Crypto Taxes Are Complicated, But Changes Might Be Coming

Crypto taxes have been, and continue to be, a major obstacle to wider adoption for investors, traders, and users of cryptocurrencies. Since in the United States the only regulatory agency to have issued – and consistently enforced – guidance as it relates to cryptocurrency is the Internal Revenue Service (IRS), that is the regulator that continues to set the tone around crypto policy. Prior to very recently, the tax treatment for crypto – as complicated as crypto has become – has been that every transaction, trade, exchange, or transformation will incur a tax reporting and payment obligation.

Despite public resistance to changing this stance, and no indication that formalized changes are coming on a broader basis, there is a sign that the attitude might be evolving, albeit slowly. Prior to this case (see below), many tax advisors and practitioners – rightly so – were advising clients to practice conservative tax reporting. Even with the facts of this case indicating that a shift in policy might be coming, it is still prudent for practitioners to advise clients conservatively and do so based on the facts and circumstances of that specific situation.

While the following pertains specifically to block rewards, and staking activities, the implications might potentially pertain to a broader array of crypto activities. An analysis of the specifics of the headline case –Joshua and Jessica Jarrett vs. United States – can be found here.

The broader implications of this case, whether or not they actually manifest, are quite interesting so let’s dive in.

Decentralized finance, redefined. The issue at hand in this specific case can be boiled down to the following question. When do investors have ownership or control over rewards/coins/tokens or other assets that are generated from previously deposited assets in a project or at an organization? Secondly, when should these newly created assets be taxed? These questions expose a core question surrounding the DeFi sector, which has rapidly grown from a niche sector to a sector with over $200 billion in assets allocated to these projects.

A key aspect of DeFi is the concept of staking, which is where investors are basically replicating the process of earning interest in a bank account. Investors leave coins/tokens in a wallet or at an exchange that supports staking projects (using Proof-of-Stake consensus), and receive periodic payouts. Although these periodic payments might seem exactly the same as earning interest on a bank account, or accruing dividends, there is one fundamental difference that changes this analysis; the tax code itself.

With the pace of growth in the DeFi sector, obtaining clarity around the taxation and accounting for rewards and other related activities is essential, especially since how crypto is defined by the IRS is a driving force behind this confusion.

All crypto is still property. This might sound like old news to individuals that have been involved in the crypto space for years at this point, but as far as the IRS is concerned all crypto is classified as property. As far as trading activity, as well as using crypto for the payment of goods and services, this makes the tax implications (relatively) straight forward; every time there is a transaction that involves cryptoasset there is tax reporting and potential tax payment obligation. Transaction is the key word there, which is where the crux of the current argument around DeFi taxation is grounded.

The very same conservative tax advice that has been so readily dispensed by well-meaning tax practitioners and CPAs over the last several years might not be as widely applicable as previously thought. This differentiation in tax treatment is not due to any inherent differences between crypto themselves, but how combining the 1) current tax stance and 2) current tax classification of crypto creates an interesting problem.

Tax timing matters. Crypto investors and advisors with crypto clients are now facing the following conundrum. If crypto is indeed treated as classified as property, and every transaction involving crypto generates a tax reporting and possible payment obligation, where do DeFi activities (including staking) fit in?

Interpretation of current IRS guidance would result in taxpayers being assessed – and owing taxes on – staking rewards determined by the fair value of these rewards at the date/time of issuance. On the surface this might sound correct, but the IRS tax code itself actually creates the problem that has now burst into the headlines.

Staking rewards create new cryptoassets (which are classified as property by the IRS), and under IRS code, new property – linked to minerals such as gold traditionally – are only taxed when they are sold. This creates a potential paradox. Following tax consensus, which has been reinforced by the IRS and practitioners for years, and treating staking and block rewards as ordinary income, could be resulting in overpayments for taxpayers.

As DeFi, including staking, continues to increase is both size and scope, clarity and consistency are imperative for taxpayers and the IRS alike.

It is far too early to accurately state the impact of this current court tussle in terms of the impact it will have on crypto tax policy. Stated simply, there has been no change – or even comments indicating change is coming – in how the IRS views and treats cryptocurrencies. Every single court case, including those related to crypto, are a unique set of facts and circumstances that should be treated as such. That said, it is interesting to see that the IRS might just be (finally) evolving its view on how cryptoassets should be taxed, and the entire ecosystem will benefit as a result.