Proposed federal legislation would move the time of taxation for rewards received from staking cryptocurrency and other digital assets to the time of sale. IRS guidance currently provides that staking rewards are taxed at the time the taxpayer gains dominion and control over the rewards; that is, when the taxpayer has the ability to sell, exchange, or otherwise dispose of the cryptocurrency.
Cryptocurrency Staking Overview
In general, cryptocurrency staking is when an owner of cryptocurrency pledges all or part of its cryptocurrency toward helping validate transactions on the blockchain. The incentive for staking is earning validation rewards, which typically consist of one or more newly created units of the cryptocurrency native to a specific blockchain.
Complications for Cash Basis Taxpayers
Last Summer, the IRS released Revenue Ruling 2023-14, which addresses the tax treatment of cryptocurrency staking rewards. The problem with the IRS guidance is that it requires cash basis taxpayers to pay tax on validation rewards before the validation rewards are sold. For example, a taxpayer may receive a validation reward in 2024 but not sell it until 2025. If the taxpayer has the right to sell the validation reward in 2024, it must determine the fair market value at the time it has the right to sell it and pay tax in 2024.
While the IRS guidance may be consistent with general tax policy, it requires taxpayers to pay tax before they receive any gain they might realize on the sale of the validation reward. Moreover, the value of the validation reward might go down between the time the taxpayer has the right to sell it and the time it is actually sold. This might give rise to a tax loss, but the loss may be little consolation for having to pay tax in a prior year.
Uncertainty and Next Steps
The proposed legislation does not currently address important tax issues of staking income, such as income characterization, whether or not staking can constitute a trade or business, and whether non-U.S. persons/entities may be subject to income taxation in the U.S. on certain staking income.
The fate of the proposed legislation is unclear, and it may never be enacted. For now, taxpayers should follow the guidance in Revenue Ruling 2023-14.
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