Understanding

Staking your crypto IRAs – What You Need to Know

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.

Key Features

  • 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.

Conclusion

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.’

The Dangers of Investing in Cryptocurrencies

DO NOT under any circumstance take this as financial advice. I have no idea what I’m doing with regards to investing, I merely want to point out some of the dangers to you. DO EXPECT to throw money out the window unless you know very well what you are doing. ANY INVESTMENT is a dangerous game, especially for novices like me.

There, that should get the mood set.

In this article, I’ll focus on explaining to you some of the dangers of investing in cryptocurrencies. I’m doing this to warn you about the dangers involved, and maybe even scare you away from investing completely. This isn’t a beginners game and you will get burned if you approach it without proper preparation.

Investing Bits and Bytes? You’re Joking, Right?

You may be surprised that there is a thriving market for Bitcoin based investments. Even Litecoins now have dedicated stock and options markets. Why on earth would such a thing exist at all? It’s just numbers, right? Not real money?

Note: No, I’m not having the debate about the merits of Bitcoin, whether Litecoin has a place at all, cryptocurrencies in general, or other similar discussions now. My opinion is that there is a market need for cryptocurrencies, Bitcoin, Litecoin, or otherwise. Currently, Bitcoin and Litecoin are my favorites to lead this race, but don’t listen to me.

Well, as with all things subject to speculation, people will speculate, trying to make more of what they already have. Whether they speculate in the volatility of the market, or the long-term success of any particular cryptocurrency, these markets will pop up and as long as there are willing participants who believe they can benefit, they will thrive.

I would like to stress, though, that investing with and in cryptocurrencies is an extremely risky business. It is even more tricky and complicated than regular speculation because you also need to take into consideration the exchange rate between the various cryptocurrencies, and the exchange rate between cryptocurrencies and fiat currencies.

In other words, and make no mistake about this: DO NOT under any circumstance put money into cryptocurrency speculation that you are not completely comfortable considering lost the moment you buy in. Nobody understand this market, nobody knows where it is going, nobody has any relevant previous experience with cryptocurrency markets, much less with how stocks and options work.

So, Why Are You Investing?

Personally, I have a few Bitcoin and Litecoin investments, but like I explained, I consider these funds lost and have no hope of ever recovering them. I am using the investments to learn more about investing in general and about cryptocurrencies in particular. I have faith in cryptocurrencies as the future of commerce, and I want to learn as much as possible. I’m a learning junkie, in case you haven’t read anything I’ve written before.

At the time of this writing, I have yet to realize any losses on my investments, but I have also spent weeks and months learning and calculating, reading about investment strategies, how traditional markets work, how psychology plays into the game, and so on. I have spread my investments to balance any risks, and I’ve constructed an investment profile that matches my risk profile (which is ‘let it ride’, basically) with my expectations for the growth of cryptocurrencies.

I am a complete novice at this game; I expect to suffer heavy losses, perhaps even a complete loss, or, as it stands right now, even more than I have invested. I have spent considerable time learning, and that time may instead have been used for other, more profitable ventures.

I have, however, put in some of the legwork to understand as best I can how this game works, and it has taken considerable time. When I say I’ve worked weeks on this, I’m talking about 15-18 hour days, seven days a week. This probably makes me more informed than most first-time investors, but make no mistake; I am utterly incapable of making sound decisions, and I’m having to completely rethink what I’m doing on a daily basis. DO NOT take any of what I tell you as any kind of advice on what you should do, with one exception (two, counting the previous sentence): DO YOUR HOMEWORK.

Why is it So Complicated?

I’ll talk more about the complications of investing in cryptocurrencies in a later blog post, but be aware that investing in cryptocurrencies is more complex than regular investments. Rather than having an investment go up and down based on a single or few market conditions, you need to take the exchange rate into consideration, and that may move in any direction at any time.

Further, since Bitcoins and other cryptocurrencies are by nature decentralized and out of government control, you have no recourse if something goes wrong (recourse meaning your ability to get money back if you’re tricked or scammed). Plenty of people have lost plenty of money to scammers, but also to people who have had honest intentions but very little experience or just plain bad luck.

Also take into consideration that the cryptocurrencies’ exchange rates are extremely volatile at present. This is partially due to its size but also because it is a young market and nobody really knows what drives the exchange rate.

Many people lost large fortunes during April 2013 after what seems to have been a bubble in the Bitcoin/US Dollar exchange rate, even seasoned investors who thought they could ride the wave into the sky.

Finally, because the Bitcoin stock investment market is extremely young and small, but also due to its decentralized nature, it is to a large extent based on trust. You need to do far more investigations into the background of the issuers of stock denominated in cryptocurrencies than you would for a regular stock exchange, where you can trust somewhat in the exchange to do some of the due diligence for you.

The cryptostock market is definitely maturing in this area, but has a long way to go before its reputation and process for admissions is as strict as it would be for example for being traded on NASDAQ.

So, if I haven’t scared you off yet, I haven’t done a good job, but I would like to see that you’ve at least become more aware of the dangers inherent in investing in an unproven, highly speculative, and largely misunderstood market.

Be safe, and in the case of Bitcoin, Litecoin, or other cryptocoin investments, that may mean sitting on the bench for a while.