For many crypto investors, including Crypto IRA investors, staking has become a term that is often discussed. In essence, staking is the manner in which a growing number of cryptocurrencies verify their transactions. Just kike Bitcoin mining, which is based on the proof of work (“POW”) principle, proof of stake (“POS”) is a more environmentally friendly way to mine cryptos and earn rewards to confirm transactions.
- Staking cryptos is a way to passively generate returns on your cryptos
- More and more cryptos are adopting the Proof of Stake concept
- Staking Crypto IRAs may have tax repercussions you should be aware of
What is Proof of Stake (POS)?
In general, staking cryptocurrency is a method that involves committing one’s crypto assets to support a blockchain network and confirm transactions on the blockchain. POS is available for cryptos that use the proof of stake model to process payments. POS has been gaining n popularity over POW because it is a more energy-efficient alternative to POW, which relies on mining devices that use a great amount of computing power and electricity to solve mathematical equations.
Without getting too technical, POS is the process of how new transactions are added to the blockchain for that particular cryptocurrency. Solano and Cardano are the cryptos using POS with the largest market cap. Although, Ethereum 2 is expected to go live in the middle of 2022 and will enhance the Ethereum network by moving from POW to the POS model. In addition, cryptos, such as Polygon, use their own POS blockchain and Commit Chain connectivity to help scale the Ethereum network.
How Does POS Work?
First, one will pledge his or her coins to the cryptocurrency protocol. The protocol then chooses the participant to serve as the validator in order to confirm blocks of transactions. The more coins a participant pledges, the more likely the participant will be picked as the validator.
Every occurrence that a block is added to the blockchain, new coins are “minted” and distributed as rewards to that block’s validator. POS can be viewed as a type of lottery. The larger the stake of tokens committed, the higher odds that the participant has of being chosen as a validator, and thus, receiving a reward.
The advantage of POS is that it replaces bitcoin miners with validators, which requires far less energy consumption than POW’s in energy-intensive computer farms. Essentially, if you want to stake your cryptos in a POS, you would simply move your crypts to a wallet, enter into a smart contract, and use a bit of computer code that runs on the blockchain. One can stake coins individually or use a staking service in order to pool resources with other participants.
IRS & The Crypto IRA
The IRS treats cryptocurrencies, such as Bitcoin, as property, like stock or real estate. In IRS Notice 2014-21, the IRS issued guidance on the tax treatment of cryptos. In the Notice, the IRS confirmed that cryptos would be treated from a tax perspective as a capital asset. Hence, the sale of a cryptocurrency held by an IRA is not subject to tax and all gains are tax-deferred or tax-free in the case of a Roth IRA.
Tax Treatment of POW
IRS Notice 2014-21 provides some guidance as to how the IRS will treat crypto rewards received from POW. The Notice states that “if” a taxpayer’s “mining” of virtual currency constitutes a trade or business, then the cryptos received as part of the mining activity would be deemed business income.
In the case of a Crypto IRA, engaging in an activity that gives rise to business income could be subject to a tax known as UBTI, which can go as high as 37% in 2022. Therefore, if a Self-Directed IRA is deemed to invest in a crypto mining activity that is deemed a trade or business, the income or coins generated from that activity could be subject to the UBTI tax.
The use of the word “if” in Notice 2014-21 reinforces the position that not all mining activity would be deemed a trade or business. Hence, an argument can be made that if an individual or a Crypto IRA invested in some mining activity and was treating the activity as passive and not a trade or business, the cryptos earned as part of the mining activity would not be subject to ordinary business income.
Other than Notice 2014-21, there is very little additional guidance on the IRS’s position on the tax treatment of POW mining activity.
Tax Treatment of POS
A recent court case could potentially offer insight into the IRS’s position on the tax treatment of earning rewards via POS. In 2019, Joshua Jarrett of Nashville engaged in a small-scale virtual currency staking enterprise using a home computer. Jarrett owned a few hundred thousand tokens in Tezos, a POS platform. Over the course of a year, he generated roughly 9,000 new tokens. Jarrett then reported these tokens on his federal income tax return and was assessed $3,793 in taxes.
