What is the concept of “staking” in terms of cryptocurrency assets and what are the new IRS tax implications of crypto staking for US Taxpayers who invest in cryptocurrencies? The concept of staking requires a general understanding of the blockchain networks and how information is captured and validated. In simplest terms, a blockchain is form of informational database or financial ledger shared across and between all points or “nodes” of a given network.
Blockchains and the Consensus Mechanism
In the context of cryptocurrency, a blockchain is required to secure and perform cryptocurrency transactions and keep associated information and records. The information is stored in chains of data known as “blocks” linked together and secured by cryptographic code(s). Blockchains are, in theory, spread in a way that prevents any single user from controlling shared information. Information is shared by and collectively controlled by all of the users within the blockchain. The information entered into the decentralized exchanges of a crypto community is permanent/unchangeable, irreversible and viewable to anyone within the blockchain. Multiple copies of the information within these blocks are saved within the chain or nodes of the network and must remain identical in order for the information to be and remain validated.
Validation can be performed by human auditors (slow, unreliable) or through an automated program known as “consensus mechanism.” The consensus mechanism provides security, trust and agreement (consensus) in any decentralized network or blockchain.
The most common consensus mechanisms in the world of crypto are “Proof of Work (PoW)” and “Proof of Stake (PoS).” Many crypto blockchains use the PoW as the consensus mechanism. In essence, PoW allows a blockchain participant to perform work (mining) which ultimately qualifies them to be given the right to add new transactions into the blockchain network. The PoS algorithm is a less expensive alternative requiring less powerful technology in order to perform the task of ledger maintenance at a node level, which is generally relevant to the proportion of crypto assets held.
What is “Staking”
What is “staking” in the context of cryptocurrency assets? Staking is an agreement to lock up a specific user’s crypto portfolio or assets for a given period of time to support blockchain operations. The “stake” provides a return for the user, almost always in the form of additional cryptocurrency.
Staking occurs in blockchains deploying the Proof of Stake or PoS consensus mechanism. A user gains trust and verification by successfully completing the work of data and transactional validation. If the user “validates” fraudulent or incorrect data within the blockchain, they forfeit part or all of their stake. A trustworthy user provides valid data and genuine transactions and ultimately earn additional cryptocurrency as a reward for their valid “stake” and associated actions on the blockchain.
These concepts can become quite sophisticated. A group of crypto token holders may combine to form a “staking pool” where the operator of the stake pool assumes responsibility for blockchain data and transaction validation. Staking can also be “illiquid” or “liquid” based upon whether the stake is tied up (illiquid) throughout the staking process or if the reward proceeds are tokenized in a tradeable or collateralized form (liquid).
The net benefit of staking is passive income. The IRS has become keenly aware of and interested in the process of and new IRS tax implications of crypto staking for US taxpayers who participate in any exchange or blockchain.
What are the New IRS Tax Implications of Crypto Staking for US Taxpayers?
If staking generates passive income what are the new IRS tax implications of crypto staking for US taxpayers? Late in the summer of 2023, the IRS released “Revenue Ruling 2023-14” that established the requirement for US taxpayers to include staking rewards in the taxpayer’s gross income for the year in which the staking reward is “realized.” In essence, once a stake is rewarded with additional cryptocurrency, the stakeholder has control over the reward (in the form of additional cryptocurrency) and the value of that reward must be declared as income in the year the taxpayer “acquires dominion and control of the awarded cryptocurrency.”
Most financial transactions involve forms of risks and rewards and the same is true for the staking of cryptocurrency assets. Staking ties up the associated crypto tokens for several weeks and months in a market which is always extremely volatile. Staked cryptocurrency cannot be liquidated and sold in a quickly appreciating market to lock in gains. The stake cannot be sold if prices are rapidly dropping. Therefore, staking may provide apparently lucrative returns yet still result in a substantial loss in a volatile market.
For those who invest in cryptocurrencies and are involved in the process of staking, the IRS tax implications of crypto staking for US taxpayers and resulting passive income add an additional factor to the equation.
