Ethereum is migrating from a Proof of Work (PoW) to Proof of Stake (PoS) consensus mechanism. Currently, there is no direct tax guidance on how to handle conversion transactions between ETH and ETH2 tokens. This guide explains how to deduce tax implications for various ETH2 related transactions including: locking ether, earning staking rewards, and redeeming ETH2.
Self-staking vs. exchange staking
There are two methods to stake ether: self-staking and exchange staking. Self-staking requires depositing a minimum of 32 ether into an Ethereum deposit contract and becoming a validator on the beacon chain network. This process may be complicated for non-tech savvy people. It also requires at least 32 ether (~$80,000 in today’s value) to participate. You cannot self-stake if you don’t have 32 ether.
An alternative to self-staking is exchange staking. This method allows people to easily stake their ether through participating exchanges like Coinbase or Kraken. This method works with any amount of ether.
One downside of exchange staking is that you will have to share a portion of your staking rewards with the exchange for making the staking process easier. For example, Kraken charges a 15% administrative fee on all staking rewards received.
Tax implications of locking ETH
Converting ETH to ETH2 requires temporarily locking (staking) the original PoW-based ether (ETH). Exchanges use different labels to represent these staked ether. For example, “ETH2” and “ETH2.S” represent staked ether on Coinbase and Kraken, respectively.
Converting ETH to ETH2 is likely not a taxable event because it’s not a disposition of the original coin. Original ether holders are merely upgrading the coin to ETH2 to enable staking; their intention is not to dispose of the coin. Further, ETH holders receive an equivalent amount of ETH2 when depositing their ether to the contract resulting in no access to additional wealth. Finally, ETH2 is just a label used to represent the same original ether with PoS support, not a different coin.
For example, let’s say Sarah purchased 1 ETH for $100 (cost basis) a few years ago. In 2021, Sarah converts this ETH to ETH2 on Coinbase to enable staking. At the time of conversion, one ETH is worth $2,000. This transaction is not a taxable event. Sarah’s ETH2 takes on the original holding period and the cost basis ($100).
Once the upgrade to the Ethereum 2.0 network is complete, ETH2-labeled coins will cease to exist. They will be replaced with just “ETH” coins which will be fully powered by PoS. This is likely another non-taxable event similar to depositing initial ether because the taxpayer has not gained access to additional wealth.
Tax implications of earning ETH2 rewards
The IRS has not issued any staking specific tax guidance about ETH or ETH2. Therefore the conservative approach is to recognize income at the time you receive staking rewards.
Following the above principle, earning ETH2 as staking rewards is a taxable event. Of note: the taxpayer doesn’t have the taxable event until they gain dominion and control over their ETH2 rewards. This occurs when the user has the ability to move/trade ETH2.
Let’s continue Sarah’s example to illustrate this. In 2021, Sarah earned 6.0% interest on ETH2 and received 0.1 ETH2 as a staking reward. At the time she received the reward 0.1 ETH2 was valued at $100. Although she sees this 0.1 ETH2 in her exchange wallet, she can neither move nor sell it. In fact, this is the situation if you stake ether on many exchanges including Coinbase today.
"Rewards will be reflected in your account, but will not be actually credited until the end of the lockup period. Unless otherwise stated, you will not be able to trade, transfer, or otherwise access your ETH staking rewards during the lockup period" (Coinbase User Agreement)
In this case, Sarah doesn’t have any taxable income to report because she doesn’t have dominion and control over the 0.1 ETH2 yet.
In 2022, the exchange gives Sarah access to her 0.1 ETH2. At this time, 0.1 ETH2 is valued at $500. At this point, Sarah has dominion and control so she should report $500 of ordinary income on her tax return.
Liquid staking & taxes
Self-stakers and exchange stakers will not have access to the original ether deposited nor staking rewards earned until transaction support is enabled on the Ethereum 2.0 network (unknown future date). Until this point, both original ether locked in the deposit contract and the earned ETH2 staking rewards are illiquid. Liquid staking overcomes this interim liquidity issue by offering liquidity to both staked ether and ETH2 rewards earned.
Let's say Sarah decides to pursue Liquid staking with a service like Lido instead of self-staking and exchange staking. Sarah sends 1 ETH ($100 cost basis) to Lido and receives 1 stETH coin. stETH represents the value of the initial staking deposit. Her stETH balance also goes up when she earns staking rewards.
Converting ETH to stETH is not likely a taxable event because stETH is a mere representation of the initial ether deposited. Sarah sends one ETH to the smart contract and receives one stETH; the dollar value of one stETH is always equal to the dollar value of one ETH. stETH will have no use case when ETH2 goes alive. At this point, stETH will be burned and users will get an equivalent amount of ETH2. Further, this is not a traditional wrapping scenario (such as converting BTC to wBTC to participate in DeFi) where users can take either an aggressive or a conservative position. A standard wrapping transaction doesn't involve a major network upgrade like we see in the ETH to ETH2 case. These factors likely will make converting ETH into stETH a non-taxable swap vs. a taxable disposition (crypto-to-crypto trade).
Consequently, Sarah’s cost basis on stETH will be $100 (carryover basis from original ether). These stETH tokens can be used like regular ETH to trade and participate in other DeFi activity. These activities could trigger taxable events similar to any other crypto asset.
In liquid staking, earning staking rewards are taxable at the time of receipt because the user has dominion and control (the ability to move/trade/withdraw funds).
Finally, stETH can be redeemed for ETH2 when the transition is fully complete. At this time stETH will be burned by the protocol and replaced by newly minted ETH2. This would also be considered a non-taxable event based on the above analysis.
What if Ethereum 2.0 fails?
The transition to Ethereum 2.0 is expected to evolve over multiple phases and may take several years to complete, or may never be completed. Self stakers, exchange stakers and liquid stakers have little to no control over the actual execution of the process. Therefore, if crypto users lose their deposited ether, they may be able to write it off as an abandonment loss on their taxes.
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.