Chalk another one up to the law of unintended consequences. Our dumb policy of treating every crypto-to-crypto trade as a taxable event has given rise to an equally dumb, but somewhat delightful, loophole, made possible by emerging blockchain-based lending platforms.
How it works
Say you own $30,000 worth of Bitcoin, purchased eight months ago and you’re aching to move into Stellar. Normally, you’d need to sell some Bitcoin to buy Stellar, but that would trigger short-term capital gains (it’s been less than a year since you bought your Bitcoin). With the lending loophole, you avoid taxes by taking out a loan against your Bitcoin to buy Stellar.
The web is dotted with blockchain-based lending platforms, some traditional and some decentralized; some trustworthy and some with flagrant red flags. Evaluating them is outside the scope of this article, but for illustration’s sake, let’s assume you take out your loan with BlockFi, a New York-based platform that’s raised $51 million in blue-chip funding.
You send BlockFi your $30,000 in Bitcoin and they safely stow it away. They issue you a fiat loan for half of your Bitcoin’s worth, $15,000, which you use to buy Stellar.
Four months pass and you can finally exchange your Bitcoin without incurring a tax penalty. Use some to pay off your loan and, tada, your portfolio is now perfectly apportioned between Bitcoin and Stellar, penalty-free. Since the interest rate on your loan is less than the tax penalty you would’ve incurred, you’ve profited handsomely. And if the price of Bitcoin went up in the meantime, you’ve doubly profited. Free money! Not quite.
There are downsides
- If Stellar and Bitcoin plummet in price, you’re in despair AND you owe $10,000 or so dollars. That’s how lives are ruined.
- You’re limited by a crypto-to-fiat loan ratio; BlockFi’s is 50 percent. There’s no way to go all-in from Bitcoin to Stellar with a loan.
- It gets ridiculous if you want to pull an Inception and lock up your Stellar to take out ANOTHER loan. For the moment, you can’t do that anyway since not all coins are supported.
- Different platforms have different geographical limitations. For example, BlockFi only operates in some states in the U.S. This will be less of a problem in the future.
Why not use a service like LendingClub?
You can, but LendingClub, or any bank for that matter, needs a credit score, which is a no-no for the 15-year old Bitcoin robber baron. They’ll also need collateral or a guarantor for larger loans. Most importantly, they won’t let you pay off your loan with crypto, which is much more convenient than cashing it out first.
Do people actually do this?
You’re probably wondering if anyone actually goes to the trouble of doing this, especially since many crypto traders skirt taxes to begin with. I asked BlockFi and they told me it’s a popular use case, but so is taking whirlwind trips around the world. Here are their top five reasons overall:
The bottom-line: our crypto tax policy is dumb and it takes equally dumb maneuvers like the lending loophole to outfox it.
How startups are scaling communication: The pandemic is making startups take a close look at ramping up their communication solutions. Learn how