Unstaked ETH continues to complicate crypto tax planning

Although tax season is quickly receding into the past, crypto taxes and crypto tax planning continue to cause headaches for investors. After the Shapella upgrade of the Ethereum blockchain, which brought the long-awaited Ethereum 2.0 upgrade to the next phase, many cheered the primary effect of this upgrade. For the first time, users who had staked ETH could withdraw these funds. Since the Ethereum 2.0 upgrade process had been ongoing for several years, this means that some depositors and investors did not have access to either the funds deposited, or the stake rewards, for that entire period of time. With over $30 billion in ETH released into the market as a result, this inevitably raised questions related to crypto taxes; What do investors need to know?

Crypto staking, and specifically staking ETH, has proven to be a controversial issue for those in the tax community. Some pro-crypto tax and accounting practitioners advocate the deferral of income tax liabilities until staked assets and rewards are actually withdrawn and/or used for an external transaction. On the other hand, and due to the lack of crypto-specific guidance from the IRS on the matter, stake rewards have generally been considered taxable upon creation. While these unsettled activities won’t show up on most individuals’ tax returns until the filing season begins in early 2024 (for 2023 activities), it makes sense to take a look at some of the key issues that crypto betting has created.

Taxes. Putting aside the tax debates and controversies surrounding block rewards, the release of stake ETH will cause other tax issues and headaches for practitioners and investors alike. Since Ethereum forms the basis of many Layer 2 applications, including 76% of non-fungible tokens and 67% of decentralized finance applications, ETH utilization will most likely increase going forward.

Especially since many users who had staked ETH may not be tax preparers or accounting experts, the fact that ETH powers many of the new applications – not to mention smart contracts that enable blockchains to communicate with each other – will create more complicated tax and tax planning scenarios. For example, the creation, issuance and management of an NFT can create tax liabilities at each step of the process, in addition to the 28% collection tax rate on NFTs themselves that is promoted by the IRS.

Different types of striking. Although the concept of staking has been discussed a lot during the upgrade of Shapella, it is important for investors to understand that there are several types of staking. Passive investment is the type of investment that is most popular among private investors, and this is very similar to how traditional interest products are constructed at banking institutions. For example, users of ETH deposit these tokens either on a centralized exchange (such as Coinbase), or by a decentralized protocol. Over time, these stakes result in block rewards, which are accumulated to release or withdrawn by the depositor.

Active stake, which for Ethereum means stake of 32 ETH, is when the depositor is an active validator. Under proof-of-stake, the probability of being chosen to validate a block (transactions) is correlated to the amount staked. In other words, active staking is the process by which a proof-of-stake blockchain works as advertised. These validators (nodes) provide the processing power of the Ethereum blockchain, as well as serving as an additional check on the integrity of these records. Users who have large amounts of ETH staked, the thinking goes, are the most motivated to maintain the validity and accuracy of the blockchain itself.

Property Definition. One of the most controversial topics surrounding crypto betting is what block rewards represent. The tax authority has an extremely broad definition for what is considered taxable income, and this broad approach has been confirmed through a number of court cases. Under current guidance from the IRS, and confirmed by the IRS’s refusal to provide further guidance or clarification – even during the Jarrett staking case – stake awards are taxable upon creation. Through this lens, effort rewards are considered to be income created as a result of the effort process, and valued and taxed as soon as they arise.

An opposing view, advocated by both some investors and political groups, is that the block rewards are newly created property. Similar to how crops are not taxed before they are sold, the same treatment should be applied to the newly created tokens issued as block rewards, according to these political groups and advocates.

However, under current IRS guidance, there is no exemption or exemption for block rewards, and investors should consider all such rewards taxable when created.

Taxes may only make headlines for a short period of time during the year for most investors, but as the ETH market continues to evolve, crypto tax planning will need to keep pace.

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