Understand the tax implications of NFTs, staking and yield farming

Understand the tax implications of NFTs, staking and yield farming

Even in the depths of winter, crypto continues to make fundamental strides – especially in terms of adoption by the world’s top businesses and institutions. Ethereum, the pioneering blockchain for innovative technologies such as decentralized finance (DeFi) and NFTs, recently completed its long-awaited merger – sparking institutional interest and unlocking opportunities for return generation via its proof-of-stake (POS) blockchain.

Miles Fuller is head of government solutions at TaxBit. This piece is part of CoinDesk’s Tax week.

As an emerging asset class, crypto raises many perplexing questions for investors and regulators alike. At the same time, an October poll conducted by the Crypto Council for Innovation indicated that a majority of US voters want more crypto regulation and believe that lawmakers should treat cryptocurrency as a serious and valid part of the economy. But the lack of regulatory clarity has been a significant barrier to crypto adoption for both individuals and institutions.

To solve this problem, we should try to better understand a key component of regulation: taxes. Especially when it comes to NFTs, staking and yield farming.

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How are NFTs taxed?

In November, Meta announced that Instagram will soon allow creators to create and sell non-fungible tokens directly on the social platform. Reddit is also helping to take NFTs mainstream. Since opening its NFT marketplace in July, over 2.5 million new wallets have been created and cumulative Reddit NFT sales have surpassed $6.5 million. As NFT initiatives from the world’s top enterprises continue to take flight, users should carefully consider the key tax implications:

  • NFTs are not taxable upon creation, but are taxable when sold according to the fair market value (FMV) of the cash or cryptocurrency received.

  • The value of assets received from the sale of an NFT is considered gross income which can then be reduced by costs relating to the creation and sale (such as gas taxes) of the NFT.

  • The resulting net income from the sale of NFTs is characterized as ordinary income for tax purposes and may also be subject to self-employment tax if the NFT creation activity rises to the level of a “trade or business.” However, there are currently no clear rules or guidance as to when NFT activity rises to the level of a “trade or business.” Traditionally, an activity must be carried on with continuity, regularity and an intention to make money in order to be considered a trade or business for tax purposes.

  • Commissions or royalties received from the downstream resale of an NFT are almost certainly income, but there is no official guidance on this yet.

  • The resale of an NFT will be a taxable sale of property similar to other cryptocurrencies (which are considered property under the tax code).

  • It is possible that some NFTs may also potentially constitute a “collectible” for tax purposes, and will thus be subject to a higher tax rate of 28%. But there is currently no clear guidance from the IRS on when an NFT is considered a collectible, and existing law likely limits it to NFTs that are works of art.

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How is striking taxed?

Given the historic upgrade of Ethereum to proof-of-stake, and that many leading exchanges offer custodial opportunities (such as ETH annual stake returns of up to 4-5%), issues of stake rewards are important to many US. investors. There is no official guidance on how betting should be taxed, but the Internal Revenue Service appears to view it as taxable under the following points:

  • The initial act of staking crypto is probably not a taxable event in itself, although there is probably an exception with regard to “liquid staking” on Ethereum which gives you a tradable token in return for your staked ETH.

  • Delegation of units to a staker (such as staking via a pool versus solo staking) is also likely not taxable as long as only the staking rights are transferred by the delegator and not the actual units.

  • Units received from stakes (via block rewards and transaction fees) are taxable upon receipt. In the case of Ethereum, stake rewards are currently locked and cannot be withdrawn directly, which raises an open question of whether the rewards should be taxed as income at fair market value (FMV) according to the moment of receipt or only at fair market value when they can be unlocked.

  • FMV is treated as the gross income from staking, and can also be reduced by costs of staking (such as the costs of running a dedicated node).

  • Net income is treated as ordinary income and may be subject to self-employment tax if the effort rises to the level of a “trade or business.” (Like the above for NFTs, this threshold has not yet been officially defined.)

  • Often, received units will be treated as a capital asset in the recipient’s hands, meaning they are likely to receive a favorable tax rate on last-day sales.

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Given the lack of official guidance, an alternative view has been put forward that rewards received from betting are not taxable upon receipt. Instead, any rewards received from wagering may not be taxable until the eventual sale. If sold, the rewards will be taxable as ordinary income (rather than capital gains), so they will not receive a favorable tax rate.

This view was sued in federal court in Tennessee regarding Tezo’s stake rewards as part of a tax refund claim, but the government granted the refund and the case was dismissed. So unless the IRS issues an express statement on the matter or it arises in court cases again, the issue will remain unresolved.

In the event that Ethereum stakes rewards via a centralized exchange such as Coinbase, the platform may issue a 1099-MISC to individuals and the IRS for users who earn at least $600 in “miscellaneous” income. Regardless of whether rewards can be unlocked or not, the safest path is likely to treat all rewards as income at fair market value as of the time of receipt.

How are DeFi returns and liquidity farming taxed?

The 2022 US individual tax return prominently highlights “Digital Assets” for hundreds of millions of taxpayers to see. As part of the instructions, the 1040 form states: “Check ‘Yes’ if at any time during 2022: Received new digital assets as a result of mining, staking and similar activities.”

As discussed above, this question reveals that the IRS likely views the receipt of wagering rewards as a taxable event. Separately, the inclusion of “similar activities” also indicates that the IRS is likely to view any receipt of a digital asset that was not made through a cash purchase or exchange of other property as a taxable event. The language appears to encompass a wide range of income-generating activities, including DeFi activities such as yield farming and liquidity farming.

Although there is no official guidance on the tax treatment of DeFi activities such as yield farming, there are important points to consider:

  • Contributing funds to a liquidity pool is likely to be a taxable event if control of the units is relinquished in exchange for a token received in return from the pool, particularly where the contribution is linked to the value contributed rather than the number of units contributed, exposing individual to permanent loss.

  • If the deposit into the pool was a taxable event, any exit or withdrawal from the pool will also be a taxable disposition of the token received from the pool.

  • Units received as returns are likely to be treated as ordinary income according to the fair market value of the units at the time of receipt. The moment of receipt can be difficult to track because the receipt of devices by a user is often tracked in the smart contracts that control the DeFi protocol and is only visible through a user interface rather than on a public blockchain. The user’s receipt of units is only shown on the blockchain when the user actually withdraws the units from the DeFi protocol.

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The lack of explicit guidance and the disconnect between actual receipt of returns in DeFi and data reflecting this receipt for record-keeping purposes currently makes DeFi one of the trickier aspects of digital asset taxation.

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Although there are still many gray areas, crypto adoption continues at a remarkable pace. Individuals and institutions should carefully consider their tax obligations and, in the absence of official guidance, consult tax experts or take the most conservative approach to avoid costly audits in the future.

Some of this uncertainty should be resolved as the IRS continues to provide guidance. Proposed regulations implementing tax reporting rules for digital asset brokers would help clarify some of the tax rules and make it easier for taxpayers to accurately report their taxes.

The IRS recently identified tax guidance related to digital asset transaction validation, including staking, as a priority during 2023. As the digital asset ecosystem continues to grow and the tokenized economy takes hold, it will be critical for the IRS to, whenever possible, issue guidance that clarifies the tax treatment of certain activities.

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