 on one Bitcoin valued at $100,000 for a loan to value ratio of 50%. Due to Bitcoin’s volatility, many Bitcoin lenders cap their loan to value ratios at or around this level to allow for wide swings in Bitcoin’s price and a general aversion to liquidating an asset. If there’s a liquidation, the loan is satisfied, and the borrower generally must pay the capital gains tax.
The tax consequences of taking out a Bitcoin-backed loan in this fashion are initially straightforward. Loan proceeds aren’t considered income when received because the loan is coupled with an obligation to repay.
This is why borrowers can raise liquidity without incurring capital gains tax for the sale or exchange of the asset. Conversely, when a loan is forgiven, this results in “discharge of indebtedness” income for solvent borrowers because that repayment obligation is extinguished.
The potential to deduct the interest paid on the loan is a second, more complicated, benefit. This is known as the “investment interest expense deduction” and concerns “interest paid or accrued on indebtedness properly allocable to property held for investment.”
This itemized deduction is subject to limitations. For example, someone can’t deduct the loan interest where the proceeds are used to purchase tax-exempt debt instruments, a personal residence, consumer goods, or for use in a passive activity.
The deduction for investment interest is further limited to one’s net investment income, which is defined as one’s investment income less investment expenses.
The taxpayer should perform careful calculations before making such an election, however, as they would be giving up the more favorable capital gains rates on such income to convert it to ordinary income against which the investment interest deduction is taken.
Regardless of whether it’s deductible, the interest expense may be less important economically over the long term if Bitcoin continues to appreciate and the borrower has maintained their exposure to the asset. Borrowing against any asset should be done with the advice and counsel of a tax professional skilled in this area.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
Ari Good is a Miami-based cryptocurrency lawyer with Good Attorneys at Law and a member of Consensus Partners, a due diligence firm for crypto-backed lending.
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