The Ethereum network is transitioning from a Proof of Work (PoW) consensus system to a Proof of Stake (PoS) system which will be more scalable, secure, and sustainable according to the Ethereum community. This post discusses the crypto tax implications of this transition and earning staking rewards under ETH2.
Before we go into the details, it’s important to note that the IRS has not issued any staking-specific crypto tax guidance yet. In the absence of staking tax guidance, we are left to use existing generic guidance (IRS Notice 2014-21, Rev. Rule 2019-24, and FAQs) to infer tax implications about staking. Therefore, we present multiple tax positions you could take as specifics around the actual transition become more clearer.
Primarily, there are two topics related to ETH2 where the tax treatment is uncertain:
- Converting ETH into ETH2
- Earning staking income
The uncertainty is caused by limited IRS guidance and the lack of specifics on how the transition will work in practice.
Crypto tax implications of converting ETH to ETH2
Although the ETH2 network launched on December 1, 2020, it is still unclear how the exact transition from ETH to ETH2 will look in practice. The transition will likely fall into one of the categories below, each with its own tax treatment.
Case 1: Treating ETH and ETH2 as two separate currencies
If ETH and ETH2 behave as two different cryptocurrencies and you can trade back and forth, converting from one to another will be a taxable event. The brief Coinbase post on Ethereum 2.0 implies that ETH and Eth2 will behave like two different coins — at least on Coinbase.
“While staked ETH2 tokens remain locked on the beacon chain, Coinbase will also enable trading between ETH2, ETH, and all other supported currencies providing liquidity for our customers.”
Case 2: Treating migration as a one-time upgrade
On the other hand, If ETH2 is merely an upgrade to ETH, then there is no taxable event. This would be akin to a coin swap where the same property is simply represented by a new token. In this case, switching from ETH to Eth2 would be a one-time upgrade where you get an equivalent number of ETH2 tokens for each ETH token. In this case, your cost basis and holding period of ETH will transfer to your ETH2 coins. This process will be treated similar to a non-taxable coin swap.
Crypto tax implication of ETH2 staking rewards
Earning ETH staking rewards is a taxable event. The controversial question is as to when they should be reported and taxed.
The most conservative approach is to report ETH2 staking income at the time you receive each reward into your wallet. This perfectly aligns with PoW cryptocurrency mining tax guidance mentioned on the IRS Notice 2014-21. If you run your own validator, it’s your responsibility to track the market value of rewards every time you receive them. You can use a tool like CoinTracker to track the right value and generate the right tax forms.
There are some cases where you can receive staking rewards but not have the right to immediately sell, trade, transfer, or withdraw the rewards. In technical terms, this is a situation where you don’t have “dominion and control” over your assets. In such cases, you may recognize staking income at the time you gain dominion and control (not at the time when rewards get deposited into your account). This approach closely aligns with how the IRS wants taxpayers to report income arising from airdrops. Likewise, we could rely upon existing guidance on airdrops to infer the tax treatment on staking rewards if there’s a lock-in period for the rewards.
“A taxpayer does not have receipt of cryptocurrency when the airdrop is recorded on the distributed ledger if the taxpayer is not able to exercise dominion and control over the cryptocurrency” - (Rev. Rul. 2019-24)
Exchanges like Coinbase are also offering an option to stake your ETH. If you stake on Coinbase and earn over $600 in any year, the exchange will issue you a Form 1099-MISC summarizing your annual staking income. A copy of this form will also go to the IRS. Staking rewards are reported on Schedule 1, Line 8 as “Other income”. Staking income will be subject to ordinary income taxes. When you later sell the tokens earned from staking rewards, the gains will be taxed as capital gains.
ETH staking example transaction
Say you receive 1 ETH as a staking reward on January 15, 2021. At the time you receive this in your wallet, it’s worth $500. Here, you would report $500 on Schedule 1. It will be subject to ordinary income tax rate depending on your tax bracket. If you later sell this for $800, you would pay capital gains taxes on $300 ($800 – $500).
On the other hand, you could take an aggressive tax position and pay taxes only when you sell the staking rewards (not at the time you receive them and/or gain dominion and control as mentioned above). Although this is not advisable to every taxpayer, given the lack of regulatory clarity and new property like crops or mined minerals do not generate taxable income until they are sold (Reg. section 1.61-4), there’s a potential case you can make for this tax treatment. Further, the non-binding nature of the IRS crypto tax guidance, could also make your position stronger.
Ultimately, there is no black and white clarity on ETH2 crypto taxes. The best practice is to be conservative, consistent, and reasonable with your approach until the IRS released more guidance.
If you have any questions or comments about crypto taxes let us know on Twitter @CoinTracker.
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Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.