Even in the depths of winter, crypto continues to make fundamental strides – especially in terms of adoption by the world’s leading companies and institutions. Ethereum, the pioneering blockchain powering innovative technologies like decentralized finance (DeFi) and NFTs, recently completed its much-anticipated merger – sparking institutional interest and unlocking revenue generation opportunities via its Proof-of-Stake (POS) blockchain.
Miles Fuller is Head of Government Solutions at TaxBit. This article is part of CoinDesk’s Tax Week.
As an emerging asset class, crypto raises many confusing questions for both investors and regulators. At the same time, a poll conducted by the Crypto Council for Innovation in October found that a majority of U.S. voters want more crypto regulation and believe lawmakers should consider cryptocurrencies as a serious and valid part of the economy. However, the lack of regulatory clarity poses a significant barrier to cryptocurrency adoption for both individuals and institutions.
To address this issue, let’s try to better understand a key component of regulation: taxes. Especially when it comes to NFTs, staking and yield farming.
See also: The key to digital asset taxation is finding the right filing compartment | Opinion
How are NFTs taxed?
In November, Meta announced that Instagram will soon allow YouTubers to mint and sell non-fungible tokens directly on the social platform. Reddit is also helping bring NFTs into the mainstream. Since launching its NFT marketplace in July, over 2.5 million new wallets have been created and Reddit’s cumulative NFT revenue exceeds $6.5 million. As NFT initiatives continue to rise from the world’s leading companies, users should carefully consider the key tax implications:
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NFTs are not taxable when created, but are taxable when sold based on the fair value (FMV) of the cash or cryptocurrency received.
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The value of the assets received on the sale of an NFT is considered gross income, which can then be reduced by costs associated with the creation and sale of the NFT (e.g. gas fees).
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The resulting net income from the sale of NFTs is considered ordinary income for tax purposes and may also be subject to Independence Tax if the NFT production activity reaches the “trade or corporation” level. However, there are currently no clear rules or guidelines as to when NFT activity escalates to a “trade or company” level. Traditionally, in order to be considered a trade or trade for tax purposes, an activity must be carried out with continuity, regularity and the intention of making a profit.
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Commissions or royalties from downstream resales of an NFT are almost certainly income, but there is no official guidance on this yet.
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Reselling an NFT would be a taxable sale of property, similar to other cryptocurrencies (which are considered property under tax legislation).
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It is possible that some NFTs may also constitute a “collection” for tax purposes and would therefore be subject to a higher tax rate of 28%. However, there is currently no clear guidance from the IRS as to when an NFT is considered a collectible, and current law likely limits this to NFTs that are works of art.
The story goes on
Read more: The tax implications of this year’s platform and protocol bugs | Opinion
How is the stake taxed?
Given Ethereum’s historic upgrade to Proof-of-Stake and the fact that many leading exchanges offer stake custodial opportunities (e.g. annual ETH stake returns of up to 4-5%), stand for many Americans Questions about stake rewards in the foreground investors. There is no official guidance on how stakes should be taxed, but the Internal Revenue Service appears to consider them taxable based on the following:
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The initial act of staking cryptocurrencies is unlikely to be a taxable event per se, although there is likely an exception regarding Ethereum “liquid staking” where you receive a fungible token in return for your staking ETH.
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Also, the transfer of shares to a staker (e.g. staking through a pool versus individual staking) is unlikely to be taxable as long as only the staking rights and not the actual units are transferred by the delegator.
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Units earned through wagering (via block rewards and transaction fees) are taxable upon receipt. In the case of Ethereum, staking rewards are currently locked and cannot be withdrawn directly, raising an open question as to whether the rewards should be taxed as income at fair market value (FMV) according to the time of receipt or only at fair market value once unlockable .
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The FMV is treated as gross revenue from the deployment and may also be reduced by the cost of the deployment (e.g. the cost of running a dedicated node).
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The net income is treated as ordinary income and may be subject to self-employment tax if the stake increases to a “trade or business” level. (Similar to what was mentioned above for NFTs, this threshold is not yet officially defined.)
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Frequently, shares received are treated as a capital asset in the hands of the recipient, which means they are likely to receive a favorable tax rate on subsequent sale.
Given the lack of official guidance, an alternative view has been taken that rewards from deployment are not taxable when received. Instead, the rewards received from the stake may not be taxable until eventual sale. If sold, the rewards would be taxable as ordinary income (rather than a capital gain), so they would not receive a favorable tax rate.
That view was argued in federal court in Tennessee regarding Tezos’ stake rewards as part of a tax refund claim, but the government granted the refund and the case was dismissed. Thus, unless the IRS issues an explicit statement on the matter, or litigation recurs, the matter remains unresolved.
In the case of Ethereum deposit rewards through a centralized exchange like Coinbase, the platform can issue a 1099-MISC to individuals and the IRS for users who generate at least $600 in “other” income. Regardless of whether or not rewards are unlockable, it is probably the safest way to treat all rewards as income at their fair market value at the time of receipt.
How is DeFi income and liquidity farming taxed?
The 2022 US income tax return will feature “digital assets” prominently for hundreds of millions of taxpayers to see. As part of the instructions, the Form 1040 states, “Click ‘Yes’ if during the year 2022 you received: New digital assets as a result of mining, staking, and similar activities.”
As discussed above, this question shows that the IRS is likely to consider receipt of staking bonuses to be a taxable event. Separately, the inclusion of “similar activities” also indicates that the IRS is likely to consider any receipt of a digital asset other than through a purchase with cash or an exchange of other assets as a taxable event. The language appears to encompass a wide range of income-generating activities, including DeFi activities such as yield farming and liquidity farming.
While there is no official guidance on the tax treatment of DeFi activities such as yield farming, there are important points to note:
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The contribution of funds to a liquidity pool is likely to be a taxable event when control of the units is relinquished in exchange for a token received as consideration from the pool, particularly where the contribution is linked to the value contributed rather than the number of units contributed is, causing the individual to the point of transient loss.
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If entry into the pool was a taxable event, any exit or withdrawal from the pool will also constitute a taxable disposal of the token received from the pool.
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Shares received as income are likely to be treated as ordinary income at the fair value of the shares at the time of receipt. The timing of receipt can be difficult to track, as a user’s receipt of units is often tracked within the smart contracts that govern the DeFi protocol and is only visible through a user interface rather than on a public blockchain. The user’s receipt of the units only appears on the blockchain when the user actually withdraws the units from the DeFi protocol.
The lack of explicit guidance and the discrepancy between actual earnings yield in DeFi and the data reflecting that earnings for record-keeping purposes make DeFi one of the more difficult aspects of digital asset taxation right now.
See also: Why Selling Some Bitcoins at a Loss Can Maximize Your Holding Potential | Opinion
While there are still many gray areas, cryptocurrency adoption is progressing at a remarkable pace. Individuals and institutions should carefully consider their tax obligations and, in the absence of official guidance, consult tax experts or take the most conservative approach to avoid costly audits in the future.
Some of that uncertainty should be resolved as the IRS continues to issue guidance. Proposed regulations to implement tax reporting rules for digital asset brokers will help clarify some tax rules and make it easier for taxpayers to report their taxes correctly.
The IRS recently identified tax guidance related to the validation of digital asset transactions, including pledging, as a priority in 2023. As the digital asset ecosystem continues to grow and the tokenized economy takes hold, it will be imperative for the IRS to issue tax guidance whenever possible, clarifying the tax treatment of specific activities.
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