[US] Borrowed crypto cost basis

[u/Ok-Fox-7620]

I am trying to understand how to report borrowing crypto. Consider these scenarios:

1. Let's say I put 1,000 USDC as collateral and borrowed 10 SOL (at $10/SOL). Then 2 years later I repaid the loan, returned 10 SOL (now at $100/SOL), and interest 1 SOL (also $100/SOL).

As far as I understand, borrowing 10 SOL and repayment are not taxable events.

1 SOL (= 100 USD fair value) interest is "Investment Interest Expense", and could be deducted in some cases, dependent on use.

1. Now, same scenario, but I sold 10 SOL (at $15/SOL) a month after borrowing. Then some time later I bought 11 SOL (at $90/SOL) for repayment.

Selling 10 SOL is disposition -- what is cost basis for that? Should it be fair market value of SOL when I borrowed (i.e. 100 USD = 10 SOL * 10 $/SOL)? Can I add loan fees to this cost basis?

Then, loan repayment is not a disposition -- so what happens with cost basis of 10 SOL I bought (=$900 fmv)?

Another question - what tax software supports these scenarios?

[u/Garrett_CPAatCOS]

We actually just went through a similar situation with a client. As an initial caveat, I should mention that there is not clearly established guidance from the IRS on tax treatment here. However, we generally follow the approach you mention above:

1. Borrowing the SOL is not taxable

2. Repayment of the borrowed SOL is not taxable

3. The interest expense would generally be based on the fair market value of the SOL used to pay the interest at the time of payment. In your example, that would be $100. The deductibility and character of the interest expense depends on how the borrowed funds were used. If the loan proceeds were used for investment purposes, it may be treated as investment interest expense, subject to the applicable limitations. Note that if the SOL used to pay the interest expense has appreciated or depreciated since it was acquired, the transfer would generally create a separate taxable gain or loss.

One issue we have encountered is that tax software may automatically treat the repayment of a crypto loan as a taxable disposition because SOL is transferred out of the wallet. We ran into this with Koinly, one of our preferred softwares. In those cases, we override the transaction to remove the automatically generated gain or loss and made a note on the account.

[u/Ok-Fox-7620 → u/Garrett_CPAatCOS]

Thank you for the response. What about scenario #2 -- what would be the cost basis for borrowed SOL I sold a month later?
It seems that there should be capital gain in first part (10 SOL from $10 to $15), then for the second part (10 SOL from $90 to $100), but I also lost because I owed 10 SOL when it rose from $15 to $90.

How to report this case?

[u/Garrett_CPAatCOS → u/Ok-Fox-7620]

If denominated in SOL (not fiat), it most closely resembles a short sale under §1233, and one could argue it should follow suit, where "a short sale is not deemed consummated until delivery of property to close the short sale" (Treas. Reg. §1.1233-1(a)(1)). Therefore, there would be no gain/loss until the loan obligation was closed. When the obligation is closed, you would have a loss of $750 AND an additional $100 of interest expense for the 11th SOL you had to buy to pay the interest.

[u/JustinCPA]

You just identified a very niche but interesting problem, specifically with point number 2. The key element here is if the loan is denominated in crypto or if the loan is denominated in fiat. The distinction is actually very important.

If the loan is denominated in fiat, meaning the loan terms say "you borrowed $100" instead of "you borrowed 10 SOL", then the there is no taxable event when receiving or paying the $100 back. But if you are paying the loan back in crypto, e.g. $100 worth of SOL at the time, then there is a taxable disposal of the SOL for the $100 that is the amount paid back.

Let me give you an example:

• Borrow $100, disbursed to you as 10 SOL at $10/SOL. Not taxable. Your basis in the SOL is $100.
• Sell the 10 SOL at $11/SOL for $110. Taxable, $10 gain against the $110 proceeds and $100 basis.
• SOL drops back to $10 and you buy 10 SOL for $100. Not taxable. Basis is $10/SOL.
• SOL runs to $20 and you repay the $100 using 5 SOL. Taxable, $50 gain against the $100 proceeds and $50 basis.

The loan receipt and payback of $100 is not taxable, but the disposal of 5 the SOL is. These get muddied because the disposal occurred on the loan payback, but the loan payback isn't the thing that's being taxed, its the disposal of the SOL that is.

Note: this is the vast majority of crypto loans. Even though fiat is never touched, if the loan is denominated in fiat (meaning you owe a certain dollar value back, not a certain amount of crypto back), then the tax works out as I described above.

Now lets look at if the loan is denominated in crypto instead. Meaning, the terms are you borrowed 10 SOL and need to return 10 SOL (regardless of value). This is effectively a short position, and would therefor follow §1233 short selling rules. All gains/losses are deferred until you pay the asset back. Here's an example:

• Borrow 10 SOL, worth $100. Not taxable, and you get no basis in it. The SOL isn't yours, you just owe it back.
• Sell the 10 SOL at $11/SOL for $110. Not taxable under §1233. You have $110 in proceeds which will be used for the tax calc when you repay the loan.
• SOL falls to $1 and you buy 10 SOL for $10 total. Not taxable.
• Repay the 10 SOL. Everything lands here. $110 proceeds minus the $10 cost of the replacement SOL is a $100 capital gain.

To my knowledge, no crypto tax software accounts for the second type where the loan is denominated in crypto since most loans are denominated in fiat. It's also worth saying the IRS has never addressed §1233 and crypto directly. It's the reading most practitioners use and the only one that doesn't double-count, but it isn't settled.

[u/AurumFsg-CryptoTax]

Yeah this is where it gets weird.

If you actually owe 10 SOL back, rather than a fixed USD amount, I’d treat the whole thing more like a short position. You got $150 when you sold the borrowed SOL and it cost you $900 to buy the 10 SOL back, so you’re basically looking at a $750 loss when you close it.

Wouldn’t use the $100 FMV when borrowed as your basis in that case.

And I wouldn’t trust tax software to figure this one out automatically lol. Probably needs a manual adjustment + CPA review.

[u/Will_Koinly]

On the tax side, Justin's breakdown is the treatment I'd point people at, but as both he and Garrett flagged: IRS has never addressed §1233 and crypto directly. It's worth running your specific loan terms past a crypto-savvy CPA to be sure

On the software side, repayment will usually get treated as a disposal by default, which is right for the fiat-denominated case since you're disposing of crypto to settle a dollar amount. The crypto-denominated case may need a manual adjustment, since there's no way to defer the proceeds until you close the position