Tax Guide for ETH 2.0

Ethereum has been in the process of migrating from a Proof of Work (PoW) to Proof of Stake (PoS) consensus mechanism ever since the launch of the Beacon Chain on December 1, 2020. As we continue to move closer and closer to “The Merge” there are many questions circling around the taxability of each step.

Currently, there is no direct tax guidance on how to handle conversion transactions between ETH and ETH2 tokens. This guide explains how to deduce tax implications for various ETH2 related transactions including: locking ether, earning staking rewards, and redeeming ETH2.

What is “The Merge”?

Ethereum is migrating to a PoS mechanism because it is more secure, less energy-intensive and better for scaling solutions. The Beacon Chain (or “consensus layer”) is running separately and runs parallel to the Ethereum Mainnet (PoW). The goal is to swap out the current PoW algorithm and replace it with the PoS consensus protocol which the Beacon Chain provides. This process is known as The Merge.

Here is the analogy that Ethereum uses to describe the merge.

“Imagine Ethereum is a spaceship that isn't quite ready for an interstellar voyage. With the Beacon Chain, the community has built a new engine and a hardened hull. After significant testing, it's almost time to hot-swap the new engine for the old mid-flight. This will merge the new, more efficient engine into the existing ship…”

Once the Merge happens, the mining of ETH will no longer be the way to create blocks and earn rewards. Instead, people who stake ETH will receive staking rewards. Since the merge is essentially replacing the engine of block production, no history will be lost. The Mainnet merging with the Beacon Chain will also merge the entire transactional history of Ethereum. It is still not clear when this will occur, but it is anticipated to happen in Q3 or Q4 of 2022.

How to Stake Ether?

Here are the methods to stake ether and earn staking rewards: Solo-staking, staking as a service (SaaS), pooled staking and exchange staking.

• Solo-staking requires depositing a minimum of 32 ether into an Ethereum deposit contract and becoming a validator on the beacon chain network. This process may be complicated for non-tech savvy people. It also requires at least 32 ether (~$50,000 in today’s value) to participate. You cannot solo-stake if you don’t have 32 ether.
  
• SaaS is another option available for individuals with at least 32 ETH. This could be a better alternative if you don’t feel comfortable dealing with the hardware and the technical aspects involved with Solo-staking. Under this method, a qualified operator/company will run the validator on your behalf and send you staking rewards after deducting fees. SaaS providers listed on ethereum.org include Abyss Finance, BloxStaking, Kiln, and Allnodes.
  
• Pooled staking is an option for individuals who don’t have 32 ETH available. Here, you are still relying on someone else to run the validator. But unlike SaaS you can participate with a smaller amount of ETH.      
  
• The last alternative is exchange staking. This method allows people to easily stake their ether through participating exchanges like Coinbase or Kraken. This method works with any amount of ETH.

One downside of exchange staking is that you will have to share a significant portion of your staking rewards with the exchange for making the staking process easier. For example, Kraken charges a 15% administrative fee on all staking rewards received.

What are the Tax Implications of the Ethereum Merge?

ETH 2.0 Tax Classification

Although there is limited ETH2 tax guidance, overall, the Merge looks akin to a soft fork described in the IRS FAQ 30.

“A soft fork occurs when a distributed ledger undergoes a protocol change that does not result in a diversion of the ledger and thus does not result in the creation of a new cryptocurrency.  Because soft forks do not result in you receiving new cryptocurrency, you will be in the same position you were in prior to the soft fork, meaning that the soft fork will not result in any income to you”

In addition, the IRS further confirmed in IRS CCA 202316008 on March 27, 2023, that a protocol upgrade does not result in a taxable disposition or income.

The Merge will not result in two Ethereum chains. The existing Ethereum chain will be merged with the Beacon chain; no history will be lost. After the merge, you will still hold the same ETH coins (but PoS enabled) that you held prior to the Merge. After the Merge, you will be in the same economic position as before resulting in no taxable income. Therefore, the Merge itself is a Soft fork and will not result in any income that you have to pay taxes on. (Note: you don’t have to do anything to go through the Merge)

For example, Sam holds 1 ETH. He does not participate in staking prior to the Merge. The Merge goes through and Sam’s 1 ETH gets upgraded automatically to PoS-enabled ETH. In this situation, Sam will not have any income to report.

Locking in ETH

You can earn staking rewards even prior to the Merge. This requires locking in your PoW-based ether (ETH) until the Merge. Exchanges use different labels to represent these staked ether. For example, “ETH2” and “ETH2.S” represent staked ether on Coinbase and Kraken, respectively.

