What are Bitcoin loans, and how do they work?

The saying “it takes money to make money” is timeless – and just as true for digital assets as it is for traditional currency. In fact, one way traders are leveraging their crypto to grow wealth is by taking out Bitcoin loans.

Loans against appreciated cryptocurrency allow traders to access liquidity without triggering capital gains taxes. But to benefit from crypto-backed loans, it’s important to understand their intricacies. 

In this guide, we’ll explain how to get a Bitcoin loan. We’ll also break down the risks and tax implications.

Factors to consider before applying for a Bitcoin loan

With the appreciation of digital assets like Bitcoin (BTC) and Ether (ETH), loans for cryptocurrency have become a popular tool for investors to access liquidity without selling their holdings. However, traders should be aware of several important factors before applying for a Bitcoin loan. Factors to consider include:

Risks associated with rehypothecation

When taking out a Bitcoin loan, lenders typically require borrowers to deposit crypto assets as collateral. Bitcoin occurs when the lending platform uses this collateral to lend to others, introducing counterparty risks. If the platform faces solvency issues due to third-party activities, borrowers could be at risk of losing their collateral, but many remain unaware of this potential danger.

Annual percentage rate (APR)

The APR is the yearly interest rate charged to borrowers on Bitcoin loans. Similar to traditional finance, it represents the annual cost of the loan, expressed as a percentage of the total loan amount. Typically, short-term Bitcoin loans have lower interest rates than long-term ones. Traders often compare APRs across platforms to secure the best deal, as lower interest rates generally mean lower payments.

LTV requirement

Before taking a Bitcoin-backed loan, traders should consider the loan-to-value (LTV) requirement, which determines the loan size relative to the collateral. Different platforms have varying LTV requirements, which, along with the APR, help calculate the total cost of the loan. Generally, a lower LTV requires more crypto to be deposited for the same loan amount. For example, a $20,000 Bitcoin loan with a 20% LTV requires $100,000 worth of Bitcoin collateral to be deposited, whereas the same loan with a 50% LTV requires only $40,000 worth of Bitcoin collateral at the time of loan origination.

Collateral-to-principal (CTP) versus loan-to-value (LTV)

LTV has an inverse value known as collateral-to-principal (CTP), which helps traders assess their current deposit ratio. A 100% CTP indicates a balanced loan. Over-collateralized loans, with a CTP above 100%, may allow for partial withdrawals, while under-collateralized loans, with a CTP below 100%, could trigger a margin call, requiring an additional deposit. Due to the volatile nature of the underlying Bitcoin collateral, Bitcoin loans typically have CTP above 100% to mitigate against margin calls and potential loss of collateral due to liquidations during market downturns.

Receiving a Bitcoin loan

Currently, traders can access crypto loans from an expanding list of reputable companies, often within 48 hours after applying if they qualify. While some popular cryptocurrency lending platforms like BlockFi and Celsius have closed due to bankruptcy, several centralized finance (CeFi) companies, including Coinbase and Unchained Capital, continue to offer Bitcoin loans. Mobile apps like Cash App also provide a convenient way for traders to secure loans on the go.

While the approval process is often swift, the qualification requirements can vary between platforms. Most CeFi exchanges impose strict know-your-customer (KYC) requirements before allowing traders to open an account, and additional conditions like minimum account balances and credit checks may apply. After meeting the platform's conditions and receiving loan approval, the trader deposits their collateral. Once the platform confirms the deposit, it disburses the loan.

Lenders typically issue Bitcoin loans in fiat currency, such as USD, or stablecoins, like Tether (USDT) and USDC (USDC). Most centralized exchanges offer intermediary services to transfer fiat from the platform to the customer's bank account. To avoid default, borrowers must repay their loans according to the terms set by the crypto lending platform (in this case, Bitcoin). If a borrower defaults, the exchange may liquidate the collateral to cover the loan.

DeFi platforms: Peer-to-peer Bitcoin loans

In addition to CeFi services, decentralized finance (DeFi) platforms offer peer-to-peer (P2P) Bitcoin loans. DeFi platforms generally allow traders to lend one cryptocurrency in exchange for a collateral deposit made in another. These decentralized exchanges (DEXs) use self-executing smart contracts to automate agreements, including the terms of Bitcoin loans and liquidations.

DeFi services often use stablecoins as collateral for Bitcoin loans. Stablecoins are tied to the value of another asset, such as the U.S. dollar, providing stability that reduces the risk of margin calls due to value fluctuations.

Some DeFi platforms also offer Bitcoin loans without any upfront collateral, known as flash loans. In these cases, borrowed crypto assets must be returned within the same blockchain transaction. Smart contracts handle the processes of arbitrage, liquidations, and collateral swaps, ensuring that all aspects of the loan are executed automatically and efficiently.

