Loans are easy to come by in the crypto market. Defi (decentralized finance) and other crypto finance apps make everything about the loan process easy and accessible. All that a crypto owner needs are the crypto assets and the knowledge as to where to deposit the assets to get the best LTV (loan to value ration).

Why would you take out a loan?

Regardless of the reason for taking out a loan, the borrow is betting that the value of the collateral won’t decrease after the loan is taken out. If the value decreases to a predetermined threshold, let’s use 80% LTV, small repayments begin. If the account does not recover and LTV remains above 80%, repayments continue and potentially all collateral could be liquidated.

Whammy #1 — Liquidation means you are forced to sell the collateral. The collateral is sold at market price and the proceeds are applied toward the outstanding loan balance. All repayments are initiated automatically unless more assets are added to the account or the value of the current assets increase.

The loan is paid down or paid off, so that is a plus. But all future wealth is gone and if the value of the assets rebound in the coming days or weeks, the absence of that once healthy account will be a sore subject.

Whammy #2 — liquidation could result in capital gains tax and leave the account holder without any cash or any assets to cover the tax bill.

Here is an example to illustrate the situation:

Account at loan origination

Account at liquidation

Applying the above scenario to a taxpayer situation:

Taxpayer information for 2021

One detail I have intentionally left out is whether the realized gain is short term (asset held < 1 year) or long term (asset held > 1 year).

Gain == short term

Gain == long term

Not planning for a downturn in the market could come with a tax bill if you use your crypto assets as collateral. In the scenario above, the additional tax was at least $4,400, and if the liquidated assets were owned less than a year, the additional tax was almost double.

The alternative is liquidation creates a capital loss. But, if this is the only loss and there are no other capital gains, the taxpayer can only take a loss to the extent of 3k per year. The losses that aren’t utilized are carried forward to the next tax year.

Reach out to your accountant and let them know if anything like this happens. If you don’t have an accountant and have a portfolio with a good amount of activity, be on the search for one. Interview the accountant and ask simple questions about the crypto market. Good starters are whether the accountant knows about Defi, prepared a tax return with transactions from a decentralized exchange (DEX) like Uniswap, andif they have tested any of the popular crypto tax software.

Good luck out there.