Cryptocurrency lending and borrowing have become popular thanks to the rise of stablecoins and DeFi platforms. In the fiat world, borrowing and lending dollars do not typically result in any taxable events. However, borrowing and lending using cryptocurrencies like bitcoin and ether could result in taxable income because cryptocurrencies are treated as property by the IRS.

How Fiat Loans Work

Before we dive into analyzing crypto loans, it is important to understand two key ingredients that make fiat loans non-taxable: fungibility of USD & return of the same exact collateral at loan settlement.

Government issued currency like USD is considered fungible. This means every dollar bill is equal, identical, and interchangeable for any other dollar bill. Since USD is fungible, you are deemed to be paying back the exact dollar bills you borrowed at the loan initiation. This is why receiving loan proceeds from a personal, credit card or student loan and/or repaying the loan in USD are tax neutral.

In the case of property-backed fiat loans (car title loans & equipment loans), as long as the lender returns the same exact collateral borrower deposited at the loan initiation, there is no tax implication. This is in fact the case with almost all fiat asset-backed loans. For example, if you get a $5,000 title loan after collateralizing your 2005 Honda Civic, at loan repayment, the lender will give back your same exact car. Receiving anything other than your exact car could trigger a taxable event.

Crypto Loans

Technically speaking, crypto loans fail to meet the fungibility and return of the exact same collateral standards which shield loans from taxation as mentioned above.

First and foremost, cryptocurrencies are treated as “property” per IRS 2014-21 and most property is not fungible unlike the US dollar. Every unit of cryptocurrency is different from each other. Moreover, at the loan settlement the borrower is not getting back the same exact cryptocurrency he/she deposited at initiation. These two factors could convert generally tax neutral loan transactions into taxable sale transactions in the crypto world.

For example, let’s say you purchased one ether (1 ETH) for $200 in January 2020. In April 2020, this 1 ETH is worth $1,000 so you put this as collateral on a DeFi platform and receive $500 USDC. In May 2020, when you settle the loan, you are not getting back the exact 1 ETH you deposited at the loan initiation in April because property is not fungible like the US dollar and the platform most likely has used that unit of ether to provide liquidity to other users. Therefore, this could theoretically be considered a sale of your original ether and result in $300 gains ($500 – $200).

Likewise, lending one property and receiving anything else other than the original property at loan settlement could be considered a sale of the original property (as opposed to putting it as collateral, which is non taxable)

Best Practices For Crypto Borrowing & Lending

With that said, in the DeFI world, when you use cryptocurrency for loan transactions, the parties involved intend to use them as a fungible asset like the US dollar. However, whether the IRS will agree with this treatment or not still remains a question. In fact, the IRS has not issued any guidance on how cryptocurrency loans should be taxed.

In the absence of crypto loan specific guidance, there are few best practices you can follow to make a strong case for fungibility and non-taxability. For starters, make sure to document that involved parties are treating the transaction as a loan, not as a sale. Further, loan documents could have a requirement to return the collateral in the exact same cryptocurrency (if possible) provided to the lender to preserve fungibility standards and avoid getting taxed as a sale.

This post was originally published on Forbes by Shehan Chandrasekera on July 21, 2020

Disclaimer: this post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.