How To Use Leverage in Cryptocurrencies And Take a Tax Deduction

Since assets are never taxed before you sell it, it makes sense to use some of your cryptocurrency as collateral to borrow cash.  This way you gain liquidity without incurring a current tax bill.  It is not without risk of course.  Digital currencies are price volatile and vulnerable to theft by hackers. 

The Borrowers

Borrowers seem eager to leverage crypto profits into cash.  Cryptocurrency lenders report increased volumes, with Genesis Capital handing out loans of more than $1.1 billion and Nexo reportedly lending out $330 million since launching in August 2018.

Nexo is a Swiss-based company with affiliates in Delaware, the Cayman Islands, and Estonia, conducts its lending business from their office in London, England. 

What The ‘Experts’ Say

Conventional lending experts consider the digital-lending environment risky.  Lenders often abruptly appear in the market connected to global networks of affiliates and subsidiaries with a patent lack of transparency and evasive responses to queries ad to where and how the borrower’s digital currencies are stored and protected against hackers. It certainly seems risky.

The Risk

The risks seem obvious.  Whenever you leverage a loan on risky underlying assets, you are entering the danger zone.  To add fuel to the fire, these global lenders are free from SEC, and CFTC oversight and those that admit to regulation are governed by non-banking oversight agencies.  Moreover, the SEC is mute on crypto-backed cash loans. 

The Volatility

Bitcoin gained value from $1,300 in April 2017 to $19,100 in December 2017, providing huge gains for early investors that could be used as collateral for cash loans.  However, what goes up, must come down again, or so the adage warns, and since December 2017 the market bottomed out before surging back to about $4,100 in recent days.

The Loans and Tax Consequences

To carry the risk of volatility the borrower provides between 20 and 50% more cryptocurrency than they borrow, for loans from $500 to $ 2 million, for periods of up to a year.  Interest rates vary greatly, and peak at about 16%.

If the prices of the cryptocurrency fall during the period of the loan, the borrower has to provide more collateral, or the crypto will be sold.  In the meantime, the lender also has the option to secretly lend out the pledged cryptocurrency, something the IRS would probably consider as a sale taxable to the original owner who pledged it as collateral. 

Where Are The Lenders Keeping My Pledged Currency?

According to reports, some lenders are depositing the collateral at regulated custodians like PrimeTrust, but not all lenders do this.  The SEC is investigating  company SALT Lending for example, in respect of $50 million in ‘digital tokens’ they sold to borrowers.

The Trend

It seems that the borrowers are those who gave up on their dream of a virtual currency for the lure of cash, and the borrowing craze is partly driven by creative market making by lenders who argue that the tax perks provided could even benefit investors who made significant paper losses on their cryptocurrency. 

The Lending Pitch and Tax Advantages

According to Zac Prince of Block, one strategy to benefit even after making paper losses would be to sell, then to repurchase the currency, and to then borrow against it. According to Prince, this would trigger a deductible loss of about $3,000 per year for the investor while holding on to the currency for long enough to reach the capital gains rate of 20% down the line.

Another point the lenders make is that this form of borrowing is free from credit-scoring.  This has been the way executives have been leveraging their equity assets into cash without selling it and paying capital gains taxes, for a long time.

Tax Tips for Cryptocurrency U.S. Investors

Most jurisdictions, including the United States do not yet give crypto legal tender status, but that may be changing. Crypto seems to be a significant player in the investment marketplace and is causing countries around the world to question their regulatory status and try to race to build a framework that both regulates and answers all of the legal questions that have popped up. In fact the IRS has had to invest some serious resources quickly to combat the rampant tax non-compliance for those who have invested in crypto and failed to pay taxes on the earnings.

Right now there are over 1,664 different cryptocurrencies with new ones being introduced almost daily. The underlying rules of the network might change and cause a “fork” in the cryptocurrency that causes a split and makes it so the owner may actually own two different crypto currencies like bitcoin cash, and bitcoin. There are derivatives like bitcoin futures, and you can bet we are only seeing the beginning and it’s already become a complex system that has left a lot of unanswered questions for those who are trying to regulate it.

The IRS issued Notice 2014-21 to try and apply some general tax principles to crypto. Some of the main points that came from that notice are:

• Cryptos have “an equivalent value in real currency or act as a substitute for real currency”
• IRS doesn’t view cryptos as generating foreign gain or losses for a U.S. tax return
• Cryptos are treated as property (like stock, inventory, or personal property)
• Taxpayers that receive cryptos in exchange for services or goods must include it’s fair market value at the time it was received in gross income
• Exchange rate is established by market supply and demand
• 1099 independent contractors are subject to self-employment tax if they receive cryptos for performing services
• Cost basis is determined by fair market value in U.S. dollars on the date received
• Record keeping should incorporate specific identification, first-in, first-out (FIFO) and the average-cost method can all be used to keep track of basis for tax reporting purposes
• It remains unclear how to treat crypto forks for tax purposes. If it forks is it considered income?  It’s income if it’s not a gift and has measurable value.  How about the timing of income recognition? It’s assumed it depends whether or not the holder of the pre-fork crypto exercises control and dominion over the post-fork crypto (crypto forks are only becoming more common which is making IRS guidance a more urgent necessity on how to proceed)
• FinCEN Form 114 says that cryptos that are held on an exchange that is foreign-based may be subject to reporting requirements. These foreign exchanges exhibit characteristics that are similar to foreign financial institutions and have custody of the users’ crypto.

