Decentralized Finance (DeFi) is an ever-growing crypto field that lets people access various financial services, like borrowing, lending, and trading, without interruptions or additional prices included by middlemen. Among these innovations is crypto lending, which is only continuing to grow in popularity.


Crypto loans technically fail to meet the fungibility and return of the same standards of collateral that protect loans from taxation. They are deemed as property and during a loan settlement, the borrower won’t be receiving the same cryptocurrency that they had initially deposited.


That being said, like with any cryptocurrency activity, understanding the tax implications of DeFi and crypto loans is important.


Receiving and lending proceeds


Acquiring cash for depositing cryptocurrency as collateral is not a taxable act. This is akin to getting a home equity line of credit in which you collateralize your home with the bank and later receive cash against the appreciated property value. Spending the cash you receive is also not a taxable event. In fact, you can spend this cash on pretty much anything. However, it is important to remember that failure to pay back the loan will result in a taxable event. 


Then there is the topic of interest expense on cryptocurrency loans. Crypto lending platforms usually charge an annual interest rate for cash loans against your cryptocurrency. Generally speaking, this rate is roughly 5%. You are allowed to write-off the interest expense on your taxes so long as you use the loan proceeds for investments or business objectives.


Likewise, lending a property and receiving anything other than the original property during loan settlement is considered a sale of the original property. This is in stark contrast to putting it as collateral, which is not taxable.


Paying off the loan


For the most part, paying back a crypto loan and in turn receiving the collateral is not a taxable event. To better understand this, let’s use a hypothetical situation involving someone purchasing a bitcoin as an example.


If a person purchases a single bitcoin (BTC) in 2017 for $1,000, then it is worth $50,000 now. They then decide to put this BTC as collateral in a lending platform and subsequently receive a loan. From here, the lending platform offers them a $30,000 loan, which is not taxable. From here, let’s say this person repaid the $30,000 to the lending platform and received the 1 BTC they originally deposited. This is not a taxable act even if the BTC’s price has increased in value while it was collateral.


Evidently, when properly handled, crypto-backed loans do not typically lead to taxes of any kind. Be that as it may, the IRS could argue that cryptocurrency loans are indeed taxable. Their reasoning is that cryptocurrencies such as Bitcoin are not fungible like fiat. However, it is extremely rare – if not unlikely – that crypto loans will receive this treatment.