Staking your crypto IRAs – What You Need to Know
Staking has become a word that many cryptocurrency investors, particularly Crypto IRA investors, are familiar with. Staking is the practice of validating transactions using a growing number of cryptocurrencies. POS is a more environmentally friendly method to mine cryptos and get rewards to confirm transactions than Bitcoin mining, which is based on the proof of work (“POW”) principle.
- Staking cryptos is a method for generating income in the background using your cryptos.
- The Proof of Stake method is becoming more popular among cryptocurrencies.
- Staking your crypto IRAs might have tax consequences that you should be aware of.
This article will explain how POS works, how a Self-Directed IRA can benefit from POS bonuses, and how it may be taxed in the context of a Crypto IRA.
What is Proof of Stake (POS)?
POS, also known as “Proof of Signature,” is a cryptocurrency that uses a variant of the proof-of-work system.
Staking cryptocurrencies is the process of committing one’s cryptocurrency assets to a blockchain network in order to confirm transactions on the blockchain. POS is available for cryptos that use the proof of stake approach for transaction processing. Because POS consumes less energy than POW, it has become more popular than it was previously.
POS, in a nutshell, is the process by which new transactions are added to a blockchain for a certain cryptocurrency. The cryptos that employ POS with the highest market capitalization are Solano and Cardano. Although, Ethereum 2 is anticipated to go live in the middle of 2022 and will improve the Ethereum network through switching from POW to POS. In addition, Polygon and Commit Chain connectivity help scale the Ethereum network by using their own POS blockchain and Commit Chain connection.
How Does Point-of-Sale (POS) Technology Work?
The first stage is to invest one’s assets in the cryptocurrency protocol. The protocol then selects the participant who will serve as a validator to confirm transactions blocks. The more coins a person pledges, the more likely he or she will be chosen as a validator.
Each time a block is added to the blockchain, new coins are “minted” and given out as rewards to the block’s validator. POS can be compared to a lottery. The greater the amount of tokens committed, the higher the chance is that the participant will be chosen as a validator and earning a reward.
POS eliminates the need for bitcoin miners by introducing validators instead, resulting in significantly less energy usage than POWs. In essence, if you want to stake your cryptos using a POS, all you have to do is move them to a wallet, create a smart contract, and employ blockchain code. Staking coins individually or via a staking service allows users to pool resources together.
A Beginner’s Guide to IRS & The Crypto IRA
The IRS considers cryptocurrencies, such as Bitcoin, to be goods. Cryptocurrencies are treated by the IRS the same way as equities or real estate. The IRS provided guidance on the tax treatment of cryptos in IRS Notice 2014-21. The IRS made it clear in the notice that cryptos will be taxed as a capital asset from a tax standpoint. As a result, selling bitcoin held in an IRA is not subject to taxes; instead, all gains are tax-deferred or tax-free if invested in a Roth IRA.
The tax treatment of a P.O.W.
The IRS released a new Revenue Procedure on October 12, 2014 that provides some clarity on how the agency will treat crypto rewards earned through POW. The notice adds that “if” a taxpayer’s mining of virtual currency is considered a trade or business, the funds received as part of the mining operation would be deemed business income.
A tax known as UBTI, which can reach up to 37% in 2022, may apply to a Crypto IRA if the investor engages in an activity that generates business income. As a result, if the proceeds or coins generated by a crypto mining operation are deemed to be a trade or business for purposes of the Self-Directed IRA’s investing standards, the income or tokens earned from that activity could be subject to the UBTI tax.
The use of the word “if” in Notice 2014-21 emphasizes the fact that not all mining operations will be considered a trade or business. As a result, an argument may be made that if you invested in some mining activity and viewed it as passive rather than as a trade or business, the cryptos earned as part of the activity would not be subject to ordinary business income.
Aside from Notice 2014-21, the IRS’s position on the tax treatment of POW mining activity is largely unaddressed.
Tax Treatment of POS
The IRS’s position on the tax treatment of earning rewards via POS may be revealed in a recent court case. Joshua Jarrett of Nashville, Tennessee, ran a small-scale virtual currency staking business using a home computer in 2019. Jarrett owned several hundred thousand Tezos tokens, which is a POS platform. He generated 9,000 new tokens over the course of a year and reported them to his federal income tax return.
The IRS was asked to pay out a $1 million bonus to Jarrett, who would then be taxed on the new tokens he generated through staking but had not yet transferred or sold. Jarrett felt that he couldn’t. The IRS attempted to avoid an unfavorable decision that might limit its ability to tax staking activities as complete ordinary income transactions in the future by offering to return all of Jarrett’s compensation in exchange for dismissing the case.
On February 3, 2022, he announced that he had decided to decline the IRS’s offer and pursue a final court decision instead. The case will now be decided by a U.S. District court in the Middle District of Tennessee, having significant consequences for both individual investors and Crypto IRA investors when it comes to tax treatment.
The Jarrett case is intriguing from a Crypto IRA perspective because he was involved in POS activity passively, not as a trade or business, which the IRS guidance on Notice 2014-21 appears to exclude. As a result, the court’s decision in Jarrett may have significant tax ramifications for passive Crypto IRA investors engaged in POS operations.
The tax treatment of POW and POS rewards will become more clear as the popularity of cryptocurrency investments rises. In general, if an activity is labeled a trade or business, an individual investor would be subject to ordinary income tax and a Crypto IRA investor would be subject to UBTI on the reward received. Despite this, POS Crypto IRA investors may get a definitive answer to their tax treatment sooner than later thanks to the Jarrett case. Stay tuned!
‘Staking does not always deliver the profits you may be looking for. This is especially true if the gains are taxed. Before engaging in staking, Crypto IRAs, please consult a financial advisor.’