Then the IRS issued a statement in 2014 that said:

The Financial Crimes Enforcement Network [FinCEN], which issues regulatory guidance pertaining to Reports of Foreign Bank and Financial Accounts (FBARs), is not requiring that digital (or virtual) currency accounts be reported on an FBAR at this time but may consider requiring such accounts to be reported in the future. No additional guidance is available at this time. [“IRS Says Bitcoin Not Reportable on FBAR (for Now),” Forbes (June 30, 2014), available at tinyurl.com/yav9z88v]

Regardless of what it says above, we suggest you err on the side of caution and report any foreign exchange accounts. Getting stuck with a huge bill and penalties that you aren’t prepared to pay is no walk in the park. Unless the IRS comes out with specific guidelines that indicate otherwise-report it. Save yourself the trouble.

The IRS has a dedicated task force that spends their days sniffing out tax fraud from crypto currency. So all of the money launderers out there that have been using blockchain technology to launder money should be on notice. The IRS considers virtual currency as a taxable asset and added it to their list of compliance campaigns. One of the largest exchanges out there, Coinbase has already provided the IRS user data that includes social security number, name, account activity and date of birth. It’s only a matter of time before the IRS will issue summonses to other exchanges besides just Coinbase. If you are caught not complying, there are civil penalties that include:

• Failure to file a tax return under Sec. 6651(a)(2): 0.5% per month of the unpaid tax, up to 25% of the unpaid tax.
• Failure to file Form 8938: Base penalty of $10,000 per failure to report an applicable asset, with an additional $10,000 for each month the failure continues, beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000.
• Failure to file FBAR: Base penalty of $10,000 per failure to report an account per year; increasing, if the failure is willful, to the greater of $100,000 or 50% of the total balance of the foreign financial account per violation.
• Accuracy-related penalty under Sec. 6662: 20% or 40%.
• Failure to file a tax return under Sec. 6651(a)(1): 5% of the unpaid tax per month, up to 25% of the unpaid tax.
• Civil fraud penalties under Sec. 6651(f) or 6663: 75% of the unpaid tax.

If you haven’t filed your taxes for your crypto holdings, you may want to reconsider your course of action because the above list doesn’t even include criminal charges for tax evasion or whatever other crimes you can be charged with.

The IRS wants to help tax payers play ball and welcome any noncompliance individuals to come forward voluntarily and disclose their noncompliance. They have tried to streamline their procedures for compliance. They are trying to offer fairly easy processes to file delinquent or amended tax returns to fix the error of non-disclosure and resolve any outstanding penalty or tax obligations. This is only available to those that did fail to report their foreign income as a result of willful conduct. It’s probably the only time the IRS will allow an individual to claim ignorance to the law. If failure to comply is deemed criminal or results in huge penalties, then the streamlined compliance procedure is not an option for the taxpayer in question. It should be noted that voluntary disclosure does not necessarily grant immunity from prosecution, but it may result in the IRS being more sympathetic and not recommending prosecution. Also, you’ll still be stuck with the penalty. Unless you could sway the IRS that there was a good reason for your non-disclosure (which is unlikely, and ignorance isn’t a good reason).

Obviously what is best for each and every taxpayer will vary by each person’s situation and personal circumstances. It’s probably a safer route to voluntarily disclose and fix the non-compliance rather than waiting to be caught red-handed. Clearly we need more guidance from the IRS on cryptocurrency and all of the issues that surround the digital currency world, and it’s certain that such guidance will be coming. After all, the IRS wants their piece of the pie. Cryptocurrency is still new and growing and evolving quickly. You can rest assured that the powers that be will figure out how to regulate it and make sure individuals are compliant.

Common Crypto Tax Pitfalls To Avoid

Reporting only losses and tax-friendly transactions

Crypto holders often report significant losses (bear markets) but then avoid reporting gains entirely during bull markets. The IRS may flag this behavior and penalize you for it.  Similarly, when a crypto-mining operation never makes a profit and keeps on reporting losses for years on end, the IRS can easily decide that the enterprise is not a ‘trade or business’ and deny all deductions, something that can cost thousands of dollars. Never overstate your losses and deductions.  The IRS uses benchmarks with which they will compare your numbers to industry trends as well as your past return data.

No records or incomplete records

Don’t do crypto if you cannot keep an almost perfect record of your transactions.  Your tax returns demand full disclosure based on comprehensive records.  Generally speaking, you have to retain all your records for at least three years.

• If you do not file a return, you have to keep your records forever
• If you filed a fraudulent return, you HAVE TO KEEP your records FOREVER
• If you did not report the income you should have (if it’s more than 25% of the gross income shown on your return), you have to keep your records for at least six years.

It is vital to use high-quality crypto software to calculate your crypto capital gains and losses and to guarantee that all your source data collects in one place. Do not take the view that your accountant is responsible. The responsibility to prove the amounts reported to the IRS is yours, as is the burden.

It’s as easy as that. Do the above, and you will most likely stay off the IRS radar forever.

Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services.  This article cannot serve as a substitute for such professional services or advice.  Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation.  This article is subject to change at any time and for any reason.