Understanding the New Rules on Taxes for Staking Rewards

Batten down the hatches, crypto stakers - the IRS just dropped some turbulent tax guidance on staking rewards. All those juicy returns you've been earning? Taxable as income, effective immediately.

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This seismic ruling has the potential to create major accounting headaches and discourage US staking innovation. But don't abandon ship just yet. In this post, we'll guide you through what the new IRS rules actually mean, key uncertainties that remain, and most importantly, solutions that can help you smoothly navigate these choppy tax waters.

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By the time you're done reading, you'll understand the implications of the IRS guidance and have actionable next steps to keep your staking business sailing smoothly ahead, IRS be damned. So grab a life vest and let's dive in - the crypto tax party is just getting started!

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First, What Is Staking?

Let's break down how staking works for all the newbies out there.

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Blockchains are like giant digital ledgers that keep track of transactions. They're spread across a bunch of computers (nodes) that all sync up to keep the records straight. These nodes are like the blockchain's accountants. They make sure each transaction is valid, and no funny business is going on (like trying to spend the same crypto twice).

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When a new batch of transactions gets added to the ledger, it's called a new block. To add these blocks, some nodes become validators who do the work of verifying the transactions. As a reward for doing this grunt work, the validators get paid in the blockchain's native crypto. It's kind of like mining bitcoin, but instead of using fancy hardware, validators just need to stake some of their coins to participate.

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Different blockchains use different formulas to choose their validators and pay rewards. But in "proof-of-stake" systems, the more coins you stake, the more likely you are to be picked. Get chosen as a validator, do your job correctly, and you'll earn some sweet staking returns. But mess up, and you could lose part or all of your staked coins as punishment. That's what they call "slashing" - ouch!

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So in summary, staking is a way to earn passive crypto income while helping secure the network. It's candy for blockchain nerds!

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The Crypto Staking Rewards Tax Debate

Previously, there was debate about when staking rewards should be taxed. Some people argued they should only be taxed when sold, just like other capital assets.

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Treating staking rewards as income right away doesn't jive with how we've taxed stuff for over a century. Think about it - when an artist finishes a painting, they don't owe tax until it's sold. A farmer doesn't get taxed when crops are harvested, only when they're sold. The same should go for staking rewards. Just because new tokens are created doesn't mean the staker's income should be taxable yet.

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This debate made headlines when Tennessee taxpayers Joshua and Jessica Jarrett filed a lawsuit against the IRS seeking a nearly $4,000 refund on taxes paid for Tezos tokens earned through staking in 2019, arguing these newly created tokens should not be taxed as income until sold just like other forms of property; despite being issued a refund in early 2022, the couple rejected it and continued their legal battle in hopes of forcing a broader judicial ruling that staking rewards are only taxable upon sale.

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Updated IRS Guidance On Staking Rewards

But tax policy is rarely so logical. Despite the compelling arguments, on July 31, 2023 the IRS released new guidance taking a rigid stance on staking rewards.

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According to the IRS:

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“The fair market value of the validation rewards received is included in the taxpayer's gross income in the taxable year in which the taxpayer gains dominion and control over the validation rewards.”

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Well, so much for treating crypto like other forms of property. With this new ruling, the IRS is officially bringing down the tax hammer on staking returns.

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What This Means For Stakers

We hate to be the bearer of bad news, but the IRS staking guidance could create some major headaches for crypto stakers. Let’s break down what this guidance means for investors, staking providers, and proof-of-stake blockchains.

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First, staking rewards that are accrued but locked won’t be taxable until the recipient can exercise ‘dominion and control’ over their staking rewards.

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Second, this could discourage US participation in staking. Some providers generate thousands of reward tokens per hour. Expecting them to track tax on each individual token is an administrative nightmare. Many may decide staking stateside isn't worth the hassle.

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Third, the IRS guidance doesn't just create paperwork headaches. It also forces stakers into uncomfortable positions just to pay their tax bills. If stakers have to claim income on rewards immediately, they'll need to take drastic steps to fund those new tax obligations. Their options are:

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• Dump their new reward tokens, undermining network security
• Stop staking part of their holdings, reducing staked assets
• Tie up other money meant for investing
• Not pay taxes (don’t pick this one)

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No matter how you slice it, stakers lose. And here's the real kicker - crypto prices fluctuate wildly. The reward token a staker receives today could be worthless when tax time comes.

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For new or illiquid cryptocurrencies, selling rewards to pay taxes might be impossible. There are no buyers! So stakers could get stuck owing tax on "phantom income" from rewards that later tank in value or can't be sold at all.

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Open Questions on Staking Reward Taxes

While the IRS guidance brings some clarity, open questions remain:

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• Are slashing penalties considered ordinary losses if rewards are ordinary income? Seems only fair, but the IRS is mum.
• Do foreigners owe US income tax for delegating staking to US nodes? One could argue it creates a "US trade or business."
• If so, will the 30% withholding tax on income earned for US services apply to foreign stakers?
• How will liquid staking assets like Lido's stETH be treated? Many believe they should get capital gains treatment, turning current income into deferred gains.

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Until these wrinkles are addressed, the full tax implications for stakers and staking providers remain uncertain. While we appreciate the IRS's guidance, additional clarity would allow taxpayers to properly comply without undermining this emerging innovation.

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How Bitwave Can Help

The IRS staking guidance undoubtedly complicates taxes for crypto stakers. But it doesn't have to be doom and gloom. With the right solutions, stakers can stay zen even with the taxman watching.

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This is where Bitwave comes in. Our comprehensive staking management platform streamlines reward tracking and accounting. By supporting all reward types, customizable accounting methods, and consolidated data, Bitwave reduces staking tax friction.

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Schedule a demo today to see how we can make your staking business IRS-ready. And breathe easy knowing you've got an adaptive platform built to handle regulatory curveballs with no added stress.