IRS May Not Tax Passive Income From Holding Crypto Right Away

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What Happened

Taxation of staking rewards has been a controversial topic for many years because the IRS has failed to issue any clear guidance on this matter. In the absence of this guidance, many taxpayers defaulted to following a conservative approach for taxation — reporting income at the time you receive staking rewards.

Joshua Jarrett, Jessica Jarrett (plaintiffs) v. US (defendant) case

During 2019, a Nashville couple (Jarrets) received 8,876 Tezos (XTZ) staking rewards. These coins were worth $9,407 at the time of receipt. By relying on the conservative approach above, the Jarrets reported $9,407 as income and paid related taxes.

On July 31, 2020, the couple filed an amended tax return arguing that $9,407 staking income shouldn’t have been income in the first place. The amended return demanded a $3,793 tax refund from the IRS. The couple didn’t receive a timely response from the IRS.

In a complaint dated May 21, 2021, the couple argued that newly created property is taxed only at the time of sale, not at the time of receipt. For example, if you create a book, you pay taxes only when you sell it, not at the time you are done authoring the book. In response to this complaint, the Tax division of the US department of Justice ordered the IRS to issue a refund of $3,793 on a letter dated December 20, 2021. Interestingly, the Jarretts refused to accept the refund because the IRS didn’t acknowledge the true reasoning for issuing the refund. This reasoning is essential to create a precedent for other stakers and protect himself from IRS scrutiny in the future. The Jarretts decided to take this to the court to get a formal court ruling. This is an ongoing case.

“Fast forward to late December 2021 when I received a letter saying the government wanted to grant me a refund—in other words, a year and a half into this process, the government didn’t want to defend the position that the tokens I created through staking were taxable income. At first glance, this seemed like great news. But until the case receives an official ruling from a court, there will be nothing to prevent the IRS from challenging me again on this issue. I need a better answer. So I refused the government’s offer to pay me a refund.” (statement from Joshua Jarrett)

Key Concepts

What Is Staking?

Before we dive into the tax implications of staking rewards and Jarrett’s case, let’s discuss what staking is. Staking is very similar to having an interest-bearing bank savings account. Cardano (ADA), Solana (SOL) & Tezos (XTZ) are some cryptocurrencies you can stake. These coins run on Proof-of-Stake (PoS) consensus mechanism as opposed to Proof-of-Work (PoS) mechanism that powers Bitcoin.

The way it works is simple. You can leave these coins in your wallet and/or an exchange that supports staking, and receive periodic payouts based on the amount of funds you stake. The below snippet shows how staking rewards appear on a dashboard of a major US crypto exchange.

Staking rewards example

Shehan Chandrasekera

How Staking Is Taxed Today

IRS has not issued any staking specific crypto tax guidance. The closest guidance that could be used to infer how staking income should be taxed is the tax guidance on mining income issued on Notice 2014-21. According to this notice, mining income should be reported on your taxes at the time you receive the rewards. When you sell those mined coins, another taxable event is triggered.

For example, assume David receives the following XTZ staking rewards on the corresponding days.

January 1, 2021 – 1 XTZ valued at $10

January 25, 2021 – 1 XTZ valued at $10

May 1, 2021 – 1 XTZ valued at $5

His total ordinary income from staking operation for the 2021 tax year would be $25.

Assume he sells 1 XTZ received on January 1, 2021, for $15 in March 2021. This would also create a capital gain of $5 ($15 – $10). In 2021, his total income subject to taxes would be $30 ($25 + $5).

Why Staking Should Not Be Taxed At The Time Of Receipt

Staking results in a creation of “new property”. New property is taxed only at the time of sale, not when you discover it. As Abraham Sutherland, a lecturer at the University of Virginia, describes on Cryptocurrency Economics and The Taxation of Block Rewards, crops do not generate income until they are sold or exchanged, according to reg. section 1.61-4. According to Reg. section 1.61-3(a) gross income from mined minerals such as gold is only recognized at the time of sale, not at the time of extraction. Applying these fact patterns to staking, it could be argued that staking rewards should only be taxed at the time of sale. This is the exact argument Jarretts made in their complaint.

Implications of the Jarret’s case

The IRS issuing a refund to the Jarretts signals that staking rewards should not be taxed at the time of receipt. However, a formal court ruling must be issued on the case for others to safely rely on this tax treatment. If a court judgement is made in favor of the Jarretts in a future date, this case could set precedent for how staking income should be taxed going forward. This is a huge win for crypto holders in the US. In light of this new information, even without this formal court ruling, some taxpayers might decide to follow a bit aggressive approach and not report staking income at the time of receipt.

Also, it is very important to know that the outcome of this case will not completely shield staked coins from taxation. Staking income is NOT taxed at the time of receipt; it will be taxed only at the time of sale. For example, say Sam received 1 ADA staking reward worth $2 in 2022. Sam does not have any taxable income at the time he receives the token. The cost basis of the ADA token will be zero. If Sam later sells this coin for $10, he will have to report $10 of income.

The Jarretts’ judgement could also lead to many taxpayers amending their previous tax returns with staking income. You can file a Form 1040-X to amend your previous tax returns where you reported staking income when you received it. The IRS gives taxpayers three years from the date the original return was filed to file an amended return and request a refund. Consult your tax adviser to see if you are eligible to amend your tax returns and potential pros and cons.

Finally, this favorable tax treatment could accelerate the growth of Proof-of-Stake (PoS) based cryptocurrency projects.

Next Steps

Contact your tax adviser to see if you are qualified to amend your previous tax returns with staking income.