Taxation of Crypto Margin Trading | law of the free man


This year has been a banner year for cryptocurrencies, with Bitcoin and Ethereum prices reaching all-time highs in November. There is no doubt that margin trading – borrowing capital from a broker or margin lender to execute crypto trades – has played a significant role in boosting crypto prices. But even though margin trading has become an increasingly popular strategy for increasing returns, crypto traders may have fundamental questions about the tax implications of using margin. For example, what gain should taxpayers recognize if part of their position is borrowed? Is this a capital gain or ordinary income? What happens if the taxpayer trades a cryptocurrency, part of which was bought with margin, for another cryptocurrency instead of liquidating their positions?

This confusion is partly attributable to the lack of specific IRS guidance on cryptocurrencies and strong tax reporting capabilities from many crypto exchanges. Nonetheless, in light of increased efforts by Congress and the IRS to regulate and subject crypto income to federal taxation, crypto investors should generally be aware of the implications of buying and selling crypto, including including the use of margin in such transactions.

Introduction to Margin Trading

Before diving into the tax implications of trading crypto on 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 cryptocurrency, with the promise to repay the borrowed principal and interest to the lender by a specified date. Traders are generally subject to limits on the amounts they can borrow, with the cryptocurrencies in the account acting as collateral for the margin loan. As with any other loan, taxpayers must pay interest on margin, which can vary depending on the broker/margin lender and the amounts borrowed.

Buying on margin effectively allows you to invest more capital in a cryptocurrency, thus amplifying the return on investment. At the same time, margin trading can also magnify your losses. For example, if the price of the cryptocurrency falls below the price at which you bought it, you may effectively lose some or all of your own capital when selling 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 broker/margin loan may initiate a margin call on your loan. In such a process, the lender will ask you to deposit more funds to bring your account up to the minimum equity requirements or initiate a sale of the collateral (i.e. cryptocurrencies) to repay the loan on margin.

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, the 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 the 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 one year prior to the sale of the cryptocurrency, any gain (or loss) on the sale is taxed at the marginal income tax rate to which the taxpayer is subject.[3] Conversely, if the holding period is longer than one year, any gain is subject to the more preferential long-term capital gains rate.[4]

Other corporate taxpayers may deduct investment interest only to the extent that such interest does not exceed net investment income for the tax year.[5] “Investment Interest” means interest paid or accrued on debt justly attributable to property held for investment purposes and generally includes interest on margin.[6] Any investment interest that cannot be deducted in a tax year due to this limitation may be carried forward to the next tax year.[7]

The principles set out above can be applied to determine the tax consequences of crypto transactions involving the use of margin. Specifically, in the sections below, we will discuss the taxation of (1) gain on the sale of cryptocurrency purchased with margin, (2) losses on the sale of cryptocurrency purchased with margin, and (3) trading of cryptocurrency purchased on margin. for another cryptocurrency.

  1. Gain on sale of crypto-currencies purchased with margin

As mentioned above, for the purpose of calculating the gain on the sale of cryptocurrency, the adjusted basis is equal to the acquisition price of the currency (including certain acquisition costs). If a taxpayer borrows capital to acquire cryptocurrency, the amount of that borrowed capital is included in the taxpayer’s adjusted base in the currency (along with any capital the taxpayer has invested himself). As an example, suppose Tom wants to buy $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, its adjusted basis in Cardano tokens is $10,000. Tom decides to sell the Cardano tokens a month later at the 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 will also be able to deduct the $200 interest he paid to the brokerage.

  1. Loss on sale of cryptocurrencies purchased with margin

Determining the loss on cryptocurrencies bought with margin is a bit trickier. Assume the same facts as above, except that the value of Tom’s Cardano investment decreases to $7,000, in which case he decides to sell his Cardano tokens. At the time of the sale, the brokerage takes $5,000 of the proceeds in repayment of the margin loan, leaving Tom with $2,000 of the remaining proceeds. In this case, Tom will recognize a short-term capital loss of $3,000. Suppose the value of Tom’s investment in Cardano drops to $5,000, triggering a margin call from his brokerage. If Tom makes the deposits required to bring his account value to the minimum equity level, there will be no taxable trade and Tom will have an unrealized loss of $5,000. However, if Tom is unable or unwilling to make the required deposits and the brokerage sells the Cardano investment to cover the margin loan, then Tom would recognize a short-term capital loss of $5,000. In this scenario, Tom would effectively lose his entire $5,000 investment in Cardano tokens.

  1. Exchange cryptocurrency purchased on margin for another cryptocurrency

Trading cryptocurrency purchased with margin would likely result in tax consequences similar to those described above. Indeed, such an exchange triggers a taxable transaction under Notice 2014-21. So, suppose 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 swaps the Cardano tokens for Ether coins when the value of his investment climbs to $25,000, the brokerage will likely apply $5,200 of the Cardano investment to pay off the margin loan and accrued interest. Tom would recognize a gain of $15,000 and his base in Ether tokens would be $20,000 (traded value of $25,000 minus $5,000 used to pay off the margin loan). Conversely, if the value of Tom’s investment in Cardano drops to $7,000 at the time of the trade, 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 base in the Ether investment will be $2,000.

Takeaway meals

Margin trading has played a significant role in driving crypto prices higher this year. Since the use of margin can significantly affect the gain (or loss) on the sale of cryptocurrencies, traders should generally be aware of the tax implications of trading crypto margin, especially in light of from increased scrutiny from the IRS and Congress.

[1] IRC § 1001.

[2] See IRC §§ 1011, 1012.

[3] See IRC §§ 1221, 1222.

[4] See IRC §§ 1(h), 1221, 1222.

[5] IRC § 163(d)(1).

[6] See IRC § 163(d)(3)(A); Miner c. Comm’r, Transport Canada Note 2003-39.

[7] IRC § 163(d)(2).

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