The question that was then posed to the U.S. District Court for the Middle District of Tennessee was can Jarrett be taxed for new tokens that he generated through staking but has not yet transferred or sold? Jarret believed no. Hoping to avoid an unfavorable decision that might limit its ability to tax staking activities as full ordinary income transactions in the future, the IRS offered to refund Jarrett the full amount of his claim in exchange for dismissing the case.
However, on February 3, 2022, he announced that he was turning down the IRS’s offer and would seek a final court decision instead. The case will now be settled by a U.S. District Court in the Middle District of Tennessee and will have a significant impact on the tax treatment of POS for both individual investors and Crypto IRA investors.
The Jarrett case is so interesting from a Crypto IRA standpoint because he was engaged in POS activity passively and not as a trade or business, which would seemingly be covered by the language in IRS Notice 2014-21. Hence, the court’s ruling in Jarrett can have far-reaching tax consequences for passive Crypto IRA investors involved in POS activity.
Revenue Ruling 2023-14
Revenue Ruling 2023-14 states that staking rewards of taxpayers must be included in taxable income when they acquire possession of the rewards under the “dominion and control” standard. Dominion and control basically means that the taxpayer gains the capability to sell or otherwise transfer the asset.
The Ruling details an example in which a taxpayer-owned 300 units of an unspecified cryptocurrency, staked 200 of such units, validated a new block of transactions on the blockchain associated with such cryptocurrency, and received two units as a staking reward (reward units), which were nontransferable for a short period of time (lock-up period). On the day following the lock-up period, the taxpayer had the ability to sell, exchange or otherwise dispose of the reward units. The IRS ruled that the taxpayer was required to include the fair market value of the reward units in gross income after the lock-up period because the taxpayer had accession to wealth when the taxpayer gained “dominion and control” over the reward units. The taxpayer was held to have gained “dominion and control” over the reward units on the day following the lock-up period when the reward units became freely transferable.
The IRS view set forth in Revenue Ruling 2023-14 is that the receipt of staking rewards is taxable when the taxpayer has control over the crypto, whereas, under Notice 2014-21, crypto rewards received as a result of POW are taxable upon receipt.
One of the most significant aspects of Revenue Ruling 2023-14 is that it clearly discards a common taxpayer tax position that staked tokens received as a reward of POS should not be taxable until the taxpayer disposes of them in a taxable transaction. The Ruling is clear that the taxpayer recognizes income based on the fair market value of the reward token received on the date they have dominion or control, generally after the lock-up period ends.
POS and Your Self-Directed IRA
Similar to Notice 2014-21 treatment of crypto mining, in the case of POS, Revenue Ruling 2023-14 is clear that the reward tokens are subject to gross income or business income when the taxpayer gains control over the cryptos. Thus, the question then becomes whether the Self-Directed IRA’s staking activity rises to a trade or business. If the activity did, the UBTI tax would be triggered. Whereas if the staking activity did not rise to the level of a trade or business, it would appear the IRA would not have any tax on the income.
The fact that the POS or POW activity would generate ordinary income in the hands of a non-retirement taxpayer and not when generated by an IRA seems odd, but other than the UBTI tax regime, a Self-Directed IRA would not be subject to tax on the income generated. The unique aspect of POW and POS is that it could generate ordinary income without being associated with a business. For almost all other activities, the income generated would be passive or ordinary income in the hands of a business.
The IRS has not addressed the specific taxation of POW or POS for retirement accounts. However, we do now know that in the cases of POW and POS, the income generated is deemed ordinary income or business income if done by a business. As outlined above, since the UBTI tax regime is really the only way an IRA can be subject to tax on investment income or gains, the belief is that so long as the POW or POS activity does not rise to a trade or business, a Self-Directed IRA would not seem to be subject to taxation on rewards earned by POW or POS so long as its activity did not rise to a trade or business.
As always, crypto investing is quite volatile, and staking doesn’t always reap the rewards you may be seeking. This is especially true if the gains received are taxable. Please consult a financial advisor before engaging in staking Crypto IRAs.’