Proof-of-work cryptocurrencies have come under fire in recent months amid rising environmental concerns. Bitcoin alone consumes more than one-half percent of global power, which is equivalent to countries like Malaysia or Sweden. These high energy costs, coupled with performance bottlenecks, have led to a new generation of cryptocurrencies.
Let’s take a look at how Ethereum, or ETH 2.0, solves these energy and performance concerns, as well as some of the tax implications that traders and investors should know before they buy Ethereum.
What is Ethereum 2.0?
Ethereum 2.0, or ETH 2.0, is an upgrade to the Ethereum network that aims to improve security, scalability and sustainability. At its core, the upgrade swaps a conventional proof-of-work algorithm for a proof-of-stake algorithm that doesn’t require energy or computing resources but still penalizes network disruptions and thwarts malicious actors.
Proof-of-stake algorithms involve employing a network of validators that stake their own cryptocurrency in exchange for a chance at validating new transactions, updating the blockchain and earning a reward. The winner is based on the amount of crypto each validator has in the pool and the length of time they’ve had it there.
With the launch of the Beacon Chain last December, Ethereum holders can stake their ETH to help secure the upgraded network in exchange for rewards. These rewards change based on how much ETH is staked at any given point in time, but as of June 2021, investors can earn upwards of 7% APR in exchange for staking ETH and may even be covered from losses.
Later this year, the Mainnet Ethereum is expected to merge with the Beacon Chain to enable staking for the entire network and signal the end of energy-intensive mining. Next year, shard chains will expand Ethereum’s capacity to process transactions and store data while gaining more features over time as it’s rolled out in multiple phases.
What Are the Tax Implications?
The switch to Ethereum 2.0 is considered a soft fork since the Ethereum 1.0 blockchain will cease to exist when the transfer is complete. While hard forks followed by an airdrop of a new coin are taxable transactions, as was the case with Bitcoin Cash, the Ethereum soft fork is not a taxable event since one cannot own both ETH and ETH2 in the end.
When ETH is replaced with ETH2, the cost basis for the new ETH2 will carry forward from the original ETH. Traders and investors should maintain a record of the original cost basis in order to ensure that their taxes are accurate and up to date. Depending on the wallet or exchange, the original cost basis may not be available following the migration.
A thornier tax question is: Do you owe taxes on staking rewards from ETH when it’s still locked up? Tax professionals are still debating the answer to that question, but the most likely precedent would be the Original Issue Discount rule, which requires that taxpayers make payments on accrued interest before it’s received (e.g., with a certificate of deposit).
Gas Fees & Gas Fees Tax
Many actions on the Ethereum blockchain require the payment of gas fees, including yield farming, transfers, approvals and staking rewards. With the rise in decentralized finance, or DeFi, the Ethereum network has started to reach its performance limits, which is one of the reasons that Ethereum 2.0 was developed to dramatically improve via shards.
Gas fees will likely experience a significant drop from their current levels with the rise of ETH2 by both eliminating the need for costly computational resources and dramatically improving underlying performance. Many experts believe that gas fees could drop to cents rather than dollars, enabling the DeFi ecosystem to continue its robust expansion.
From a tax standpoint, gas fees are often added to the cost basis of an asset, which reduces capital gains or increases capital losses when it’s sold. Transfers and other transactions are treated differently since there was no asset acquisition. Most experts simply remove gas fees from holdings without recognizing a capital gain or loss.
How to Get Started with ETH2
MyEtherWallet is one of the most popular software wallets that enables ETH tokens to be staked into the ETH2 Beacon Chain. In order to qualify, MyEtherWallet users need at least 32 ETH while a partnership with Staked will run a validator node for them, eliminating the need for in-depth technical knowledge in order to participate.
Coinbase is the largest crypto exchange that supports ETH2 staking. Any users that hold ETH in their account, living in an eligible country, complete verifications and agree to terms and conditions can stake ETH. Customers in the U.S. that earn over $600 in staking rewards will receive a 1099-MISC from Coinbase and the rewards will appear under Lifetime Rewards.
Before staking ETH, it’s important to keep in mind that there’s a possibility of loss if validator duties are not met or if the Ethereum network upgrade is unsuccessful. Investors should also keep in mind the tax implications of staking rewards, including the fact that they may be taxed on the rewards before they are able to fully withdraw them.
Proof-of-Stake Cryptocurrencies Checklist
Use the following checklist to identify the different proof-of-stake cryptocurrencies.
- BNB: BNB is a cryptocurrency coin that powers the Binance ecosystem. As one of the world's most popular utility tokens, not only can you buy or sell BNB like any other cryptocurrency, but BNB comes with a wide range of applications and benefits.
- Flow: Flow is a new blockchain built for the next generation of apps, games, and the digital assets that power them. The development team behind Flow originally hails from the CryptoKitties project.
- AKT: AKT is the utility token powering the world’s first open-source cloud. It’s used as the primary means to govern, secure the blockchain, incentivize participants, and provide a default mechanism to store and exchange value.
- Raydium: Raydium offers DeFi and AMM projects a clear path for bridging platforms and liquidity with the evolved capabilities of Solana and Serum. It provides on-chain liquidity to a central limit order book.
- Tezos: Tezos is an open-source platform for assets and applications backed by a global community of validators, researchers, and builders.
- NOW: NOW is the first native digital asset introduced by an instant exchange platform to serve as an internal currency accepted within the NOW product system
The Bottom Line
The migration to Ethereum 2.0 addresses critical shortcomings in the performance and sustainability of conventional proof-of-work cryptocurrencies. While investors have flocked to an opportunity to stake ETH and earn an attractive yield, they should keep in mind the risks associated with staking as well as the potential tax implications.
If you have a complex crypto tax situation, try ZenLedger to simplify your taxes and ensure that you’re not overpaying each year. ZenLedger aggregates transactions across hundreds of different wallets and exchanges and computes the cost basis and capital gain or loss for each transaction, including complex DeFi transactions.