How DeFi Lending and Borrowing Protocols Work for US Borrowers

A DeFi lending and borrowing protocol replaces a bank's loan desk with open-source smart contracts running on a blockchain. Users deposit cryptocurrency as collateral into liquidity pools and can borrow against it without credit checks or identity verification. All loans are overcollateralized at 50% to 80% loan-to-value ratios. Interest rates adjust algorithmically every few seconds based on pool utilization, and smart contracts enforce liquidation automatically when collateral value drops below the protocol's liquidation threshold. No FDIC insurance applies.

Key takeaways

• DeFi lending protocols replace bank loan desks with smart contracts: no credit checks, no human approval, but also no FDIC insurance and no customer support.
• All DeFi loans are overcollateralized, you must deposit more value than you borrow, typically at 50-80% LTV depending on the asset.
• Your health factor is your early-warning number; when it drops to 1, the protocol liquidates your collateral automatically with no grace period.
• Liquidation penalties of 5-15% apply on top of your collateral loss, making maximum-LTV borrowing extremely risky during volatile markets.
• US regulation remains unsettled, the SEC, CFTC, and FinCEN have signaled interest but no comprehensive framework exists yet for DeFi lending.

What Is a DeFi Lending and Borrowing Protocol?

A DeFi lending and borrowing protocol is a set of open-source smart contracts deployed on a blockchain that lets anyone lend crypto assets to earn yield or borrow against crypto collateral, without a bank, credit union, or centralized intermediary sitting in the middle.

The protocol handles everything a loan officer normally would: it holds the collateral, calculates how much you can borrow, adjusts interest rates based on supply and demand, and liquidates your position if your collateral value falls too far. But it does all of this through code running on Ethereum or another smart-contract blockchain, not through a human underwriter reviewing your application.

For a US borrower, this changes the risk equation completely. There is no FICO score requirement, no employment verification, and no waiting period. There is also no FDIC insurance protecting your deposited collateral, no phone number to call if something goes wrong, and no regulator you can file a complaint with. The protections you take for granted in traditional finance simply do not exist here.

If you are brand new to the concept and want the fundamentals before diving into the mechanics, our primer on what DeFi lending actually means walks through the core ideas in plain language.

Smart contracts as the 'loan officer'

Smart contracts are self-executing programs stored on the blockchain. In a DeFi lending protocol, these contracts contain all the rules: maximum loan-to-value ratios for each collateral type, the interest rate formula, liquidation thresholds, and penalty fees. Nobody can alter these rules for a specific borrower, and nobody can grant exceptions.

This is fundamentally different from a bank. A bank can negotiate terms, grant forbearance, or manually review a borderline case. A smart contract cannot. It executes its programmed logic deterministically, every time, for every user. For borrowers, this means certainty about how the system will behave, but zero flexibility when circumstances change.

Liquidity pools: where the lendable money actually comes from

The money you borrow from a DeFi protocol does not come from the protocol itself. It comes from liquidity pools: smart contracts where other users deposit assets specifically to earn interest from borrowers. When you deposit USDC into Aave's liquidity pool, that USDC becomes available for someone else to borrow, and you earn a variable yield in return.

Each pool has a utilization rate: the percentage of deposited funds currently lent out. When utilization is low, rates are low. When borrowers draw heavily from the pool, rates rise automatically to attract more deposits and discourage excessive borrowing. This is the same supply-and-demand dynamic behind any lending market, but it plays out algorithmically and updates every few seconds rather than at quarterly bank meetings.

Smart contracts as the 'loan officer'

Smart contracts are self-executing programs stored on the blockchain. In a DeFi lending protocol, these contracts contain all the rules: maximum loan-to-value ratios for each collateral type, the interest rate formula, liquidation thresholds, and penalty fees. Nobody can alter these rules for a specific borrower, and nobody can grant exceptions.

This is fundamentally different from a bank. A bank can negotiate terms, grant forbearance, or manually review a borderline case. A smart contract cannot. It executes its programmed logic deterministically, every time, for every user. For borrowers, this means certainty about how the system will behave, but zero flexibility when circumstances change.

Liquidity pools: where the lendable money actually comes from

The money you borrow from a DeFi protocol does not come from the protocol itself. It comes from liquidity pools: smart contracts where other users deposit assets specifically to earn interest from borrowers. When you deposit USDC into Aave's liquidity pool, that USDC becomes available for someone else to borrow, and you earn a variable yield in return.

