The Case for Cash vs Margin: Crypto Tax Edition

The Case for Cash vs Margin: Crypto Tax Edition

Let's pretend that you owe the IRS $10,000 USD in taxes.

You can afford to pay this from your bank savings, but you also have $20k in Solana at current prices that has appreciated 100% since you bought it for $10k six months ago.

You could sell half to pay taxes but then you’d owe another $2000 in taxes on the $5000 gain (assuming 40% tax rate). You are annoyed by this because your tax burden is already high this year. Plus, you want to hodl on your crypto investment anyway.

The problem is that you recognize that using cash and _not_ selling your crypto to pay this tax you owe now (to a debtor with lots of guns) is effectively making an additional $10k cash bet on the future of Solana. You’re not sure if you want to do that.

Wat do?

You decide to put $20k Solana up as collateral to borrow $10k USD coin at 8% APY and convert that to fiat to pay your taxes. You are at 50% borrowing leverage and liquidation will happen at 70%, so as long as Solana does not drop by 30%, you’re fine.

The government men with guns are happy and you now owe a shady defi network $10k USDC which will cost you roughly $800 per year (compounding) till you pay it back.

What happens next if you make no more moves during the following year?

Case 1: Solana Goes Up 100%

Solana once again doubles in value over the following 12 months and your collateral is now worth $40k. You can go back and pay your $10,800 in USDC to settle your loan at any time and release it back to your wallet. You pay this now from cash and recover your collateral with no tax burden. (Gain $9.2k)

If you had converted your crypto for fiat to pay your taxes last year, you would only have $20k in Solana and you’d still owe the IRS $2000 from the conversion, but you would have kept your 10k cash. (Loss $12k)

If you had paid $10k cash out of pocket last year, you would just have your $40k worth of Solana. (Gain $10k)

Case 2: Solana Stays Flat

Solana moves hardly at all this year and your collateral is still worth about $20k. You could choose to pay your debt now in cash and recover the collateral for $10.8k, which you do because you’ve decided you want out of the crypto game. (Loss $800)

If you had converted your crypto for fiat to pay your taxes last year, you would have your flat $10k left in Solana, and you’d still owe the IRS $2000 from the conversion, but you would have kept your 10k cash. (Loss $2k)

If you had just paid your taxes in cash last year, you wouldn’t be any better or worse off than you were. (No change)

Case 3: Solana Flash Crashes 30% and Recovers

Some passing defi news event occurs that causes your Solana value to drop by 30% of what it was worth when you took out the loan, but it recovers within a day or two. Unfortunately, this auto-liquidated your collateral to pay your loan when you hit 70% borrowing leverage (when your collateral was worth about $14k).

You no longer have a debt and you got to keep your $10k cash from last year, but you only have $4.2k left in Solana (after the market recovers from the 30% dip). Extra sad is that this (most likely ??) triggered a tax liability for you when they sold your coins—the only silver lining is they did it at market low, so your tax burden is reduced to about $1.2k.

Also, you believe the coin will recover, so as soon as it starts climbing from the crash you take your cash $10k and reinvest it into Solana, capturing 70% of the climb back up in value to flat (approx. 21%). You now have an additional $12.1k in SOL. (Loss $14.9k)

If you had sold crypto to pay tax last year, you’d owe the IRS $2k, have kept your $10k cash, and wait out the dip until your SOL was worth $10k again. (Loss $2k)

If you had just paid your taxes in cash last year, you wouldn’t be any better or worse off than you were. (No change)

Case 4: Solana Crashes 80% and Does Not Recover

Something bad happens that has major market impacts and Solana does not recover. It loses 80% of its value and stays there. As with the last case, you were auto-liquidated on the way down. You no longer have a debt to pay, but your remaining SOL is only worth $200.

You owe the IRS $1.2k from the liquidation, but you can sell your remaining SOL to offset this gain with a loss. You still have your $10k cash. (Loss $10k)

If you had sold crypto to pay tax last year, you’d owe the IRS $2k, have kept your $10k cash, and could now sell your SOL worth $1k to offset what you owe the IRS, but you’re still out your $20k. (Loss $20k)

If you had paid cash last year, you’d be out $10k cash and your SOL would only be worth $2k. (Loss $28k)

Discussion

What does this look like if we lay it out in a chart?

