Crypto Tax: Tax treatment of cryptocurrency gained from mining and staking

Feb 22, 2022

Cryptocurrency tax laws and guidance develop at a much slower pace than the technology that gives rise to the issue. Much uncertainty remains, but to the degree possible, Blue J helps clarify tax obligations arising from cryptocurrency mining and staking.

The tax treatment of income gained from mining and staking cryptocurrency differs from that of any cryptocurrency received in the course of a trade. In the latter case, assuming the cryptocurrency is held by the taxpayer as a capital asset, the gain on a trade will be taxed as a capital gain, hence only 50 percent of it is taxable. Income from mining and staking is taxed just as employment income would be if it was paid in cryptocurrency.

Mining

Mining is one of the processes by means of which cryptocurrency transactions are validated and recorded on a new block on the public ledger, the blockchain. Successful miners automatically receive a reward in the form of newly minted cryptocurrency as well as transaction fees also in the form of cryptocurrency.1 Newly minted cryptocurrency did not exist prior to being mined, hence there is no transfer taking place when the miner receives the mining reward. This is different with regard to the transaction fees. The IRS’s guidance does not explicitly address the transaction fees miners receive as part of their compensation. It may be prudent to assume that it is treated similarly to newly minted cryptocurrency.

The IRS opines that the receipt of newly mined cryptocurrency by a miner is a taxable event and the cryptocurrency must be included in the miner’s gross income in the year of the receipt, not merely when the cryptocurrency is sold.2 Self-employment tax is payable on this income if the mining is undertaken as a trade or business and not in the course of an employment or as a hobby. 3

Mining requires extensive computing resources which leads miners to pool their resources in mining pools. There is currently no guidance available from the IRS on the taxation of pooled mining, i.e., the timing and character of income generated in a mining pool. It is conceivable that mining pools constitute partnerships for tax purposes in which case an election under § 761(a) may be possible. 4

Staking

To reduce the enormous resources required to power the computers miners use to solve the mathematical problems in order to validate a new block and add it to the chain, staking was invented as an alternative to mining while serving the same function and resulting in the same kinds of rewards. In contrast to mining where all miners try to validate the new block as quickly as possible and the first to solve the mathematical problem succeeds, in staking, only one node in the network is randomly selected to validate the new block, thereby drastically reducing the electrical and computing power required to affect the transactions on a block.

No IRS guidance exists regarding the taxation of staking rewards. Presumably, it would be taxed similarly to mining awards. However, in their complaint Jarrett v. United States, No. 3:21-cv-00419 (M.D. Tenn. May 26, 2021), the plaintiffs argue that they should be taxed on the cryptocurrency they received in the course of their staking enterprise to validate transactions on the Tezos public blockchain only once the tokens are sold, not upon receipt. The plaintiff recently posted on Twitter, attaching a letter from the IRS offering a refund for the tax that they had paid in wise precaution and then reclaimed, suing the IRS when the refund request was not responded to initially. Mr. Jarrett also indicated in a further post attaching a response letter that he will continue pursuing his case, as the refund offer provides no certainty that his staking rewards will not be taxed in the future. It remains to be seen if this case changes the IRS’s guidance on the taxation of staking, and possibly mining rewards, and how the court will weigh in on this matter.

Deductibility of hardware expenses 

Generally, ordinary and necessary expenses are deductible from business income, that is, only if the activity performed and in the course of which expenses are incurred qualifies as a business as opposed to a mere hobby. Likewise, losses cannot be used to offset income when the activity is undertaken as a hobby. 5

There exists no guidance on the deductibility of hardware expenses, such as cold wallets or mining equipment. 6 The AICPA recommends that mining equipment expenses “are treated similarly to expenses incurred in providing other services (i.e., expensed as paid or incurred)” because the IRS guidance treats mining income similarly to income from services rather than from production activity. 7

See also Blue J’s Crypto Tax blogsTax treatment and reporting of cryptocurrency transactions”, “How to calculate gains and losses on cryptocurrency transactions”.