Each pool has a utilization rate: the percentage of deposited funds currently lent out. When utilization is low, rates are low. When borrowers draw heavily from the pool, rates rise automatically to attract more deposits and discourage excessive borrowing. This is the same supply-and-demand dynamic behind any lending market, but it plays out algorithmically and updates every few seconds rather than at quarterly bank meetings.

How the Borrowing Process Works Step by Step

Understanding DeFi borrowing means following one loan from deposit to repayment, or to its less pleasant alternative: liquidation. The entire sequence runs on smart contracts, and every step matters for your collateral.

If you have already read how crypto-backed loans work in practice, the DeFi version strips away the custodian entirely and replaces it with code. The borrowing logic is similar, but the risk profile shifts dramatically.

Step 1, Depositing collateral and calculating your borrow limit

You connect a non-custodial wallet like MetaMask to a DeFi lending protocol, select the asset you want to deposit as collateral, and approve the transaction. The protocol receives your tokens and locks them in its smart contract. You receive a receipt token, aTokens on Aave, cTokens on Compound, representing your deposit plus any interest it earns.

Immediately, the protocol calculates your maximum borrowing capacity. Each collateral asset has a maximum loan-to-value ratio: for ETH on Aave V3, the max LTV is typically 80% for stablecoin borrowing. If you deposit $10,000 worth of ETH, your maximum borrow amount is $8,000. Borrowing that full amount pushes you to the edge of liquidation from the first second.

Step 2, Borrowing assets and how interest accrues on-chain

You choose what asset to borrow. Most borrowers choose stablecoins like USDC or DAI because they want dollar-denominated liquidity without selling their crypto. The interest rate is not fixed: it is determined by the utilization curve of that specific pool and updates with every block on Ethereum, roughly every 12 seconds.

Interest compounds continuously. There is no monthly statement, no due date, and no minimum payment. Your debt grows block by block, second by second. You can repay any amount at any time simply by returning the borrowed asset plus accrued interest to the protocol, at which point your collateral becomes available for withdrawal again.

Step 3, The health factor: your early-warning number

Every DeFi borrowing position has a health factor: a single number displayed prominently in the protocol interface. A health factor above 1 means your collateral value still exceeds the liquidation threshold. The higher the number, the safer your position.

If your health factor approaches 1, you have two choices: deposit more collateral to strengthen your position, or repay part of the loan to reduce your debt. Doing nothing and hoping the market recovers is how borrowers get liquidated. This is the dashboard number that should command your attention above all others.

Illustrative example: what happens when collateral value drops 30%

Take a borrower who deposits $10,000 in ETH as collateral. The protocol allows an 80% maximum LTV, and the borrower draws $7,500 in USDC, leaving what looks like a comfortable buffer.

The liquidation threshold for ETH is approximately 82.5% on major protocols, not 80%. That means liquidation triggers when the borrowed amount reaches 82.5% of collateral value, not 80%.

Now suppose ETH drops 30% in a sharp selloff, collapsing the collateral value to $7,000. The borrowed amount ($7,500 plus accrued interest) now exceeds the collateral value. The health factor drops below 1. A liquidation bot detects the underwater position and repays the debt by seizing the collateral plus a liquidation penalty, typically 5% to 15% of the collateral amount.

The borrower keeps the $7,500 in USDC but loses the entire ETH deposit plus the penalty. If they had borrowed only $5,000 at a 50% LTV instead, the same 30% drop would still leave their health factor safely above 1.

Step 1, Depositing collateral and calculating your borrow limit

You connect a non-custodial wallet like MetaMask to a DeFi lending protocol, select the asset you want to deposit as collateral, and approve the transaction. The protocol receives your tokens and locks them in its smart contract. You receive a receipt token, aTokens on Aave, cTokens on Compound, representing your deposit plus any interest it earns.

Immediately, the protocol calculates your maximum borrowing capacity. Each collateral asset has a maximum loan-to-value ratio: for ETH on Aave V3, the max LTV is typically 80% for stablecoin borrowing. If you deposit $10,000 worth of ETH, your maximum borrow amount is $8,000. Borrowing that full amount pushes you to the edge of liquidation from the first second.

Step 2, Borrowing assets and how interest accrues on-chain

You choose what asset to borrow. Most borrowers choose stablecoins like USDC or DAI because they want dollar-denominated liquidity without selling their crypto. The interest rate is not fixed: it is determined by the utilization curve of that specific pool and updates with every block on Ethereum, roughly every 12 seconds.

