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Crypto Law/Level VII · Loopholes worth understanding/7.3 Loopholes they sell you/Lesson 4

Borrowing against crypto: tool or trap

Why a loan against crypto is generally not taxed in the US while a forced sale of the collateral is, and the custody, liquidation and interest risks that turn the tool into a trap.

Education, not legal, tax or investment advice. Crypto law differs between countries and states and changes often. Check the current rules where you live with a qualified lawyer or tax adviser before you act.

The lean path

The cheapest, lowest-tax, simplest and most private route the law allows, best first. Each step names the rule it rests on and the condition that keeps it lawful.

  1. Borrowing against coins lawfully raises cash without a taxable sale, since a loan is not income (Commissioner v. Indianapolis Power & Light, 1990); the catch is liquidation, which is a taxable sale at the worst moment.
  2. Prefer terms that forbid the lender from selling or relending collateral, and keep loan-to-value low; in the UK, HMRC treats transferring beneficial ownership to a lender or DeFi platform as a disposal.
  3. Before borrowing, compute the liquidation price and the tax on a forced sale at your actual basis; on Aave a health factor below 1.0 permits liquidation, so add collateral early.
  4. Interest on personal-use borrowing is not deductible under §163(h); interest on money borrowed to buy investments is deductible only up to net investment income under §163(d).
  5. ‘Buy, borrow, die’ works only if the position survives: heirs get the §1014 step-up and can repay from stepped-up coins, but years of interest and lender risk, as Celsius borrowers found, must be absorbed first.

MaterialsThe loan agreement or protocol documentation, especially the collateral, liquidation and insolvency termsCommissioner v. Indianapolis Power & Light Co., 493 U.S. 203 (1990)26 U.S.C. §163, on which interest is deductibleYour cost-basis records for the coins you would post as collateral

Wonder

  1. Why would anyone borrow against crypto instead of selling it?
  2. If my collateral is liquidated, have I sold my coins for tax purposes?
  3. What happens to my collateral if the lender goes bankrupt?

Explore

  1. Borrowing against crypto means posting coins as collateral for a loan, usually in dollars or a stablecoin, from a company or a lending protocol. The appeal is largely about tax. In the US a loan is not income, while selling appreciated coins usually triggers tax (lesson 2.1.2). In Commissioner v. Indianapolis Power & Light Co. (1990) the Supreme Court said that ‘it is settled that receipt of a loan is not income to the borrower’, because the borrower must repay. So a holder can raise cash without a taxable sale and keep any further gain. Some pitches present this as how the wealthy avoid tax; the details decide whether it works.
  2. The first question is whether posting the collateral is itself a disposal. The IRS has not published a ruling squarely on crypto lending or collateral (lesson 2.2.5), so the answer turns on facts: whether the lender or protocol may use, sell or relend the coins, and whether you receive a different token in exchange. The UK is more explicit. HMRC’s manual says that where a lender or liquidity provider transfers beneficial ownership of tokens to a borrower or DeFi lending platform, that is a disposal for Capital Gains Tax, and that a recipient free to deal with the tokens as it wants is a strong sign ownership has passed.
  3. The second question is liquidation. Loans carry a maximum loan-to-value ratio; if the coins fall far enough, the lender sells or takes collateral to repay itself. On Aave, a large lending protocol, a position whose ‘health factor’ falls below 1.0 can be liquidated by outside ‘liquidators’, who repay debt and receive collateral plus a liquidation bonus. For tax, a forced sale is still a sale: in Helvering v. Hammel (1941) the Supreme Court treated a foreclosure sale of investment property as a sale for capital gain and loss rules, and the IRS treats exchanging crypto for other property as a taxable disposal. Low-basis coins can produce a gain at the worst moment.
  4. The third question is who holds the collateral. With a company lender you usually hand the coins over. Celsius Network’s terms warned that coins posted as collateral under its Borrow service ‘may not be recoverable’ if it became bankrupt, leaving customers only creditors’ rights. After Celsius collapsed, the bankruptcy court ruled on 4 January 2023 that coins in its Earn program belonged to Celsius, while expressly leaving ownership of Borrow program assets undecided (lesson 4.1.4). In a lending protocol the coins sit in a smart contract instead, so the risks become code bugs, price-feed failures and governance changes (lesson 6.1.5 shows a price feed being manipulated).
  5. Interest is a real cost, and its tax treatment depends on what the money is used for. For individuals, section 163(h) of the Internal Revenue Code denies any deduction for personal interest. Interest on money borrowed to buy investments may be deductible as investment interest, but under section 163(d) only up to net investment income. The ‘buy, borrow, die’ idea adds the step-up in basis at death (lesson 7.1.5): heirs may take a basis equal to value at death, so gain never taxed during life may escape income tax. That only works if the position is never liquidated and the interest can be paid for years.
  6. Borrowing against crypto is a lawful tool; the trap is treating it as risk-free tax planning. Rules for crypto lenders differ by state and by country, so the agreement itself matters most. Before borrowing, a careful holder reads three things: what the lender may do with the collateral, the exact liquidation trigger and fees, and what happens if the lender or protocol fails. A practical check is to calculate the price at which the position would be liquidated and the tax on a forced sale at that price, using your actual cost basis. If you could not absorb both at once, the loan is a bet, not a plan.

Key facts

  • In Commissioner v. Indianapolis Power & Light Co. (1990) the Supreme Court stated that receipt of a loan is not income to the borrower.
  • In Helvering v. Hammel (1941) the Supreme Court treated a foreclosure sale of property held for profit as a sale for capital gain and loss purposes.
  • HMRC’s Cryptoassets Manual treats a transfer of beneficial ownership of tokens to a borrower or DeFi lending platform as a disposal for UK Capital Gains Tax.
  • On the Aave protocol, a borrowing position with a health factor below 1.0 is eligible for liquidation.
  • Celsius Network’s terms warned that assets used as collateral under its Borrow service might not be recoverable if Celsius became bankrupt.
  • Section 163(d) limits an individual’s deduction for investment interest to net investment income, and section 163(h) disallows personal interest.

Exercise nine, six, three, one

9CollectList up to 9 terms from a crypto loan offer, protocol page or agreement you can find, such as the loan-to-value ratio, liquidation trigger, fees, rehypothecation clause or insolvency wording (some lists are shorter).
6ClusterSort them into 6 categories: collateral rights, liquidation mechanics, interest and fees, insolvency and custody terms, tax-relevant facts, and terms you do not yet understand.
3DistillReduce the 6 to 3 groups: terms that could cause a taxable forced sale, terms that decide whether you get your coins back, and terms that set the cost of borrowing.
1CrystallizeWrite 1 sentence describing the price fall at which a loan against your own or an example holding would be liquidated, and what that would mean for tax.

Fact check

Dates, figures and claims checked against the published sources listed below.

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