As we’ve all probably heard, Ethereum has since December 2020 been transitioning to Ethereum 2.0, now known as the Ethereum merge. It’s a fork that aims to solve all those commonly known issues with Ethereum’s Proof of Work (PoW) consensus mechanism.
The update will be released in three phases. The first created the Beacon Chain, transitioning to Proof of Stake while running alongside the Proof of Work Ethereum blockchain.
Because of the lack of precedent, the tax question has left many scratching their heads as both chains continue to run.
From Proof of Work to Proof of Stake
Ethereum was built initially on a PoW consensus mechanism, like many other early cryptocurrencies. However, the method requires miners to use hardware to verify transactions and solve complex mathematical puzzles with the help of powerful computer hardware. This is, as you can imagine, very energy-intensive.
Proof of Stake (PoS), on the other hand, is by some considered preferable. This is because validators only have to stake their crypto to verify transactions. So there’s no need for energy-intensive computer processing, bringing the costs and energy usage down by a lot.
And that’s not all the benefits of ETH 2.0. Users will also enjoy a lot more transaction load. Scaling from the current 30 TPS to more than 100,000 TPS also improves speed, efficiency and scalability.
What are the Ethereum 2.0 Tax Implications?
The change in protocol to Ethereum 2.0 presents two tax questions:
- What are the tax implications of switching from Ethereum to ETH 2.0 while the original Ethereum is still active?
- What are the tax implications of staking ETH 2.0?
Tax Implications of Converting Ethereum to Ethereum 2.0
Fortunately, it’s more straightforward than you would expect. Each Ethereum will convert to Ethereum 2.0 with a registration contract. This effectively burns the original ETH and gives you ETH 2.0 at a 1:1 ratio. The IRS has already clarified its position on forks in Rev. Rul. 2019-24.
According to the IRS, hard forks happen when a “distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger.”
Usually, a new cryptocurrency is distributed together with the original legacy cryptocurrency staying in circulation with a hard fork. So if a taxpayer receives the new coin and still owns the original crypto, then the new one is considered an airdrop so it will be taxed as income.
The IRS cites Section 61(a)(3) to come to this conclusion, which defines gross income to mean any income from all sources, including income from whatever gains from dealings in property.
Additionally, with Section 61, all accessions to wealth are included in the gross income calculation. So back to our case. When converting ETH to ETH 2.0, the taxpayer does not continue owning the original legacy.
This transaction is, in short, only an upgrade to the already existing protocol and network. Thus it does not create a new currency that would result in “accession of wealth.”
ETH 2.0 is tied to the original value of ETH, with a ratio of 1:1, so for every ETH, you’ll get an ETH 2.0. Therefore according to IRS rules, this cannot be called a hard fork as it does not result in two distinct cryptocurrencies.
So by that fact, we can conclude that the ETH to ETH 2.0 conversion is not a taxable event, and the cost basis will stay the same.
Tax Implications of Staking Ethereum
As we mentioned earlier Ethereum 2.0, transitions from a Proof of Work consensus mechanism to Proof Of Stake, be it from mining to staking. The IRS has already in the past issued tax guidelines when it comes to mining. According to them, mining rewards are recognized as ordinary income at the time of receipt. Citing again Section 61, mining is considered an accession to wealth and is included in gross income.
Similarly, staking also produces an accession to wealth compared to the interest you receive on the property. The logical conclusion is that staking produces ordinary income when received for the asset’s fair market value, so it’s taxed accordingly.
Tax Forms Needed
Luckily, exchanges make our lives easier by providing all users who earned $600 in income with a 1099-MISC. On it, users can easily write all the revenue generated through staking on the platform.
This is usually done with third-party companies like TaxBit Enterprise that help crypto exchanges to comply with all their tax liability.
Like Ben Franklin said, “in this world, nothing can be said to be certain, except death and taxes.” And as much as we may not like it, that’s also true for crypto. Uncle Sam always wants his piece of the pie. That’s why we should always know the laws regarding taxation.
Transitioning to Ethereum 2.0 will open a whole new world of opportunities in the crypto space. Offering a better, quicker, cheaper, and more scalable for all users.
And thankfully, exchanging ETH to ETH 2.0 is not a taxable event. But as expected, staking Ethereum 2.0 carries income reporting obligations, considered ascension of wealth and regulated by Section 61 of the Internal Revenue Code.
With a relatively new DeFi market emerging, there’s a great need for clarity regarding tax laws and regulations. Fortunately, in this case, the IRS is fairly straightforward in what it wants from us. But there’s still a lot of work to be done regarding regulatory clarity in crypto.