Earning a little extra dough every month on your investments is something every investor looks forward to. When it comes to crypto, earning extra every month began with the idea of ‘mining.’ A more formal term for mining is the proof-of-work (PoW) consensus mechanism that was made popular by the first-ever cryptocurrency, Bitcoin. In this mechanism, miners also
known as validators use powerful computers to solve complex mathematical puzzles to validate transactions and add blocks to the blockchain. In return, they receive a reward in the form of tokens, but the problem is, it involves a lot of arbitrary computation.
Enter proof-of-stake (PoS). What is PoS? Also known as staking, it is a crypto consensus mechanism that significantly reduces the amount of computational power required to verify transactions and add new blocks to the blockchain and in turn, validators get rewards in the form of tokens. Passive income earned, right? But wait, there’s a caveat. You have to pay crypto staking taxes on whatever rewards you earned from staking. In this article, we will provide insights on taxes you have to pay on crypto staking, but first, how does crypto staking work?
How Does Crypto Staking Work?
PoS transforms the way blocks are verified by using the holdings of crypto owners. When you stake your coins, you offer your coins as collateral to get chosen for validating blocks earning you the badge of a ‘validator.’
Validators are chosen randomly to validate the blocks but to become a validator, you should have a specific amount of tokens. For instance, to stake Cardano (ADA), and become a validator, you should have at least five tokens.
The blocks are verified by multiple validators, and when a certain number of validators have verified the block and deemed it accurate, only then the block is finalized and closed. When you stake your coins, you actively become a part of the blockchain and help in creating new tokens and securing the blockchain. Moreover, this erratic selection of validators removes the need for a competition-based mechanism like PoW. A few popular PoS blockchains are:
- Cardano (ADA)
- Cosmos (ATOM)
- Polkadot (DOT)
- Avalanche (AVAX)
- Tezos (XTZ)
How to Stake Crypto Coins?
Mainly, there are two ways to stake coins.
- Non-custodial wallets
- Via third-party
This is a smart wallet that is specifically designed for peer-to-peer transactions and enables the user to manage their tokens without any interference from a third party. This also means that the users have total control over their assets and they can transfer them without any friction. Moreover, the users can easily connect these platforms to other platforms to sell or receive crypto.
Third-party wallets allow third parties to have custody of your funds. This means that a third party will handle all your transaction information just like banks have custody of your accounts. One of the most common third parties for staking is Kraken or Coinbase.
Understanding this is important because in some countries crypto staking taxes depend on whether you stake your coins via a PoS mechanism or via a third party.
What are Crypto Staking Rewards?
Staking rewards are nothing but the rewards you get when you stake your tokens. When a lot of users stake their coins, a validator is randomly picked to validate the transactions. If you stake more tokens, there’s a higher chance of you getting selected to validate transactions. The majority of times when you stake crypto, you’ll receive the reward in the same currency. For instance, if you stake ADA, you’ll receive the rewards in ADA.
What is a Crypto Staking Pool?
When a group of crypto holders unite and combine their resources, it forms a staking pool. This collaboration can help them increase their chances of becoming a validator and earn more rewards. And just like the resources, they share the rewards. Generally, a pool operator manages a staking pool and the stakeholders lock their coins in a particular blockchain address.
How do Crypto Staking Taxes work?
When we are talking about staking, the investors have to keep a couple of transaction types in mind because it dictates how their earnings will be taxed.
When you move your coins into a staking pool, third-party staking services, or a wallet, it is not a taxable event. It is considered as transferring your coins from one wallet to the other, making it a tax-free event. Transfer fees or gas fees have different tax implications.
Staking Rewards Tax
Your staking rewards tax depends on where you live and how your country’s tax authorities view staking. In a few countries, direct staking as a part of the PoS mechanism or via a third party also makes a difference.
It is an unclear topic but generally, you are liable to pay income taxes on staking rewards based on the fair market value of the tokens at the time you received them. Additionally, when you sell, trade, or spend the rewards, you have to pay capital gains tax to the authorities.
Now, let's find out how different countries view crypto staking taxes.
How is Staking Taxed in the US?
The Internal Revenue Services (IRS) has issued guidance on paying taxes on crypto mining, but the IRS is yet to issue any guidance on paying taxes on crypto staking. However, the IRS did shed some light on the staking taxes in Notice 2014-21 under crypto mining taxes.
For mining, the guidelines are clear. Mined crypto will be considered as income and will be subject to income tax based on the fair market value of the token when the miner received it in USD. And when the miner sells it, spends it, or trades it, they have to pay capital gains tax.
This is why many investors have believed that staking is taxed the same as mining but it's not all black and white.
Staking Gray Areas
Investors have argued that as they assist in minting new coins, they should not be taxed when they receive the coins. They are using the analogy of the creation of new property. For instance, when a manufacturer makes a computer, they are not taxed when the computer is done manufacturing, but only when it is sold to a customer.
Also, the 2014 notice doesn’t highlight the inflationary effect of newly staked tokens and triggering a taxable event every time a new token is minted, which is several times a day. The majority of tax professionals agree that it is a taxable event when staking rewards are disposed of.
How is Crypto Staking Taxed in Canada?
The Canadian Revenue Agency (CRA) doesn’t have any specific guidelines regarding crypto staking. In the eyes of CRA, staking is similar to crypto mining and they treat receiving coins via staking as the same as mining.
Similar to mining, if you receive coins from staking it will have different tax implications. For instance, if you take mining as a hobby then the received tokens will be considered as an asset and you are liable to pay capital gains tax when you sell it. However, the cost basis in this scenario will be zero as you didn’t spend any money in acquiring the crypto. If you undertake mining as a business activity, the tax implications will be different.
How is Crypto Staking Taxed in the UK?
Even Her Majesty’s Revenue and Customs (HMRC) considers staking the same as mining. If staking amounts to a taxable trade, taxes will be applied to the staking activity. Several factors contribute to staking taxation in the UK such as the nature of the organization and the commercial nature of the activity considering you are staking as a business or an individual.
If staking isn’t compliant with a taxable trade, the staking rewards will be taxed on the pound sterling value as miscellaneous income, and capital gains tax will be levied when the rewards are disposed of.
How is Crypto Staking Taxed in Australia?
The Australian Taxation Office (ATO) collects taxes on staking rewards as same as ordinary income at the time of receiving it. When a taxpayer receives any reward from any consensus mechanism activity such as staking by proxy or leveraging third parties for staking, the rewards are taxed the same as taxes on ordinary income at the time of receipt.
The ATO takes this approach due to its long-standing principle of tax regulation with regards to the derivation of ordinary income, which is the receiving of a reward by providing any service. In connection with crypto, ATO considers validating transactions as a service for which validators receive a reward, and upon disposal of said reward, the taxpayer has to pay capital gains tax.
If we look at it this way, staking rewards are similar to earning a dividend or an interest, and in most countries, staking rewards are considered as income and taxed as income tax. In the U.S., however, the lack of IRS guidelines has created a dichotomy on how staking rewards should be treated for federal tax purposes. Having said that, the IRS should give a more detailed direction on crypto staking taxes in the future.