After much anticipation, on December 1, 2020, Ethereum began undergoing a major update called Ethereum 2.0. Learn more about the tax implications of this upgrade.
Below, we’ll address:
- Quick overview of Ethereum 2.0; more details here
- Tax implications of Ethereum
- How staking factors into tax implications
What is Ethereum 2.0?
After much anticipation, on December 1, 2020, Ethereum began undergoing a major update called Ethereum 2.0. The update aims to address the network’s scalability and security by switching from a proof of work consensus mechanism to proof of stake. The upgrade plans to enhance the speed, efficiency, and scalability to allow more transactions and reduce system bottlenecks.
To read more about the details of Ethereum 2.0, please read our article.
Transition from Proof of Work (PoW) to Proof of Stake (PoS)
Ethereum, like many other cryptocurrencies, has long utilized a consensus mechanism known as proof of work (PoW). PoW blockchains require miners to use computer hardware processing power to solve complex mathematical puzzles to verify transactions. This process can be incredibly energy intensive and require extensive hardware to compute.
Proof of stake (PoS) allows validators to stake crypto as a means to verify transactions instead of mining. PoS algorithms remove the energy-intensive computer processing required to ensure consensus in verifying transactions.
What are the Tax Implications of Ethereum?
The change in protocol to Ethereum 2.0 presents two tax questions:
- What are the tax implications of converting existing currency on Ethereum to Ethereum 2.0 since the original Ethereum chain will continue to run?
- What are the tax implications to staking Ethereum 2.0?
Converting Ethereum to Ethereum 2.0
Users with currency on Ethereum will be able to convert to Ethereum 2.0 at a 1:1 ratio via a registration contract that effectively burns the original ETH. The IRS addressed the tax implications of forks in Rev. Rul. 2019-24.
What is a hard fork?
A hard fork occurs when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger. A hard fork often results in a new distributed cryptocurrency, along with the legacy cryptocurrency continuing.
When a taxpayer receives a new cryptocurrency and still owns the legacy cryptocurrency, then the new cryptocurrency is considered an airdrop and is subject to ordinary income rules.
The IRS reached this conclusion by citing Section 61(a)(3) which defines gross income to mean all income from whatever source derived including gains from dealings in property. Under Section 61, accessions to wealth are included in gross income.
Will taxpayers own legacy currency on Ethereum 2.0?
In the case of Ethereum 2.0, the taxpayer won’t continue to own the legacy cryptocurrency. Accordingly, the economics of this transaction are more akin to an upgrade to the existing protocol, rather than creating a new currency that results in an accession of wealth.
The original token ETH should be tied to the value of ETH2 because they can be exchanged for each other at a 1:1 ratio. It therefore appears that an upgrade from ETH to ETH2 falls outside of the definition of a hard fork and doesn’t result in an accession of wealth.
It is therefore reasonable to conclude that converting ETH to ETH2 is not a taxable event, and a user will maintain their original cost basis prior to the conversion.
What are the tax implications of staking ETH?
With Ethereum 2.0’s transition to PoS protocol, there will be a transition from mining to staking. The IRS has direct guidance on the tax implications of mining, finding that a taxpayer who mines virtual currency recognizes ordinary income at the time of receipt.
The existing guidance on mining conforms with Section 61 finding that all accessions to wealth, from whatever source derived, are included in gross income.
Similar to mining, staking results in an accession to wealth that is analogous to receiving interest on property. Accordingly, the most logical interpretation is to find that staking results in ordinary income at the time the asset is received for the fair market value of the asset.
Many exchanges provide users with a 1099-MISC if the user receives over $600 in income. This tax form will make it easy for users to know how much income they have generated on an exchange through staking activity. Taxbit Enterprise works with cryptocurrency exchanges to comply with their 1099 obligations to provide users with the necessary forms to complete their taxes.
Conclusion
The transition to Ethereum 2.0 should have many advantages that will allow further scalability and mass adoption.
It appears that exchanging currency on Ethereum to Ethereum 2.0 at a 1:1 ratio isn’t a taxable event.
However, it’s important to be aware that staking Ethereum 2.0 will carry ordinary income reporting obligations, as staking rewards would clearly be considered an ascension of wealth pursuant to Section 61 of the Internal Revenue Code.
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