Interest compounds continuously. There is no monthly statement, no due date, and no minimum payment. Your debt grows block by block, second by second. You can repay any amount at any time simply by returning the borrowed asset plus accrued interest to the protocol, at which point your collateral becomes available for withdrawal again.

Step 3, The health factor: your early-warning number

Every DeFi borrowing position has a health factor: a single number displayed prominently in the protocol interface. A health factor above 1 means your collateral value still exceeds the liquidation threshold. The higher the number, the safer your position.

If your health factor approaches 1, you have two choices: deposit more collateral to strengthen your position, or repay part of the loan to reduce your debt. Doing nothing and hoping the market recovers is how borrowers get liquidated. This is the dashboard number that should command your attention above all others.

Illustrative example: what happens when collateral value drops 30%

Take a borrower who deposits $10,000 in ETH as collateral. The protocol allows an 80% maximum LTV, and the borrower draws $7,500 in USDC, leaving what looks like a comfortable buffer.

The liquidation threshold for ETH is approximately 82.5% on major protocols, not 80%. That means liquidation triggers when the borrowed amount reaches 82.5% of collateral value, not 80%.

Now suppose ETH drops 30% in a sharp selloff, collapsing the collateral value to $7,000. The borrowed amount ($7,500 plus accrued interest) now exceeds the collateral value. The health factor drops below 1. A liquidation bot detects the underwater position and repays the debt by seizing the collateral plus a liquidation penalty, typically 5% to 15% of the collateral amount.

The borrower keeps the $7,500 in USDC but loses the entire ETH deposit plus the penalty. If they had borrowed only $5,000 at a 50% LTV instead, the same 30% drop would still leave their health factor safely above 1.

How DeFi Lending Rates Are Set (and Why They Change by the Minute)

DeFi lending protocols do not use credit committees or prime rates. They use algorithmic interest rate models that adjust borrowing and lending rates automatically based on how much of each liquidity pool is currently being used.

This is not a theoretical curiosity: it directly determines what you pay as a borrower and what you earn as a depositor. A deeper dive into how DeFi lending rates are calculated breaks down the math behind the curves, but the core logic is straightforward.

The utilization curve: supply, demand, and your APY

Every asset pool, say, the USDC pool on Aave, tracks a utilization rate: total borrowed divided by total deposited. When 30% of the USDC in the pool is lent out, utilization is low, capital is abundant, and rates stay modest for both lenders and borrowers.

As utilization rises, the interest rate algorithm pushes borrowing costs higher. This serves two functions: it attracts more depositors by offering higher yields, and it discourages additional borrowing by making it more expensive. The curve typically steepens sharply once utilization passes 80% to 90%, because the protocol needs to ensure there is always enough liquidity for depositors to withdraw.

Unlike a fixed-rate bank loan where your APR is locked at origination, a DeFi borrower's rate floats continuously. If demand for USDC borrowing spikes because traders are leveraging up during a rally, your rate climbs with it, potentially doubling or tripling within hours.

Why rate spikes happen and what borrowers can do

Rate spikes occur when utilization approaches 100%: nearly all deposited funds are lent out, and borrowers compete for the remaining sliver of liquidity. The algorithm's steep portion of the curve kicks in, and borrowing costs can jump dramatically.

A borrower with an open position has limited options when rates spike. Repaying early is the cleanest exit. Switching to a different protocol with more abundant liquidity can work if the cost of unwinding the position (gas fees, slippage) is lower than the interest savings. Doing nothing and hoping rates normalize means watching your debt compound at an elevated rate, potentially eroding your health factor faster than expected.

The utilization curve: supply, demand, and your APY

Every asset pool, say, the USDC pool on Aave, tracks a utilization rate: total borrowed divided by total deposited. When 30% of the USDC in the pool is lent out, utilization is low, capital is abundant, and rates stay modest for both lenders and borrowers.

As utilization rises, the interest rate algorithm pushes borrowing costs higher. This serves two functions: it attracts more depositors by offering higher yields, and it discourages additional borrowing by making it more expensive. The curve typically steepens sharply once utilization passes 80% to 90%, because the protocol needs to ensure there is always enough liquidity for depositors to withdraw.

Unlike a fixed-rate bank loan where your APR is locked at origination, a DeFi borrower's rate floats continuously. If demand for USDC borrowing spikes because traders are leveraging up during a rally, your rate climbs with it, potentially doubling or tripling within hours.

