It’s a seller’s market in many parts of the country, which means higher listing prices and increased competition. As buyers face these hurdles, some will need to get creative to fund their down payment. A trend I’m currently seeing, especially among millennials and Gen Zers, is the use of cryptocurrencies to fuel down payments. Although this may seem like a good idea at first, liquidating crypto brings certain challenges, from complicating the underwriting process to possibly triggering significant (and often unexpected) tax gains. Here’s a real-life example to illustrate my point.
On March 1, 2020, George purchases five bitcoins from Coinbase, a popular crypto exchange platform. On that date, Bitcoin is trading at $8,500 per coin. Therefore, George’s initial investment is valued at $42,500 (five bitcoins × $8,500 per coin). For federal income tax purposes, George’s basis equals $8,500 per coin, for a total tax basis of $42,500. George is excited about his crypto investment and hopes it will appreciate in value over the next several years.
In March 2022, George decides to buy a house (his principal residence) in the Atlanta metro area. After an extensive search, he chooses a beautiful home in midtown listed at $910,000. George has an excellent credit score, so he’s not particularly worried about qualifying for a mortgage. However, he’s under the mistaken impression that a 20% down payment would be required.
George has a little over $91,000 in his savings account. To put 20% down, he would need an additional $91,000. After wondering where he will get the additional funds, George suddenly remembers his Bitcoin investment. According to Coinbase, Bitcoin is now trading at $40,000 per coin. If he liquidates 2.275 bitcoins, George can beef up his savings by $91,000 (2.275 bitcoins × $40,000 per coin), which will give him the 20% down payment.
Without consulting his tax advisor or loan officer, George liquidates 2.275 bitcoins to cover the 20% down payment. In George’s mind, cryptocurrency is just like “real” currency, so there shouldn’t be any issues. After liquidating his crypto, George contacts his loan officer to start the preapproval process.
An unexpected tax bill
Contrary to George’s belief, crypto isn’t treated as currency for federal income tax purposes. According to Notice 2014-21, the IRS treats Bitcoin and other cryptocurrencies as property for tax purposes. That means George will recognize gain when he liquidates the 2.275 bitcoins.
George’s tax basis in the liquidated bitcoins is $19,338 (2.275 bitcoins × $8,500 per coin). This generates a tax gain of $71,662 ($91,000 − $19,338). Because George held the Bitcoins as investment property for more than one year, his gain will be a long-term capital gain. Assuming he’s subject to the 20% capital gains tax rate and the 3.8% net investment income tax (NIIT), George’s tax liability is $17,056 ($71,662 × 23.8%).
Because of his mistaken belief that a 20% down payment is required and cryptocurrency is treated as “real” currency, George’s out-of-pocket costs to buy his home have increased by $17,056, the crypto tax liability. Even worse, George may not have the cash to pay this unexpected tax bill because all of the liquidated proceeds plus his savings went toward the down payment.
Complication of the underwriting process
George’s second mistake was liquidating his crypto before talking to his loan officer. Because George had an excellent credit score, a 20% down payment most likely would not have been required. In many cases, borrowers only need to put 5% down to get a conventional mortgage. Although his interest rate and monthly payment would have been higher with a lower down payment, he could have avoided the unexpected crypto tax liability and preserved some of his savings.
Also, not all mortgage lenders allow borrowers to use crypto to fund a down payment. The ones that do will require borrowers to liquidate their crypto investments and place the funds into a checking or savings account. However, the funds must be paper-trailed. In other words, borrowers must demonstrate a 30- to 60-day transaction history for the crypto account. This complicates the underwriting process for lenders because cryptocurrency exchanges don’t always provide monthly statements as a bank would. If you have a client who wants to use crypto to fund a down payment, advise them to liquidate their crypto investments early in the homebuying process, assuming it makes sense from a tax perspective.
Lesson learned?
So, what do we learn from George’s real estate fiasco? Homebuyers looking to use crypto to fund a down payment should consult their advisors early in the process before pulling the plug. They will need help weighing the benefits of a higher down payment against the tax burden of liquidating crypto. And if you think crypto is just a fad, think again. As the popularity of crypto increases, more and more individuals will turn to crypto investments to help them realize their dream of homeownership.