Tax Pmt

Sol Gains

Sol Flat

Flash Crash

Mkt Crash

Borrow

9200

800

14900

10000

Sell SOL

12000

2000

2000

20000

Pay Cash

10000

-

-

28000

We can basically throw selling your crypto to pay taxes directly out the window—it’s a bad option in every case except for the flash crash scenario, and then only if you trust yourself not to panic sell your position when your SOL is tanking.

This is the coward’s hedge. If the market crashes, you lose big. If the market gains, you lose big.

The only reason you should consider this option is if you’re trying to reduce your exposure to crypto intentionally, but you want to do it over time because you have FOMO and you’re indecisive. This seems like a weird strategy to me, but you do you.

Now you have the question of borrowing vs paying cash. Paying cash actually turns out to be the worst option on the board if SOL tanks and doesn’t recover. You’re out the money plus your crypto.

This was the unfortunate position of lots of people when they got their tax bill after the 2017 ICO crash and had to fork over cash to pay the tab (especially if they got out entirely at that point).

But it’s the best option if SOL does really well (which makes sense, because remember that this is the equivalent of laying an extra $10k bet on SOL from your cash savings at tax time).

Borrowing, on the other hand, is by FAR your best option in the event of a total value collapse (you’re only out $10k rather than $20k or $28k for the other scenarios). If the currency stays flat, you’re also no worse off except for the interest you’re paying. If it goes up, you still get to capture those gains and only have to pay the interest. So you can think of this as an $800/year insurance policy against your currency losing all its value.

There’s only one problem with this: the flash crash scenario where your collateral gets auto-liquidated. It’s the worst scenario on the board for you outside of total market meltdown (although not much worse than if you had sold SOL to pay taxes and it does well, which is another reminder not to use that option).

If you can avoid a flash liquidation event, borrowing offers you the best across-the-board outcomes for any of the possible market conditions.

Flash liquidation is worst when the market dips sharply due to some news and then recovers shortly after before you can take any mitigation action. For heavily traded coins most news doesn’t dip them that hard unless the volatility is already super high (like when SOL was up to $210 and down to $110 this last month before settling at $130-140ish like it is now).

If things are fairly stable, a 30-40% dip on news which recovers same day is extremely unlikely. The thing about holding cash in reserve for this possibility is that you can re-enter when things start trending up again or when they stabilize and recapture some of the loss even if you do get hit (and if it doesn’t recover you’re in the market crash scenario anyway).

But better not to get hit in the first place. So what can you do to avoid this bad, expensive outcome?

Well, for one thing, you could increase your collateral and spread your position across several different coins. If you’ve been HODLing bitcoin or ETH, you can add to your leverage position so that you’re only 30% exposed or 40% exposed and that any single asset dipping doesn’t jeopardize your overall position.

You could also be super extra safe and not ever borrow more than 15-20% of your collateral, because if that triggers an auto-liquidation you’re also in a total market meltdown scenario. But now you’re taking on risk from having more and more money up for collateral with a single lender, tied to a single wallet. Putting up $80k to borrow $10k isn’t a great idea unless you wanted $80k with the lender anyway.

But there are two things we haven’t discussed yet: crypto appreciation and returns on collateral.

All of these flash crash cases have worked with an assumption that the value of your currency has stayed flat (or close to flat). For the last several years, all of the heavily traded coins have steadily appreciated (and if you’re long crypto you expect this to continue). As your coins appreciate, your leverage position on the money you borrowed will slowly increase, so unless you flash crash the day after you borrow, your risk should decrease over time.

If the value fluctuates but _doesn’t_ flash crash, you have time to add more collateral (and further reduce your risk) or pay back your debt and retrieve your precious, non-appreciating coins if you’re getting too close to your liquidation threshold for comfort.

Furthermore, you’re also earning interest on your collateral. Not a ton at .18-.5% for Solana, but not nothing, so this also further erodes your leverage risk.

If the coins continue to appreciate year over year, you could (in theory) do this as often as you wanted to and at a rate of leverage risk you’re comfortable with to continue to pay tax this way.

In fact, the implication here is that it’s advantageous from both a tax and a risk perspective to pay for everything you’d otherwise pay cash for this way, if your crypto vault is sufficiently overflowing to mitigate the liquidation risk.

The thing that gives me the most pause here is that I’m not actually crypto-wealthy enough to be willing to concentrate sufficient assets with a single lender to try this strategy… but if I could do it with 20% of my total crypto holdings?

I’d be paying rent in borrowed crypto every month, baby.