Why rate spikes happen and what borrowers can do

Rate spikes occur when utilization approaches 100%: nearly all deposited funds are lent out, and borrowers compete for the remaining sliver of liquidity. The algorithm's steep portion of the curve kicks in, and borrowing costs can jump dramatically.

A borrower with an open position has limited options when rates spike. Repaying early is the cleanest exit. Switching to a different protocol with more abundant liquidity can work if the cost of unwinding the position (gas fees, slippage) is lower than the interest savings. Doing nothing and hoping rates normalize means watching your debt compound at an elevated rate, potentially eroding your health factor faster than expected.

Key Risks Every US Borrower Must Understand

DeFi lending eliminates counterparty risk from banks but introduces new risks that traditional borrowers never encounter. Four categories deserve attention before you deposit any collateral.

Smart-contract exploits and audit limitations

Smart contracts are code, and code contains bugs. Aave, Compound, and MakerDAO have all undergone multiple third-party security audits, and their battle-tested codebases have survived years of adversarial scrutiny. But audits are not guarantees. Auditors find classes of vulnerabilities, not all vulnerabilities.

The DeFi lending news cycle in 2026 has already seen exploits on lesser-known protocols where attackers drained liquidity pools through reentrancy attacks, flash loan manipulation, or governance takeovers. Even audited protocols can be compromised if a dependency like an oracle or a cross-chain bridge is attacked. No amount of audit reports replaces the reality that your collateral sits inside code you cannot control.

Oracle failures: when price feeds lie

Protocols rely on oracles, typically Chainlink on Ethereum, to know the current market price of your collateral. If an oracle reports an incorrect price due to a malfunction, manipulation, or a flash-crash on the exchange it pulls data from, the protocol may calculate your health factor using a false number.

An artificially low price triggers unwarranted liquidations. An artificially high price lets borrowers drain funds against collateral that is worth less than reported. Oracle manipulation has been the attack vector behind some of DeFi's largest losses, and while Chainlink's decentralized node network reduces this risk compared to single-source price feeds, the dependency remains.

Liquidation cascades: the trap of borrowing at maximum LTV (COMMON MISTAKE)

The classic beginner mistake: a borrower sees "80% max LTV" and borrows the full amount, believing they have a 20% safety cushion. In practice, the liquidation threshold sits closer to 82.5%, leaving a razor-thin margin. When the market sells off and dozens of underwater positions hit liquidation simultaneously, a cascade can unfold.

Liquidators compete to seize collateral, driving prices lower in a self-reinforcing spiral. Borrowers who thought they had enough buffer watch their collateral get liquidated not because their loan was reckless, but because the protocol executed its programmed logic in a market panic. The lesson is simple: treat the maximum LTV as an emergency ceiling, not a target. A conservative 40% to 50% LTV turns a 30% drawdown from a catastrophe into a manageable event.

US regulatory gray zone: what the SEC and CFTC have signaled

DeFi lending exists in an unsettled regulatory environment for US persons. The SEC under Chair Gensler consistently signaled that many DeFi activities may implicate securities laws. The CFTC has indicated that certain DeFi protocols may fall under its jurisdiction for commodities-related activity, as outlined in its digital asset policy statements (CFTC, 2025). FinCEN has longstanding guidance on virtual currency transmission that may apply to protocol developers and front-end operators.

Several major DeFi protocols have begun geoblocking US IP addresses or restricting access from US-based wallets preemptively. The legal status of using a DeFi lending protocol as a US resident is not clearly resolved. What is clear: no US federal deposit insurance covers assets deposited in a DeFi protocol, and the CFPB, FDIC, and SIPC have no jurisdiction over them. If the protocol is hacked or your funds are lost, there is no government backstop.

Smart-contract exploits and audit limitations

Smart contracts are code, and code contains bugs. Aave, Compound, and MakerDAO have all undergone multiple third-party security audits, and their battle-tested codebases have survived years of adversarial scrutiny. But audits are not guarantees. Auditors find classes of vulnerabilities, not all vulnerabilities.

The DeFi lending news cycle in 2026 has already seen exploits on lesser-known protocols where attackers drained liquidity pools through reentrancy attacks, flash loan manipulation, or governance takeovers. Even audited protocols can be compromised if a dependency like an oracle or a cross-chain bridge is attacked. No amount of audit reports replaces the reality that your collateral sits inside code you cannot control.

