What is Staking?
Earning interest income on cash holdings or dividend income from stocks is considered one of the common ways to make passive income. What if there exists a possibility to generate interest income from crypto assets as well?
Yes, this is possible through Staking.
Put simply, Staking is a way to earn interest on your locked crypto holdings that will help validate transactions on their underlying networks. To understand it better, let’s learn the concept of ‘Proof of Work’ (PoW) and ‘Proof of Stake’ (PoS).
What is Proof of work (PoW)?
Proof of work (PoW) is a decentralized consensus mechanism, used widely in crypto currency mining for validating transactions. Since the crypto currency has no central authority, it is the proof of work that keeps the network going. The aim is to protect the crypto transaction history, secure the digital transactions and restrict any fraudulent activity. PoW essentially requires the network members to solve some mathematical puzzles. Once it is solved, the miner finds the hash value of the previous block and announces it to the network. The miner then adds the latest “block” of verified transactions onto the blockchain. He is then rewarded in the form of crypto coins.
PoW requires huge amounts of energy, which increases as more miners join the network. Since the mining involves computers with large processing power, it has an extensive carbon footprint. This has attracted huge criticism. Citing the same reason, Tesla’s CEO, Elon Musk reversed his decision in May 2021, over accepting bitcoin for electric vehicles. Besides that, there is a downside of technical difficulty in buying and setting up ASICs (Application-Specific Integrated Circuits). This requires a handful of technical knowledge.
What is Proof of Stake (PoS)?
Consequently, an alternative consensus mechanism, Proof-of-Stake (PoS) emerged in 2011, which does not need miners and any mining hardware and software. While the ultimate aim is to secure a consensus on the blockchain network, PoS is less energy intensive. Moreover, it does not require miners to solve the complex cryptographic problems, rather based on the concept of economic incentives.
Under PoS, network members lock or stake their coins in the network. In return, the network assigns them the chance to validate the next block of transactions. The probability of being chosen by the network is typically related to the amount of coins locked. However, there is a risk of losing the staked coins, in case the members attempt to make any forgery or manipulation. In a way, these staked coins work as a de-facto collateral.
Due to its nature of being less energy intensive, PoS is becoming more mainstream. Consequently, many cryptocuuencies such as Ethereum 2, Tezos, Cosmos, Cardano are moving to a PoS consensus algorithm and allow staking.
How Staking works ?
The staking process allows producing and validating new blocks in a PoS blockchain. Each blockchain differs slightly in the staking process, as each network has its own system to distribute rewards. Network participants stake their coins and are accordingly incentivized on the network. This means higher the stake, higher the probability of being chosen and higher the compensation. The cryptocurrencies are bought to lock in a smart contract. Once the stake is locked up, the network participants vote to approve transactions.
General rules for staking
Although the staking rules might vary on each network, the general conditions remain the same as follows:
- The staker is required to only validate valid transactions on the network.
- In exchange for approving valid transactions, the network rewards the staker with a reward.
- If the staker approves illegal transactions, they stand a risk of losing their coins or stake.
While staking is open for everyone to participate, several crypto currencies have a minimum investment requirement. For instance, ETH2 requires a minimum of 32 ETH, to be eligible to verify transactions in PoS and receive the associated rewards. To address the same, a group of network stakeholders form a ‘Staking pool’, where they come together, combine their funds and participate collectively to increase their chances of getting picked and certify a block.
The staking coins are reserved in a cryptocurrency wallet or staking pool and new blocks are created through a process known as ‘forging‘ or ‘minting‘. Since new tokens are minted, it raises supply and dilutes the relative ownership/participation in the network. This is also called as dilution of POS tokens or staking inflation rate. Hence, the network participants usually prefer the projects where the dilution rate does not exceed the annualized staking reward.
How’s staking income taxed?
The tax guidelines on staking income are still vague. Due to the lack of any specific crypto staking tax guidelines issued by IRS, it is currently calculated on the basis of tax guidance on mining income. According to crypto mining tax rules, the staking rewards are considered as an ordinary income. Consequently, they are taxed accordingly at the time of receipt, based on their FMV (Fair Market Value).
For instance, if you receive 0.5 ETH from staking, you’ll have to report the FMV at the time of receipt. This will be added to your overall ordinary income and you will pay income tax based on your tax bracket. However, this FMV amount will become the cost basis and you will need to recognize a capital gain or loss, if you later sell that 0.5 ETH. If you hold that 0.5 ETH for longer than 12 months, you’ll be subject to a long-term capital gains tax rate.
In a letter dated July 29, 2020, four US congressmen appealed to IRS, to tax staking rewards at the time of selling the rewards, and not at the time of their receipt.
“It is possible the taxation of ‘staking’ rewards as income may overstate taxpayers’ actual gains from participating in this new technology,” the letter said. “It could also result in a reporting and compliance nightmare, for taxpayers and the Service alike.” – As per the letter signed by signed by the Congressional Blockchain Caucus’ co-chairs Reps. David Schweikert (R-Ariz.), Bill Foster (D-Ill.), Tom Emmer (R-Minn.) and Darren Soto (D-Fla.)
Supporting this proposition, Sutherland, a lecturer at the University of Virginia, highlighted that staking rewards are not necessarily the income due to the dilution of the entire network. According to him,
“If an individual staker has seen the number of tokens they hold grow by 6%, this does not mean the staker has a 6% gain if, for example, the number of tokens on the network as a whole has increased by 5%.”
While the IRS is still working on the tax regulations on staking income and crypto space in general, President Biden announced $1 trillion infrastructure package in Jul 2021 that requires heightened reporting requirements on crypto brokerages and exchanges. The aim of this bill is to step up tax enforcement around crypto assets.
Whilst staking seems very enticing as an alternative source of income, we need to be mindful of the fact that crypto currencies are highly volatile and entail risk. Since the coins are locked during the staking period, it is generally suitable for the investors with a long term view. At Fujn, we suggest adopting a cautious approach based on your risk appetite and perform a due diligence while indulging into any crypto investing and staking.
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