Transferring ownership of cryptocurrency can occur under different circumstances. Whether such a transfer results in a taxable event, requiring the recognition of gains or losses, depends on various factors.
Additionally, any payments exchanged between the lender and borrower of cryptocurrency need to be classified appropriately for tax purposes.
Securities Loans and Their Tax Treatment
In traditional finance, securities holders can participate in “securities lending,” where the lender temporarily transfers securities to a borrower, with the understanding that the same securities will be returned, usually upon demand.
The U.S. tax code addresses this under Section 1058 of the Internal Revenue Code (IRC). If a securities loan follows the conditions outlined in Section 1058, the lender does not have to recognize a taxable gain or loss upon making the loan.
This provision was introduced in 1978, and accompanying regulations were proposed in 1983 but never finalized.
When Section 1058 was passed, additional amendments were made to ensure that tax-exempt organizations lending securities would not be subject to the unrelated business taxable income (UBTI) rules on the income they receive from securities lending.
IRS Perspective Before Section 1058
Before the enactment of Section 1058, the IRS was uncertain about the correct tax treatment of income from securities lending.
The tax code’s Section 512(b) lists specific types of income, such as interest, dividends, rents, and royalties, that are exempt from being classified as unrelated business taxable income. Initially, the IRS was hesitant to classify securities lending income under these categories, believing it to be a separate type of transaction.
Despite this uncertainty, the IRS consistently ruled that the act of lending securities itself did not constitute a taxable event. Shortly before Section 1058 was passed, the IRS provided two main justifications for this conclusion:
- Non-Recognition of Gain Under Treasury Regulations
According to Treasury Regulation Section 1.1001-1, an exchange is not considered a taxable event if the property received is not materially different in kind or value from the property given up. Since a lender in a securities loan receives back the same securities that were originally lent, the transaction does not create a taxable event. - Non-Recognition Under Section 1036
Section 1036 of the IRC provides tax deferral treatment when stocks of the same corporation are exchanged, as long as common stock is exchanged for common stock or preferred stock for preferred stock. The IRS used this logic to support its position that a securities loan should not be treated as a taxable disposition.
Does Section 1058 Apply to Cryptocurrency Loans?
Since cryptocurrency is not classified as a security under U.S. tax law, Section 1058 does not directly apply to crypto loans.
However, a similar argument can be made using Treasury Regulation 1.1001-1. The core principle of this regulation suggests that if the lender receives back the same cryptocurrency that was lent, the loan should not be considered a taxable event.
This conclusion assumes that the borrower returns the exact same type of cryptocurrency. The debate over whether an exchange of different cryptocurrencies could qualify for tax deferral under Section 1031 (like-kind exchange rules)—which was relevant before the 2017 tax law changes—is not applicable here.
The test under Section 1.1001-1 is much stricter than the like-kind exchange standard, as clarified in the U.S. Supreme Court case Cottage Savings Association v. Commissioner (1991).
Unresolved Issues with Crypto Lending
While there is a strong argument that cryptocurrency lending structured like a securities loan should not trigger a taxable event, the language of Section 1058 presents an issue that the IRS has never directly addressed.
A securities loan can be seen as an exchange of securities for an obligation by the borrower to return those securities later. If this transaction is interpreted as an exchange of securities for an obligation instead of the securities themselves, then a taxable event could occur. The proposed regulations under Section 1058 suggest that failing to meet the section’s requirements would cause a securities loan to be treated as a taxable event. Applying this reasoning to cryptocurrency lending, a crypto loan structured similarly to a securities loan may still avoid taxation under the Section 1001 regulations, provided the loan agreement contains the following key elements:
- The lender must have the right to demand the return of the cryptocurrency at any time with minimal notice.
- The lender must retain the risks of ownership while the loan is active.
There has been tax controversy in situations where lenders do not have the right to demand the return of their loaned assets for an extended period. A key case on this matter is Commissioner v. Samueli (2009), where a securities loan was structured to gain tax benefits, leading to IRS challenges. If cryptocurrency is ever legally classified as currency, then lending cryptocurrency would be treated as a straightforward loan rather than a securities transaction.
Tax Treatment of Payments Received from Cryptocurrency Loans
Another aspect of securities loans is the taxation of payments made to the lender. The IRS has historically ruled that payments received by securities lenders are not classified as interest, dividends, rents, or royalties.
- When securities are lent out, any dividends or interest earned during the loan period are typically passed back to the lender.
- The IRS ruled that since the borrower now possesses the securities, they are the rightful recipient of any dividends paid during the loan period. If the lender were also able to classify payments as dividends, it would artificially create additional dividend income, which the IRS does not allow.
Since cryptocurrency does not generate dividends or interest, there are different concerns. For example, if a hard fork or airdrop occurs while the cryptocurrency is on loan, the borrower may be required to return not only the original cryptocurrency but also any additional assets received. The correct tax treatment of these extra assets remains unclear.
Interest-Like Payments on Crypto Loans
Lenders in securities loans typically receive a return based on the value of the securities loaned and the duration of the loan. While this might resemble interest, it does not perfectly fit the definition, since the loaned asset is not cash.
- Could these payments be classified as rent? Normally, rent applies to physical property, not digital assets.
- Could these payments be considered royalties? Royalties typically apply to intangible assets, like patents or natural resources, and depend on usage, not time.
Before Section 1058 was enacted, the IRS concluded that these payments did not fit into any exempt income categories under Section 512. However, since securities lending is not considered a trade or business activity, tax-exempt entities were allowed to treat securities lending income as non-taxable. The same uncertainty applies to cryptocurrency lending income, meaning that lenders currently have no clear tax guidance on how to classify these payments.
Cryptocurrency and Repo Transactions
Cryptocurrency can also be used in repurchase agreements (repos). In a repo, a cryptocurrency holder sells the asset with a contractual obligation to repurchase it later at a fixed price.
- The return of the cryptocurrency is not dependent on its market value at the time of resale.
- Instead, the original seller must pay the original sale price plus an additional interest-like payment to regain ownership.
Historically, repo transactions prevented the lender from selling the underlying asset. However, modern repo agreements may allow lenders to dispose of the asset during the contract period.
- If the lender is free to sell the cryptocurrency, the IRS may apply the securities loan tax rules, meaning the transaction would not be taxable.
- If the lender is restricted from selling, then the additional amount paid during repurchase would likely be classified as interest for tax purposes.
Conclusion
The tax treatment of cryptocurrency lending remains an open question. While arguments exist that crypto loans should not trigger a taxable event under Section 1001, there is no explicit IRS guidance confirming this.
The classification of income received from crypto lending—whether as interest, rent, royalties, or some other category—is also unresolved. Future IRS rulings and court decisions will likely determine how these transactions are ultimately taxed.
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