What Happened
Earlier this year the total cryptocurrency market cap dropped from ~3 trillion to below 1 trillion within a matter of weeks, triggering nearly $1 billion worth of liquidations from investors trading derivatives products 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 instance, someone could borrow $100 worth of USDC against $150 worth of ether, with a liquidation ratio of 125%. If the price of that ether drops below 125% of the outstanding balance, the platform would sell the collateral unless the borrower pays down the loan or adds more funds. This is called a margin call.
When an investor gets 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 because of these forced sales and the belief that they “lost” their funds. Unfortunately, you might actually owe tax money to the IRS on your liquidations.
These forced liquidation clauses are generally mentioned in the terms & conditions of both domestic overseas exchanges. (Binance example)
Key Concepts
It is important to know the basics of cryptocurrency taxation before diving into liquidations and how they could trigger unintended tax consequences.
How Cryptocurrencies Are Taxed In The US
According to the IRS Notice 2014-21, cryptocurrencies are taxed as “property” and subject to common tax rules applicable to property transactions. This means you have to pay capital gains taxes when you dispose of (sell) crypto assets at a profit.
For example, say you purchased 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 $40,000 ($50,000 - $10,000) profit.
There are two types of capital gains: short-term capital gains & long-term capital gains. Short-term capital gains occur when you sell your crypto assets after holding them for less than 12 months. These gains are subject to your ordinary income tax bracket which could 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 more than 12 months. Long-term capital gains are subject to either a 0%, 15%, or 20% tax rate depending on your annual taxable income.
You can also write off losses related to cryptocurrency trading, subject to some limitations.
Liquidations
Liquidations occur when you borrow funds on margin and fail to fulfill the margin call on time. In such situations, exchanges convert your crypto assets into cash to limit their losses.
For example, say George purchased 1 BTC in 2015 for 1,000. In Q1 2022, during the peak of the market, this coin is worth $60,000. George deposits this coin in a crypto exchange and obtains a $30,000 fiat loan. Note that the exchange only gives him a loan for 50% of the current value of the coin. 50% is the loan-to-value (LTV) ratio.
In Q2 2022, the price of BTC falls to $30,000. While the price is going down the exchange triggers a margin call to George to add more coins to maintain the 50% LTV. If George fails to deposit more bitcoin to maintain the 50% LTV or pay down the loan, the exchange can liquidate the BTC at the market price to limit their 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 From Liquidations
Liquidations can trigger a couple of unintended tax consequences. First, if the liquidation price of the asset is higher than your cost basis, that could trigger capital gains taxes. Second, you will have to produce fiat to pay the tax liability triggered by the liquidation.
Going 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 produce fiat to pay the taxes related to the $29,000 capital gain. George’s estimated tax bill on the $29,000 gain would de $4,350 ($29,000 * 15%)
How You Can Avoid Liquidations
The safest way to avoid liquidations is by not borrowing funds based on your crypto assets. You can continue to do 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 pay attention to margin calls and have funds on the sideline to pay down the loan and/or increase the collateralized amount if/when a sudden market drop occurs.
Note that companies that have borrowed funds based on their internal crypto treasuries can also be subject to liquidations and above tax consequences, if they fail to meet margin requirements. The loss of collateralized assets would also have a negative impact on the company’s balance sheet and decrease GAAP net income in certain cases.
Next Steps
- If you were liquidated in 2022, calculate the capital gains and make sure you have sufficient fiat to cover the tax bill.
- Keep an eye on margin calls if you borrow funds collateralized by crypto assets.
Further Reading
- Large Crypto Losses May Not Become Instant Tax Write-0ffs, But Here’s What You Can Do
- IRS May Not Tax Passive Income From Holding Crypto Right Away
