This year has been a banner year for cryptocurrencies, with the prices of Bitcoin and Ethereum reaching all-time highs in November. Undoubtably, margin trading – the borrowing of capital from a broker or a margin lender to execute crypto trades – has played an important role in fueling the rise in crypto prices. But even as margin trading has become an increasingly popular strategy to boost returns, crypto traders may have fundamental questions on the tax implications of using margin. For example, how much gain should taxpayers recognize if part of their position is borrowed? Is the gain capital or ordinary income? What happens if the taxpayer exchanges a cryptocurrency, a portion of which was bought with margin, for another cryptocurrency instead of liquidating their positions?
This confusion is partially attributable to the lack of specific IRS guidance on cryptocurrencies and robust tax reporting capabilities on the part of many crypto exchanges. Nevertheless, in light of increased efforts from Congress and the IRS to regulate and subject crypto earnings to the federal tax regime, crypto investors should generally be aware of the implications of buying and selling crypto, including the use of margin in such transactions.
Overview of Margin Trading
Before diving into the tax implications of crypto trading with margin, a little background on margin trading is in order. When traders buy on margin, they are essentially borrowing capital from their brokerage or a margin lender to buy cryptocurrencies, with a promise to repay the lender the borrowed capital and interest at an established date. Traders are usually subject to limitations on the amounts they can borrow, with the cryptocurrencies in the account serving as collateral for the margin loan. As with any other loan, taxpayers must pay interest on the margin, which can vary depending on the brokerage/margin lender and the amounts borrowed.
Buying on margin effectively allows you to invest more capital into a cryptocurrency, thereby amplifying the return on investment. At the same time, margin trading can magnify your losses as well. For example, if the price of the cryptocurrency falls below the price you purchased it at, then you may effectively lose all or a portion of your own capital on the sale of the cryptocurrency because the funds must be used to repay the margin loan and interest. In the worst-case scenario, if the value of the cryptocurrencies in your account falls below the minimum equity requirements of your margin loan, the brokerage/margin lender can initiate a margin call on your loan. In such a process, the lender will require you to deposit more funds to bring your account up to the minimum equity requirements or initiate a sale of the collateral (i.e., the cryptocurrencies) to repay the margin loan.
Tax Implications of Crypto Margin Trading
As with other cryptocurrency transactions, Notice 2014-21 provides useful principles that can be applied to crypto transactions involving the use of margin. Under the Notice, cryptocurrencies are treated as property for federal tax purposes. Thus, gain or loss on the sale of cryptocurrencies is determined by taking the difference between the adjusted basis of the currency and the amount you receive on the sale.[1] As with traditional securities, the adjusted basis is acquisition price of the cryptocurrency (including commissions, fees, and other acquisition costs) less certain deductions.[2] If the taxpayer held the cryptocurrency for less than a year before the cryptocurrency is sold, any gain (or loss) on the sale is taxed at whatever marginal income tax rate that the taxpayer falls under.[3] Conversely, if the holding period was more than a year, any gain is subject to the more preferential long-term capital gains rate.[4]
Taxpayers other corporations may deduct investment interest only to the extent that such interest does not exceed net investment income for the taxable year.[5] “Investment interest” means interest paid or accrued on indebtedness properly allocable to property held for investment and generally includes margin interest.[6] Any investment interest that cannot be deducted in a taxable year because of this limitation may be carried forward to the succeeding taxable year.[7]
The principles outlined above can be applied to determine the tax consequences of crypto transactions involving the use of margin. More specifically, in the sections below, we will discuss the taxation of (1) gain on sale of crypto bought with margin, (2) losses on the sale of cryptocurrencies purchased with margin, and (3) the exchange of cryptocurrency bought on margin for another cryptocurrency.
- Gain on sale of cryptocurrencies bought with margin
As mentioned above, for purposes of calculating gain on the sale of cryptocurrency, the adjusted basis equals the acquisition price of the currency (including certain acquisition costs). If a taxpayer borrows capital to acquire a cryptocurrency, the amount of such borrowed capital is included in the taxpayer’s adjusted basis in the currency (along with any capital the taxpayer invested himself). By way of example, suppose Tom wants to purchase $10,000 worth of Cardano tokens. He borrows $5,000 from his brokerage and uses $5,000 of his own funds to make the Cardano investment. At the time of purchase, his adjusted basis in the Cardano tokens is $10,000. Tom decides to sell the Cardano tokens a month later at a total price of $25,000. When Tom sells the coins, his brokerage will take $5,200 of the proceeds to pay off the margin loan and accrued interest of $200. Ultimately, Tom will recognize a $15,000 gain on the sale of the Cardano tokens, which will be taxed at short-term capital gains rates because he would have held the tokens for less than a year. Assuming this gain is his only investment income in the year, Tom also will be able to deduct the $200 interest that he paid the brokerage.
- Loss on sale of cryptocurrencies bought with margin
Determining the loss on cryptocurrencies bought with margin is a little trickier. Assume the same facts as above, except that the value of Tom’s Cardano investment declines to $7,000, at which point he decides to sell his Cardano tokens. At the time of sale, the brokerage takes $5,000 of the proceeds as repayment for the margin loan, leaving Tom with $2,000 of remaining proceeds. In this case, Tom will recognize a short-term capital loss of $3,000. Suppose that the value of Tom’s Cardano investment drops to $5,000, triggering a margin call from his brokerage. If Tom makes the required deposits to bring the value of his account up to the minimum equity requirement, there would be no taxable transaction and Tom would have an unrealized loss of $5,000. However, if Tom is not able or willing to make the required deposits and the brokerage sells off the Cardano investment to cover for the margin loan, then Tom would recognize a short-term capital loss of $5,000. Under this scenario, Tom would effectively lose his entire $5,000 investment in the Cardano tokens.
- Exchange of cryptocurrency bought on margin for another cryptocurrency
The exchange of cryptocurrency purchased with margin would presumably result in similar tax consequences as described above. This is because such an exchange triggers a taxable transaction under Notice 2014-21. Thus, assume again that Tom uses $5,000 of his own funds and $5,000 of borrowed capital from his brokerage to acquire $10,000 worth of Cardano tokens. If Tom exchanges the Cardano tokens for Ether coins when the value of his investment climbs to $25,000, the brokerage will presumably apply $5,200 worth of the Cardano investment to repay the margin loan and accrued interest. Tom would recognize a gain of $15,000 and his basis in the Ether tokens would be $20,000 ($25,000 exchanged value less $5,000 used to repay the margin loan). Conversely, if the value of Tom’s Cardano investment declines to $7,000 at the time of exchange, the brokerage will similarly use $5,000 of Tom’s investment to repay the margin loan. Tom will recognize a loss of $3,000 and his basis in the Ether investment will be $2,000.
The Takeaway
Margin trading has played an important role in fueling the rise of crypto prices this year. Given that the use of margin can significantly affect the gain (or loss) on the sale of cryptocurrencies, traders should be generally aware of the tax implications on crypto margin trading, especially in light of increased scrutiny from the IRS and Congress.
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[1] I.R.C. § 1001.
[2] See I.R.C. §§ 1011, 1012.
[3] See I.R.C. §§ 1221, 1222.
[4] See I.R.C. §§ 1(h), 1221, 1222.
[5] I.R.C. § 163(d)(1).
[6] See I.R.C. § 163(d)(3)(A); Miner v. Comm’r, T.C. Memo 2003-39.
[7] I.R.C. § 163(d)(2).
