Crypto and DeFi Staking Tax Guide 2022

If you participate in cryptocurrency staking or any form of decentralized finance (DeFi) staking, there are tax repercussions you should know about. While crypto staking can help you grow your digital investments even more, reporting these transactions and profits on your tax returns can get complicated very quickly. 

Whether you’re a seasoned pro who has been staking for years or a newcomer to the world of digital currency, here’s everything you need to know about crypto staking, how it can grow your income, and the different ways different DeFi staking events are taxed.

What is DeFi staking?

Decentralized finance refers to non-traditional currency, such as cryptocurrency, stablecoins, Nfts, and other digital assets. Staking encourages crypto investors to hold on to their digital currency longer, engaging longer term in the blockchain network. 

Crypto investors essentially lock their digital assets into smart contracts, which are parts of code on the blockchain that serve as a financial contract. In exchange investors can receive high interest on the value of their cryptocurrency — as long as they correctly validate transactions.

Staking helps maintain the proof-of-stake network, which is much more environmentally friendly than the proof-of-work network (currently used by Bitcoin). Essentially, the network incentivizes users to verify transactions made on the blockchain by running validator nodes and staking their coins. This helps keep the network secure, while providing liquidity to help attract new investors.

But staking isn’t without risk. Although you can earn high rewards through crypto staking, if transactions are incorrectly validated, you could end up losing your cryptocurrency. However, investing in a stablecoin staking network is often the safest and most beneficial route to making a profit, since stablecoins are not as volatile as cryptocurrency.

Types of DeFi staking 

Before we jump into the tax implications of staking, it’s important to understand the different types of staking available. For this tax guide, we’ll look at a few key types of crypto staking: pure staking, yield farming, and liquidity mining.

Pure staking

This type of staking is exactly what we described above: you lock up an agreed amount of cryptocurrency to become a validator on the proof-of-stake blockchain network. After correctly validating transactions, you receive rewards, and as long as the cryptocurrency’s value hasn’t dropped, you should earn a profit. If you perform stalking with stablecoins, you’re more likely to be guaranteed returns.

Yield farming

This allows you to move some of your cryptocurrency or decentralized currency into a liquidity pool that is then lent out. You’d then make money through interest earned or on revenue made from your DeFi staking platform.

Liquidity mining

This type of staking is actually a form of yield farming, which lets you deposit crypto and digital assets into liquidity pools. You’d then earn passive income from the fees users pay when trading digital coins.

How DeFi staking transactions are taxed

Just like regular crypto transactions, whenever you earn a profit or your digital assets increase in value, there are tax implications. With crypto staking, you’re also on the hook for taxes. How you’re taxed, however, varies depending on the staking type and the way your profit was generated.

Here are a few scenarios that can help you understand how DeFi staking will impact your US taxes.

Taxes on DeFi staking

Currently, the IRS equates DeFi staking to crypto mining, which is always reported as income. Because of this correlation, any crypto received through pure staking should be reported on your tax returns as income via IRS Form Schedule 1.

Taxes on yield farming and liquidity pooling 

When sending or removing funds via yield farming or a liquidity pool, you typically do not have to worry about income tax, because you’re not earning or losing any crypto. It’s possible, however, that you may need to file Capital Gains taxes. Some experts believe adding or removing funds is similar to transferring money from account to account, and thus, not subject to taxes. 

The IRS doesn’t have a clear stance on this right now, so we recommend checking with a tax professional if you’re worried about liquidity pooling activity.

When you’re rewarded with a token for yield farming or liquidity pooling, however, you are subject to taxation. How you’ll be taxed depends on the platform, though, and how it rewards you.

For example, if you earn new coins or tokens from liquidity pooling, this new “profit” would be subject to income tax. You’d report this as income using IRS Form Schedule 1.

However, if you keep the same number of coins or tokens, but the platform increases their value, then you’re subject to capital gains tax. You’ll report the increase in value when you file your tax return, using IRS Form 8949, Sales and Other Dispositions of Capital Assets, and Schedule D, Capital Gains and Losses.

Taxes on liquidity mining

Currently, the IRS is still determining set rules for reporting cryptocurrency transactions on your tax returns. Right now, the general consensus amongst tax experts is that crypto or money earned from liquidity mining should be reported as income and not as capital gains. This is subject to change, however, so we recommend speaking to a tax professional for more information.

Although you’re technically lending money with liquidity mining and then earning “interest” on the money you fronted, current US tax law does not treat this profit as interest. Instead, it’s seen as income. 

This is important, because accidentally listing returns yielded through liquidity mining as interest instead of income can lead to improper tax reporting. That means you could be audited and stuck with an IRS fine if you didn’t pay enough in taxes owed due to the miscalculation.

When doing your taxes, you’ll report the fair market value of your yield as income. You may receive this information from your cryptocurrency platform, but if you don’t, you’ll need to calculate your yields for the tax year.

You’ll report yields from liquidity mining when filing your tax returns using IRS Form Schedule 1.

Will I owe taxes if I stake ETH?

In most cases, yes. You’ll be taxed similarly to mining cryptocurrency. You’re typically subject to pay income tax on any rewards won upon receipt of staking. You may also owe capital gains taxes on any profits you make from later selling, trading, or spending those cryptocurrency rewards.

When you’ll owe income tax versus capital gains on DeFi staking profits

Figuring out which type of tax you owe — income tax or capital gains tax — can be confusing. It’s especially convoluted because there are two types of capital gains tax, short-term and long-term. If you end up owing short-term capital gains tax, it’s actually taxed as income.

If you’re ever confused on whether you should pay income tax or capital gains on money earned through stablecoin or DeFi staking, here’s a quick cheatsheet to help.

In general, if you earn new coins, tokens or crypto, you’ll owe income tax.

Example:

Let’s say you lend 5,000 DAI. After two years, you’ve earned an additional 250 DAI through staking, bringing your balance to 5,250 DAI. You’d then owe income tax on the 250 DAI.

If a platform rewards your staking efforts by increasing the value of your existing coins, you’ll owe capital gains.

Example:

You lend 10,000 DAI. After 18 months, the value of these tokens increases, so now your DAI is worth $11,000 DAI. You would then owe capital gains on 1,000 DAI (the value your DAI increased by).

But, there’s another layer of complication to consider. If your crypto increases in value during a tax year, but you’ve held that crypto for less than a year, you’d owe short-term capital gains, which works like income tax.

Example:

You lend $10,000 DAI. After 9 months, the value of these tokens increases and now your DAI is worth $10,500 DAI. You would owe short-term capital gains taxes on 500 DAI (the value your DAI increased). Short-term capital gains are treated as taxable income, and would therefore increase the income you report on your tax returns. 

The bottom line on DeFi staking taxes

Figuring out how much you owe in taxes from DeFi staking rewards takes some time and effort, but it’s entirely possible to report on your own. You’ll just need to be cautious to review your crypto transactions and all rewards received to determine if you’ll own income tax or capital gains tax.

Even if you have a solid understanding of tax law, it’s easy to slip up and misreport your crypto taxes. It’s even easier to miss a transaction or misreport your information on the wrong tax form. Since the US is still figuring out hard guidelines on cryptocurrency and DeFi taxes, if you’ve participated in crypto staking this year, finding a tax professional with digital currency knowledge can help ensure your tax returns are correct.

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