How Crypto Liquidations Could Make You Pay Twice

What happened

Earlier this year, the total cryptocurrency market capitalization shrunk from ~3 trillion to less than 1 trillion in a matter of weeks, leading to nearly $1 billion worth of liquidations from investors trading derivatives, such as futures, or borrowed assets, such as stablecoins, against their own. crypto holdings.

Liquidations are safety valves for platforms to protect themselves or recoup losses when collateralized crypto assets fall below a certain price threshold. For example, someone could borrow $100 in USDC against $150 in ether, with a 125% liquidation rate. If the price of that ether falls below 125% of the outstanding balance, the platform would sell the collateral unless the borrower repays the loan or adds more funds. This is called a margin call.

When an investor is liquidated, it can be painful. However, that may not be the only time they pay. Some may believe that they are eligible for some tax relief due to these forced sales and the belief that they have “lost” their funds. Unfortunately, you may owe the IRS tax money on your settlements.

These forced liquidation clauses are generally mentioned in the terms and conditions of the domestic stock exchanges abroad. (Binance example)

Key concepts

It is important to understand the basics of cryptocurrency taxation before diving into liquidations and how they could trigger unintended tax consequences.

How cryptocurrencies are taxed in the US

Per IRS Notice 2014-21, cryptocurrencies are taxed as “property” and are subject to common tax rules applicable to property transactions. This means that you must pay capital gains tax when you dispose of (sell) crypto assets at a profit.

For example, let’s say you bought 1 BTC for $10,000 a few years ago and sold it for $50,000 in 2022. In 2022, you must pay capital gains tax on $40,000 ($50,000 – $10,000) of profits.

There are two types of capital gains: short-term capital gains and long-term capital gains. Short-term capital gains occur when you sell your crypto assets after holding them for less 12 months. These earnings are subject to your regular income tax bracket, which can range from 10% to 37%, depending on your total annual taxable income.

Long-term capital gains occur when you sell your crypto assets after holding them for plus 12 months. Long-term capital gains are subject to a 0%, 15%, or 20% tax rate based on your annual taxable income.

You can also write off losses related to cryptocurrency trading, subject to some limitations.

settlements

Liquidations occur when you borrow funds on margin and fail to meet the margin call on time. In such situations, exchanges convert their crypto assets into cash to limit their losses.

For example, let’s say George bought 1 BTC in 2015 for 1000. In the first quarter of 2022, during the peak of the market, this coin is worth $60,000. George deposits this coin on a crypto exchange and gets a fiat loan of $30,000. Please note that the exchange only gives you a loan for 50% of the current value of the coin. 50% is the loan-to-value (LTV) ratio.

In the second quarter of 2022, the price of BTC drops to $30,000. As the price drops, the exchange triggers a margin call to George to add more coins to maintain the 50% LTV. If George doesn’t deposit more bitcoin to maintain the 50% LTV or pay off the loan, the exchange can settle the BTC at market price to limit his losses.

If George is liquidated by the exchange at $30,000 per BTC, George will incur a capital gain of $29,000 ($30,000 – $1,000).

Unintended tax implications of settlements

Liquidations can trigger a couple of unintended tax consequences. First, if the asset’s liquidation price is higher than its cost basis, that could trigger capital gains taxes. Second, you will have to produce fiat to pay the tax liability caused by the settlement.

Continuing with the example above, George incurs a long-term capital gain of $29,000 ($30,000 – $1,000) even though he suffered an economic loss. When filing taxes, George has to present fiat currency to pay taxes related to the $29,000 capital gain. George’s estimated tax bill on the $29,000 gain would be $4,350 ($29,000 * 15%)

How you can avoid liquidations

The safest way to avoid liquidations is to not borrow funds based on your crypto assets. You can continue to trade in cash without having to worry about the risk of being liquidated.

If you still want to borrow funds, it is very important to pay attention to margin calls and have funds on margin to repay the loan and/or increase the guaranteed amount if a sudden market crash occurs.

Please note that companies that have borrowed funds based on their internal cryptocurrencies may also be subject to liquidation and over-tax consequences if they fail to meet margin requirements. The loss of secured assets would also have a negative impact on the company’s balance sheet and decrease GAAP net income in certain cases.

Next steps

  • If it was settled in 2022, calculate the capital gains and make sure you have enough fiat to cover the tax bill.
  • Be on the lookout for margin calls if you borrow funds collateralized by crypto assets.

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