Capital Gains
Profit from selling an asset for more than its purchase price. In crypto lending, capital gains can be triggered by liquidation events, collateral swaps, or converting earned interest.
You bought ETH at $1,000. It's now worth $3,000. If you sell — or if a platform sells it for you — the $2,000 profit is a capital gain, and the IRS wants a cut.
Most crypto investors know this applies to selling. Fewer realize that lending and borrowing activity can trigger the exact same tax event — without you ever clicking a sell button.
How It Works
A capital gain is realized when you dispose of an asset for more than its cost basis — the price you originally paid. In crypto lending, "disposal" is broader than most people expect. It includes liquidations, collateral swaps, and in some cases converting interest earned in one token into another.
Here's a concrete example. You deposit 1 ETH (cost basis: $1,500) as collateral on a lending platform. Your LTV ratio climbs past the liquidation threshold, and the protocol sells your ETH at $2,800 to repay the loan. You just realized a $1,300 capital gain — even though your goal was to borrow, not sell.
Holding period matters too. Gains on assets held under one year are taxed as ordinary income in the U.S. Hold longer than a year and you qualify for the lower long-term capital gains rate. A liquidation that forces a sale before that one-year mark can cost you significantly more in taxes.
Why It Matters
If you're borrowing against crypto to avoid a taxable sale — a common and legitimate strategy — a liquidation destroys that plan entirely. You end up with the tax liability you were trying to defer, plus a depleted position.
What is Liquidation Threshold?
The LTV ratio at which a lending protocol will begin liquidating a borrower's collateral. For example, if the liquidation threshold is 80%, your collateral will be sold if your debt reaches 80% of its value.
Full glossary entryBill's Take
In 25 years of mortgage lending, I watched plenty of borrowers use home equity loans to avoid selling appreciated assets. The logic was sound: borrow against the asset, keep the gain unrealized, pay the loan back over time. Crypto-backed loans work the same way — until the collateral drops fast enough to trigger a forced sale. A margin call in traditional finance at least comes with a phone call and a few days to respond. In DeFi, the liquidation happens in the same block as the threshold breach. The tax event is instant.
What to Watch
Interest earned in crypto tokens is generally treated as ordinary income when received — not a capital gain. But if you later sell or swap those earned tokens at a higher price, that appreciation becomes a separate capital gain. You can end up with two taxable events from a single yield-farming position.
Liquidation = Taxable Event
Liquidation is a taxable disposal. If your collateral gets liquidated, the IRS treats it as a sale at the liquidation price — regardless of whether you intended to sell. You owe capital gains tax on the difference between that price and your original cost basis. Maintain enough buffer in your collateral ratio to avoid forced sales, especially if you're sitting on a large unrealized gain.
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