Oracle failures: when price feeds lie

Protocols rely on oracles, typically Chainlink on Ethereum, to know the current market price of your collateral. If an oracle reports an incorrect price due to a malfunction, manipulation, or a flash-crash on the exchange it pulls data from, the protocol may calculate your health factor using a false number.

An artificially low price triggers unwarranted liquidations. An artificially high price lets borrowers drain funds against collateral that is worth less than reported. Oracle manipulation has been the attack vector behind some of DeFi's largest losses, and while Chainlink's decentralized node network reduces this risk compared to single-source price feeds, the dependency remains.

Liquidation cascades: the trap of borrowing at maximum LTV (COMMON MISTAKE)

The classic beginner mistake: a borrower sees "80% max LTV" and borrows the full amount, believing they have a 20% safety cushion. In practice, the liquidation threshold sits closer to 82.5%, leaving a razor-thin margin. When the market sells off and dozens of underwater positions hit liquidation simultaneously, a cascade can unfold.

Liquidators compete to seize collateral, driving prices lower in a self-reinforcing spiral. Borrowers who thought they had enough buffer watch their collateral get liquidated not because their loan was reckless, but because the protocol executed its programmed logic in a market panic. The lesson is simple: treat the maximum LTV as an emergency ceiling, not a target. A conservative 40% to 50% LTV turns a 30% drawdown from a catastrophe into a manageable event.

US regulatory gray zone: what the SEC and CFTC have signaled

DeFi lending exists in an unsettled regulatory environment for US persons. The SEC under Chair Gensler consistently signaled that many DeFi activities may implicate securities laws. The CFTC has indicated that certain DeFi protocols may fall under its jurisdiction for commodities-related activity, as outlined in its digital asset policy statements (CFTC, 2025). FinCEN has longstanding guidance on virtual currency transmission that may apply to protocol developers and front-end operators.

Several major DeFi protocols have begun geoblocking US IP addresses or restricting access from US-based wallets preemptively. The legal status of using a DeFi lending protocol as a US resident is not clearly resolved. What is clear: no US federal deposit insurance covers assets deposited in a DeFi protocol, and the CFPB, FDIC, and SIPC have no jurisdiction over them. If the protocol is hacked or your funds are lost, there is no government backstop.

DeFi Lending vs. Traditional Crypto-Backed Loans: Key Differences

Borrowers choosing between DeFi protocols and centralized crypto lending platforms face three structural differences that affect custody, access, and downside protection. Neither model is inherently superior for every situation.

If you are evaluating specific platforms, our guides to comparing DeFi lending platforms and top-rated crypto lending platforms cover individual options in more detail.

Custody: who holds your collateral?

DeFi lending is non-custodial. Your collateral sits in a smart contract on a public blockchain, visible to anyone. You retain control through your wallet's private keys: if you do not sign a transaction, the collateral cannot move (outside of a liquidation event or a smart-contract exploit).

Centralized platforms are custodial. You send your crypto to the platform's wallet, and the platform holds it. If the platform freezes withdrawals, goes bankrupt, or gets hacked, your collateral is at risk. The collapses of Celsius and BlockFi demonstrated this risk concretely. But centralized platforms also offer human support, account recovery, and in some cases, clearer paths through bankruptcy proceedings.

Credit checks, KYC, and access requirements

DeFi protocols are permissionless. Connect a wallet that holds crypto, and you can borrow. There is no identity verification, no Social Security number required, no minimum credit score, no geographic restriction enforced by the smart contract itself (front-end geoblocking is a separate layer).

Centralized platforms require Know Your Customer verification: government ID, proof of address, sometimes proof of income. They may check your credit history. For borrowers with poor credit or those who value privacy, this is the tradeoff: custody risk in exchange for regulatory clarity and recourse.

What happens if the platform fails?

If a DeFi protocol's governance token collapses or its development team disbands, the smart contracts continue to operate as long as the underlying blockchain runs. Aave and Compound have no corporate entity that can file Chapter 11. This is simultaneously a strength and a vulnerability: there is no CEO to arrest, and no bankruptcy judge to return your funds.

If a centralized platform fails, the legal entity enters insolvency proceedings. Depositors become creditors. Recovery rates depend on the platform's asset-liability structure and the jurisdiction. Some customers of failed platforms waited years and recovered only a fraction of their deposits.

Custody: who holds your collateral?

DeFi lending is non-custodial. Your collateral sits in a smart contract on a public blockchain, visible to anyone. You retain control through your wallet's private keys: if you do not sign a transaction, the collateral cannot move (outside of a liquidation event or a smart-contract exploit).

