How Crypto Liquidations Could Make You Pay Double

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What happened

Earlier this year, the total cryptocurrency market capitalization fell from around 3 trillion to less than 1 trillion in a matter of weeks, triggering nearly $1 billion in liquidations investors trading derivatives such as futures or borrowing 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 0 of USDC against $150 of Ether, with a liquidation rate of 125%. If the price of this ether falls below 125% of the outstanding balance, the platform will 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, this may not be the only time they pay. Some may believe they are eligible for certain tax breaks because of these forced sales and the belief that they have “lost” their funds. Unfortunately, you might actually owe the IRS money on your liquidations.

These forced liquidation clauses are usually mentioned in the terms and conditions of the two national exchanges abroad. (Binance Example)

Key Concepts

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

How Cryptocurrencies Are Taxed in the United States

According to Tax Notice 2014-21, cryptocurrencies are taxed as “goods” and subject to the common tax rules applicable to real estate transactions. This means that you have to pay capital gains taxes when you sell (sell) crypto assets for 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 have to pay capital gains taxes on a profit of $40,000 ($50,000 – $10,000).

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 more than 12 months. These gains are subject to your ordinary tax bracket, which can range from 10% to 37% based on your total annual taxable income.

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

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

Clearance

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

For example, let’s say George bought 1 BTC in 2015 for 1,000. In Q1 2022, during the peak of the market, that coin is worth $60,000. George deposits this coin on a crypto exchange and gets a $30,000 fiat loan. Note that the exchange only gives him a loan of 50% of the coin’s current value. 50% is the loan to value ratio (LTV).

In the second quarter of 2022, the price of BTC drops to $30,000. As the price falls, the exchange triggers a margin call for George to add more coins to maintain the LTV at 50%. If George fails to deposit more bitcoins to maintain the 50% LTV or repay the loan, the exchange may liquidate the BTC at market price to limit its losses.

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

Unintended tax implications of liquidations

Liquidations can have some unintended tax consequences. First, if the liquidation price of the asset is higher than your cost base, this could trigger capital gains taxes. Second, you will need to produce fiat to pay the tax liability triggered by the liquidation.

In the example above, George realizes a long-term capital gain of $29,000 ($30,000 – $1,000) even though he has suffered an economic loss. When filing taxes, George must file fiat to pay the 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 to avoid liquidations

The surest way to avoid liquidations is to not borrow funds against your crypto assets. You can continue spot trading without ever having to worry about the risk of being liquidated.

If you still want to borrow funds, it is very important to be careful of margin calls and to have funds on hand to repay the loan and/or increase the guaranteed amount if/when a sudden market drop occurs.

Note that companies that have borrowed funds based on their internal crypto treasuries may also be subject to liquidations and higher tax consequences, if they fail to meet margin requirements. The loss of secured assets would also negatively impact the company’s balance sheet and decrease GAAP net income in some cases.

Next steps

  • If you were liquidated in 2022, calculate the capital gains and make sure you have enough fiat to cover the tax bill.
  • Keep an eye out for margin calls if you are borrowing funds secured by crypto-assets.

Further reading

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