New functionality from Multi-Collateral DAI allows for using Maker Vaults (formerly collateralized debt positions or CDPs). In this post we break down what Maker Vaults are, how you can use them, and how CoinTracker can help you keep track of the tax consequences of Maker Vault transactions.
What is a Maker Vault?
In short, a Maker Vault allows a user to deposit cryptocurrency collateral and generate Dai. Each type of cryptocurrency a user locks up goes into a separate Vault (as of publishing, Vaults support ETH and BAT, with more types of cryptocurrency collateral to be expected in the future). This all happens without any centralized entity on the Maker DAO platform because Vaults are really just smart contracts automatically running on the Ethereum blockchain.
At anytime, the USD value of the locked up cryptocurrency in the Vault should remain at least 1.5x in value the amount of Dai you are borrowing. For example, if you lock 15 ETH (@ $100/ETH) in a Vault (total value locked is $1,500), you can generate up to 1,000 Dai (worth $1,000).
Let’s say Nimrata wants liquidity and is holding ETH and BAT that have unrealized capital gains from the time she got the coins. She doesn’t want to sell the coins and certainly doesn’t want to incur capital gains taxes by selling the assets. Instead, she opens two Maker Vaults: one for ETH and another for BAT (each type of coin requires its own Vault and could have different levels of collateralization). The ETH and BAT deposited into the Vaults (smart contracts) are locked in; Nimrata gets Dai as a loan.
Nimrata can withdraw the Dai to wherever she wants and spends it as she pleases. Eventually if she wants to get back her original collateralized ETH and BAT in the Vaults, she must pay back the borrowed Dai plus an accrued Stability Fee. Once she does so, the Vault will release her collateralized funds (the Vault remains open so that she can use it again in the future).
Why Open a Maker Vault?
The primary benefit of using a Maker Vault is to obtain liquidity on your cryptocurrency without triggering a taxable event. This liquidity comes at a price:
- you have to pay a stability fee (like interest) for borrowing the Dai
- if your locked up assets drop in value below the collateralization amount, the Vault will automatically start selling your locked assets to maintain the collateralization ratio
Therefore, you should have confidence that whatever you do with the borrowed Dai will generate more returns than the stability fee owed and that the locked up assets in the Vault won’t significantly decrease in value in the Vault to trigger a liquidation event.
For example, let’s say Darren holds 150 ETH and has an unrealized capital gain on the position. He bought them in July 2016 at $10 per ETH. His total cost basis is $1,500 ($10 * 150). In November 2019, 1 ETH has appreciated to $150 per ETH. He wants to purchase a new truck for using his crypto which is worth $22,500.
Option 1: Sell ETH
If Darren were to sell 100 ETH to gain $15,000, that would create a taxable gain of $14,000 (($150 – $10) x 100)). Assuming Darren is subject to a 15% long term capital gain tax rate, he would end up paying roughly $2,100 ($14,000 x 15%) in taxes. At the end of the day, his net take home will only be $12,900 ($15,000 – $2,100).
Option 2: Open a Maker Vault
In November, Darren could instead open a Maker Vault and generate 15,000 Dai (($150 x 150) / 1.5)) which is worth $15,000 (collateral ratio is required to be 1.5X the value of Dai borrowed). Darren could take the Dai to a cryptocurrency exchange to get USD to buy the truck (of perhaps the truck seller would take Dai directly!).
Assuming ETH does not decrease in value, Darren would have $15,000 of liquidity to purchase his truck without triggering a taxable event and save $2,100 in taxes. Darren would still need to pay back the 15,000 Dai + stability fee to get back his 150 ETH from the Vault (which he could recover at any time).
The primary risk of using Maker Vaults is liquidation risk due to falling prices of the collatralized cryptocurrency. In the example above, if the price of ETH drops below $150, some of Darren’s ETH would get liquidated to maintain 150% leverage. To avoid liquidation, Darren could add more ETH into the Vault and/or payback the loan using Dai.
Maker Vault Taxation
Lending ETH (or any other cryptocurrency), creating a Vault, and receiving loan proceeds are not taxable events. These transactions are similar to collateralizing land which has appreciated in value with a bank and getting a loan.
Repaying a Vault Loan & Stability Fees
Repaying the Vault loan using your earned income is not a taxable event. The stability fee is paid through MKR token. The stability fee closely mirrors interest expense and can be tracked at any time. The deductibility of this interest expense depends on facts and circumstances of each case.
- If you use the Dai loan for a personal purpose, generally, that interest is not deductible. In the case above, if Darren uses the truck he purchased for personal leisure, the interest expense would not be deductible
- If Darren uses the Dai loan for a business purpose, that interest may be deductible subject to few provisions in the tax code. For example, if Darren uses the truck as a delivery vehicle for his small business, that interest expense may be deductible (subject to some restrictions)
- If Darren instead borrows Dai for investment purposes, that interest expense may be deducted subject to investment interest expense limitations of the IRS code
CoinTracker allows you to track stability fees so that you can tell your tax advisor about the appropriate amount to deduct on your tax forms (if applicable).
If Darren’s collateral drops below the required 1.5X ratio, the MakerDAO system will automatically liquidate enough collateral to return the ratio of collateral to Dai to 150% (plus a penalty). Liquidation is a taxable event which triggers capital gains (or losses). The collateral liquidated will be taxed subject to capital gain/loss rules and tracked under the “Capital Gain” section on the CoinTracker Tax Dashboard.
Note: this means that you could be subject to capital gains tax on liquidated collateral. Even though you are losing collateral because the price is dropping, there still may be a capital gain between the fair market value of the locked asset at the time of the liquidation and the cost basis of the asset at the time when you acquired it. One way to think about this is imagining that the locked asset is being sold to USD when it is liquidated.
The IRS has not explicitly issued guidance on how to treat penalty fees. Assuming penalty fees closely resemble “accelerated interest expenses”, they may be deductible subject to the same criteria mentioned in the section above.
In short, Maker Vaults are an option to get liquidity without triggering a taxable event or paying capital gain taxes. In some cases, stability fees (interest expenses) and liquidation penalties may even be deductible on your taxes and would further reduce your taxable income.
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Disclaimer: this post is informational only and is not meant as tax advice. For tax advice please speak with a tax professional.