Centralized platforms are custodial. You send your crypto to the platform's wallet, and the platform holds it. If the platform freezes withdrawals, goes bankrupt, or gets hacked, your collateral is at risk. The collapses of Celsius and BlockFi demonstrated this risk concretely. But centralized platforms also offer human support, account recovery, and in some cases, clearer paths through bankruptcy proceedings.

Credit checks, KYC, and access requirements

DeFi protocols are permissionless. Connect a wallet that holds crypto, and you can borrow. There is no identity verification, no Social Security number required, no minimum credit score, no geographic restriction enforced by the smart contract itself (front-end geoblocking is a separate layer).

Centralized platforms require Know Your Customer verification: government ID, proof of address, sometimes proof of income. They may check your credit history. For borrowers with poor credit or those who value privacy, this is the tradeoff: custody risk in exchange for regulatory clarity and recourse.

What happens if the platform fails?

If a DeFi protocol's governance token collapses or its development team disbands, the smart contracts continue to operate as long as the underlying blockchain runs. Aave and Compound have no corporate entity that can file Chapter 11. This is simultaneously a strength and a vulnerability: there is no CEO to arrest, and no bankruptcy judge to return your funds.

If a centralized platform fails, the legal entity enters insolvency proceedings. Depositors become creditors. Recovery rates depend on the platform's asset-liability structure and the jurisdiction. Some customers of failed platforms waited years and recovered only a fraction of their deposits.

Tax Implications of DeFi Loans for US Borrowers

Tax treatment of DeFi loans is not fully settled, and the IRS has not issued comprehensive guidance specific to decentralized lending. What follows reflects the current understanding based on general principles. It is not tax advice.

According to the IRS virtual currency guidance (IRS, 2023), borrowing against cryptocurrency collateral is generally not treated as a taxable event because you are not selling or exchanging the asset: you are posting it as security for a loan. The same logic applies to traditional securities-backed lending and home equity lines of credit.

Is taking a DeFi loan a taxable event?

Simply depositing crypto as collateral and borrowing stablecoins does not trigger a taxable event under current IRS guidance. You have not disposed of the collateral. The receipt token you get (aToken, cToken) may create a paperwork question, but the dominant interpretation among tax professionals is that it represents a custody claim, not a sale.

Interest you pay on a DeFi loan may be deductible depending on what you do with the borrowed funds. If you use the loan for investment purposes, the interest may qualify as investment interest expense subject to the limitations on Schedule A (Form 1040). Using borrowed funds for personal expenses generally produces non-deductible interest.

Liquidation and its potential tax consequences

Liquidation is where the tax picture gets murky. When a protocol liquidates your collateral, it sells your crypto to repay the debt. That sale is a disposition of property. You may realize a capital gain or loss depending on your cost basis and the price at liquidation.

If you held the collateral for more than one year, the gain qualifies for long-term capital gains rates. Less than one year, and it is taxed as ordinary income. The liquidation penalty - typically 5% to 15% - may or may not be deductible as a loss, and the IRS has not clarified this point specifically for DeFi liquidations.

Is taking a DeFi loan a taxable event?

Simply depositing crypto as collateral and borrowing stablecoins does not trigger a taxable event under current IRS guidance. You have not disposed of the collateral. The receipt token you get (aToken, cToken) may create a paperwork question, but the dominant interpretation among tax professionals is that it represents a custody claim, not a sale.

Interest you pay on a DeFi loan may be deductible depending on what you do with the borrowed funds. If you use the loan for investment purposes, the interest may qualify as investment interest expense subject to the limitations on Schedule A (Form 1040). Using borrowed funds for personal expenses generally produces non-deductible interest.

Liquidation and its potential tax consequences

Liquidation is where the tax picture gets murky. When a protocol liquidates your collateral, it sells your crypto to repay the debt. That sale is a disposition of property. You may realize a capital gain or loss depending on your cost basis and the price at liquidation.

If you held the collateral for more than one year, the gain qualifies for long-term capital gains rates. Less than one year, and it is taxed as ordinary income. The liquidation penalty, typically 5% to 15%, may or may not be deductible as a loss, and the IRS has not clarified this point specifically for DeFi liquidations.

Sources

• irs.gov
• sec.gov
• cftc.gov
• fincen.gov

This content is educational and should not be read as an investment recommendation. Speak with a licensed advisor for guidance tailored to your circumstances.