Unstaked ETH Continues To Complicate Crypto Tax Planning

Even as tax season quickly recedes into the past, crypto taxes and crypto tax planning are still causing headaches for investors. Following the Shapella upgrade of the Ethereum blockchain, bringing the long-awaited Ethereum 2.0 upgrade to its next stage, many cheered the primary effect of this upgrade. For the first time users who had staked ETH were able to withdraw these funds. Since the Ethereum 2.0 upgrade process had been underway for multiple years, this means that some depositors and investors did not have access to either the funds that had been deposited, nor the staking rewards, for that entire time period. With over $30 billion in ETH being released into the marketplace as a result, this inevitably raised questions related to crypto taxes; what do investors need to know?

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practitioners advocate for the deferral of income tax liabilities until staked assets and rewards are actually withdrawn and/or used for a external transaction.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

Taxes. Setting aside the tax debates and controversies around block rewards, the release of staked ETH will cause other tax issues and headaches for practitioners and investors alike. Since Ethereum forms the foundation for 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 that had staked ETH might not be tax preparers or accounting experts, the fact that ETH powers many of the emerging 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 governance of an NFT can create tax liabilities at every step in the process, in addition to the 28% collectible tax rate on NFTs themselves that has been put forward by the IRS.

Different types of staking. While the term staking has been discussed quite a bit during the lead up the Shapella upgrade, it is important for investors to understand there are multiple types of staking. Passive staking is the type of staking that is most popular with retail investors, and this closely resembles how traditional interest products are constructed at banking institutions. For example, users of ETH deposit these tokens at either a centralized exchange (such as Coinbase), or at a decentralized protocol. Over time, these staked tokens result in block rewards, which accumulate until release or withdrawn by the depositor.

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

Property definition. One of the most controversial topics around crypto staking is what block rewards represent. The Internal Revenue Service has an extremely broad definition for what is considered taxable income, and this broad-based approach has been confirmed through a number of court cases. Under current IRS guidance, and reaffirmed by the refusal of the IRS to issue additional guidance or clarification – even during the Jarrett staking case – staking rewards are taxable upon creation. Through this lens, staking rewards are considered to be income created as a result of the staking process, and valued and taxed as soon as they come into existence.

An opposing point of view, espoused by both some investors and policy groups alike, is that the block rewards are newly created property. Akin to how crops are not taxed until they sold, the same treatment should be applied to the newly created tokens issued as block rewards, according to these policy groups and advocates.

Under current IRS guidance, however, there is no exception or carve-out for block rewards, and investors should consider all such rewards taxable when they are created.

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