Many investors use staking to earn additional income but are often unsure of the associated tax liability. Whether you are experienced at staking or considering getting into it, a strong understanding of all taxation and reporting nuances is critical. To help you avoid being bugged by the taxman, we have put together this in-depth article covering everything from calculating the accurate staking tax amount to reporting it correctly.
What Are Staking Rewards?
If you are new to staking, we recommend checking out our in-depth article on staking and how to do it. For this article, it’s just useful to know that staking is a crypto consensus mechanism used to verify transactions and add new blockchain blocks for cryptocurrencies using the proof-of-stake mechanism. Among other differences, this process is much less resource-intensive than the proof-of-work mechanism made popular by Bitcoin.
The users who directly verify the transactions (validators) or those who commit their assets to a staking pool (delegators) earn rewards for locking up their assets for some time. Thus, staking can be useful means of passive income for many users.
Staking rewards can be earned in different ways. For example, it can be through third-party wallets, with an intermediary handling all transaction information and control of assets on users’ behalf. On the other hand, it can be through non-custodial wallets, meaning users manage their assets on their own. Depending on the platform used, there can also be a difference in when you transfer the staking rewards to your wallet—as soon as they are paid out or after a certain period.
How Are Staking Rewards Taxed?
Taxation can vary from one jurisdiction to another. Therefore, we’ll limit the discussion here to tax laws in the US. Interestingly, the IRS has not yet issued clear guidelines on taxing staking rewards. Therefore, most tax experts believe that the guidance one can refer to is on taxation for cryptocurrency, especially crypto mining (Notice 2014-21). Based on these guidelines, we’ve inferred the taxation mechanism for staking rewards below. A key point to note is that US federal tax laws treat crypto not as currency but as property.
Now, the staking process involves multiple transactions. Of these, moving tokens to a wallet, staking pool, or third-party staking service is not a taxable event in most cases. This simply qualifies as moving crypto from one wallet to another. If there are gas fees or transfer fees involved, they could be tax deductible. However, as cases can vary, let’s keep that for a different article and focus on staking rewards for now.
The first tax involved in staking is income tax on the tokens received as rewards. For calculating the income tax, the fair market value of the tokens at the time of receipt is used as the basis. To understand this better, let’s look at the following simplified example where a user receives staking rewards from an exchange over three months.
|Transaction No.||Date||Tokens Received||Token Price (US$)||Taxable Income (US$)|
Note that the fair market value of the rewards on each day changes as the market price of the underlying tokens moves up or down. Thus, the user’s total taxable income for this period is the sum of fair market values on the days the respective sets of tokens were received (i.e., $267.24 + $247.05 + $286.20 = $800.49).
Capital Gains Tax
Because of being treated as property transactions, crypto transactions also incur a capital gains tax. Hence, if you sell the rewarded tokens or trade or dispose of them in any other manner, you must calculate the capital gains and report them on your tax return.
Continuing the above example, suppose the user decides to sell off 100 tokens on 2022/09/15. On this day, these tokens are trading at $7.00. For determining the capital gains, the cost basis must also be known. Using the “first-in, first-out” (or FIFO) method, the cost basis is calculated as follows:
(51 × $5.24) + (45 × $5.49) + (4 × $5.40) = $535.89
Based on the FIFO method, we assumed 51 of 100 tokens came from the first reward, 45 of 100 from the second reward, and the remaining 4 of 100 from the third. Of course, other methods, such as LIFO (last-in, first-out) and HIFO (highest-in, first-out), can also be used in the US to minimize the capital gains tax. For users unfamiliar with these techniques, working with a qualified accounting professional is recommended.
Now, capital gains = (100 × $7.00) − $535.89 = $164.11
Thus, staking rewards are taxed twice. The first is the income tax when we receive the reward tokens, and the second is the capital gains tax when we dispose of those reward tokens. The above is a simplified example, but it often gets difficult to track staking transactions and convert them to USD. Thankfully, several tax solutions today allow easy handling of staking income.
Recognizing Income from Staking Rewards
Recall our earlier comment that the time when staking rewards are earned may differ from when you actually transfer them to your wallet. This is particularly true when using a third-party platform for staking. Since the income tax on staking rewards is calculated based on the time of receipt, this difference can lead to some confusion. Which time should you consider to calculate the fair value of the tokens and recognize your income?
The concept of “dominion and control” proves useful to resolve this confusion. Per tax experts, staking rewards can be considered received and thus recognized as income when users can exercise dominion and control over them. This is when they can freely sell or trade the tokens.
Thus, the point when you can withdraw the tokens to your wallet—irrespective of whether you actually do so or not—is when you calculate their fair value for income tax purposes. There may be cases where you can’t determine when you received the rewards in your blockchain. In such cases, you should contact your tax professional to determine a suitable method for reporting your staking income.
Reporting Staking Rewards on Tax Returns
So, we have determined what income and capital gains to report for staking rewards. Now, there’s the not-so-small matter of where to report them.
For income tax, individual taxpayers should report staking rewards on Form 1040 Schedule 1 as Other Income.
Businesses earning staking rewards as part of their business activities should report it on Schedule C. Note that businesses can write off certain costs, such as the purchase of validator equipment, as an expense. These deductibles are not available to individual taxpayers.
For capital gains tax, the capital gains should be reported on IRS Form 8949.
Gray Areas and Possible Changes
In the absence of clear IRS guidance on staking rewards, investors have raised some concerns over the years. A key claim is that since staking involves assistance in the creation of new coins, the receipt of reward tokens should not be taxed. This is analogous to the creation of new property, where only capital gains are taxed on the sale of the property. The current guidance based on crypto mining doesn’t take note of the inflationary effect of newly staked tokens and triggers a taxable event whenever they are minted, which may be multiple times a day.
Notably, a 2022 case, Jarrett v. United States, saw IRS refunding the amount the taxpayer claimed to have been unfairly taxed. The case was dismissed after the full amount was refunded, even though the Jarretts wanted to continue it because of its “public importance.” Even earlier, in July 2020, four US congressmen had written to the IRS, explaining that it may be overestimating the gains from staking.
The IRS hasn’t officially responded to these concerns, but it seems aware of the issues raised. This article covers the situation as of December 2022, and a new tax policy may come out in the near future. However, even if there’s a new staking-focused guidance, the likely change will be that the taxation will shift entirely to when the tokens are sold without changing the amount to be taxed. In any case, we are committed to covering the most relevant crypto topics for you, so be sure to keep checking here for updates on policy changes.