Interest expense on Bitcoin loans

Crypto lending platforms typically charge an annual percentage rate (APR) for loans secured by Bitcoin. The interest rate can vary with market conditions and between platforms, so it’s important to compare options to find the best loan terms.

If traders use the loan proceeds for investment or business purposes., they can deduct the interest expenses from their taxes. Investment purposes include buying other cryptocurrencies or traditional assets like stocks and securities. For investment-related loans, interest expenses can be deducted using Internal Revenue Service Form 4952.

If the loan is used for business purposes, such as funding a rental property with the intent to make a profit, the interest expense is deductible on the business tax return.

However, if the loan proceeds are used for personal expenses, the interest expense is not tax-deductible.

How to pick a Bitcoin lending platform

Beyond the points already mentioned, such as rehypothecation and APRs, several additional factors can influence the overall cost of Bitcoin loans that traders should consider before choosing a lending platform:

Interest rates (APY)

The annual percentage yield (APY) is the interest rate applied to a loan or crypto deposited as collateral. Unlike APR, APY accounts for the effects of compound interest, offering a more accurate representation of a loan’s total cost. APY is included in the loan offer, and since different platforms may offer varying interest rates, it's worth comparing options to secure the best deal.

Fees

Crypto lending platforms charge different fees for their services, including Bitcoin loans. In addition to interest rates, traders may encounter origination, rebalancing, and administrative fees, which can significantly impact the overall cost of the loan. Reputable exchanges typically provide a detailed fee schedule for traders to review before proceeding with a loan.

Platform reputation

The reputation of a lending platform is crucial. Traders should investigate a platform's track record, including any security breaches or lawsuits, to assess its reliability. Reading reviews from verified customers can also provide valuable insights into the platform's customer service and overall experience.

Yield terms

Yield terms refer to the schedule on which the crypto lending platform pays interest. Payments may be monthly, weekly, or even daily. Traders acting as lenders must agree to the yield terms when securing a loan and adhere to the schedule to maintain their collateral.

Lockup requirements

Some platforms may require traders to lock up their Bitcoin for a specified period. During this lockup period, the trader cannot access their crypto but may benefit from an attractive APY in exchange. Typically, longer lockup terms correlate with lower interest rates, so traders should weigh the benefits against the inconvenience of restricted access.

Spending the loan proceeds

Traders who take out a Bitcoin loan can use the funds as they like, whether for everyday purchases, paying bills, or investing in assets like stocks or gold.

A key advantage of Bitcoin loans is that, unlike selling crypto, spending the loan proceeds doesn't trigger capital gains taxes. This makes borrowing against crypto assets an appealing option for those looking to access liquidity without selling their holdings.

However, to maintain this tax benefit, borrowers must stay current on their loan repayments. Failure to repay the loan on time could result in the lending platform liquidating the collateral to cover losses, which would create a taxable event. The disposal of collateral would lead to a capital gain or loss that the borrower must report to the Internal Revenue Service.

Paying off Bitcoin loans

After taking out a Bitcoin loan, traders enter the repayment phase, where they follow the agreed-upon schedule, interest rates, and fees set before the loan begins.

To avoid losing their collateral, traders must stay current with their repayments. Missing payments could lead the lending platform to sell the crypto collateral to cover the debt. If the value of the collateral drops significantly, the lending platform might issue a margin call, requiring traders to add more collateral. Ignoring a margin call could lead to the platform liquidating the collateral.

Upon repaying the loan, traders regain their collateral. If the cryptocurrency has appreciated during this period, they might consider taking out another Bitcoin loan.

When do you have to pay taxes on Bitcoin loans?

Generally, taking out a Bitcoin loan doesn't result in a taxable event because the underlying crypto asset isn't sold or disposed of. Instead, the collateral is temporarily deposited into a platform's custodial wallet while the borrower retains legal rights and ownership of the Bitcoin, expecting to recover it upon repayment. Even though a borrower retains legal ownership of the collateral, once it’s deposited onto a third-party custodial wallet, the owner loses control of the collateral (not your keys, not your crypto) and is at risk of not recovering the collateral if the lender becomes insolvent (e.g., BlockFi).

However, certain situations can trigger tax obligations with Bitcoin loans. If the borrower doesn't repay the loan on time, the lending platform may liquidate the collateral to recover losses, resulting in a realized capital gain or loss that must be reported to the IRS.

Price volatility can also lead to liquidation. If the value of the collateralized Bitcoin drops below a threshold set by the lending platform, the assets may be liquidated to prevent losses. To avoid this, the borrower may need to provide additional collateral or pay off the loan.

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Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.