Converting ETH to “ETH2” or “ET2.S (in other words locking assets in)” is likely not a taxable event because a disposition event has not occurred. “ETH2” & “ETH2.S” are just labels used to represent the same original ether with PoS support; They are not different coins.

For example, let’s say Sarah purchased 1 ETH for $100 (cost basis) a few years ago. In 2021, Sarah stakes her ETH and converts it into ETH2 on Coinbase to start earning staking rewards. At the time of conversion, one ETH is worth $2,000. This transaction is not a taxable event. Sarah’s ETH2 takes on the original holding period and the cost basis ($100).

Once the upgrade to the Ethereum 2.0 network is complete, ETH2-labeled coins will cease to exist. They will be replaced with just “ETH” coins which will be fully powered by PoS. This is likely another non-taxable event under the Soft fork tax rules explained earlier.

How Do I Earn Ethereum Staking Rewards?

Earning Illiquid ETH2 rewards

The IRS has not issued any staking specific tax guidance about ETH or ETH2. Therefore, the conservative approach is to recognize income at the time you receive staking rewards.

Following the above principle, earning ETH2 as staking rewards is a taxable event. That said, taxpayers don’t have to report income until they can exercise dominion and control over their ETH2 rewards. This occurs when the user has the ability to move/trade ETH2.

Let’s use an example to illustrate this. In 2021, Sarah earned 6.0% interest on ETH2 and received 0.1 ETH2 as a staking reward. At the time she received the reward, 0.1 ETH2 was valued at $100. Although she sees this 0.1 ETH2 in her exchange wallet, she can neither move nor sell it. In this case, Sarah doesn’t have any taxable income to report because she doesn’t have dominion and control over the 0.1 ETH2 yet.

In fact, this is the situation if you stake ether on many exchanges including Coinbase today.

"Rewards will be reflected in your account, but will not be actually credited until the end of the lockup period. Unless otherwise stated, you will not be able to trade, transfer, or otherwise access your ETH staking rewards during the lockup period" (Coinbase User Agreement)

Say, in 2022, the exchange gives Sarah access to her 0.1 ETH2. At this time, 0.1 ETH2 is valued at $500. At this point, Sarah has dominion and control so she should report $500 of ordinary income on her tax return.

Liquid staking & taxes

Generally speaking, stakers will not have access to the original ether deposited nor staking rewards earned until transaction support is enabled on the Ethereum 2.0 network (unknown future date). Until this point, both original ether locked in the deposit contract and the earned ETH2 staking rewards are illiquid. Liquid staking overcomes this interim liquidity issue by offering liquidity to both staked ether and ETH2 rewards earned.

Let's say Sarah decides to pursue Liquid staking with a service like Lido instead of solo-staking or exchange staking. Sarah sends 1 ETH ($100 cost basis; $1,000 fair market value) to Lido and receives 1 stETH coin. stETH represents the value of the initial staking deposit. Her stETH balance also goes up when she earns staking rewards.

The taxability of converting ETH to stETH is not straightforward. We believe it’s a taxable event based on the following analysis.

Cryptocurrencies are treated as “property” per IRS Notice 2014-21. Consequently, a taxable event occurs each time you dispose of a coin. Disposition events include selling your coin for cash and also exchanging one coin with another one.

To have a disposition event, both of the following criteria must be met (Reg §1.1001-1):

• There must be an exchange (Exchange requirement) and,
• Property received must differ materially from the property given up (Material difference requirement)

Exchange requirement

The exchange requirement is generally met when the “tax ownership” of a property has been transferred to a new tax owner. There is no direct definition for what constitutes tax ownership. That said, according to tax literature, the party with the “benefits and burdens” of a particular piece of property is considered to be the tax owner of that property.

When you convert ETH to stETH, it is reasonable to think that you have transferred the tax ownership of your ETH to Lido triggering the Exchange requirement.

Material difference requirement

Again, there’s no clearcut way to determine if this requirement is met. Questions you can ask to see if this requirement is met are

• Is the property received is substantially different from the property forgone?
• Has the taxpayer's economic position changed meaningfully after the exchange?

stETH seems materially different from the ETH you had. It allows you to earn liquid staking rewards as opposed to regular ETH.  Lastly, stETH price is not perfectly pegged to ETH which further supports the fact that they are materially different assets.

Therefore, converting ETH into stETH (and stEH into ETH) is most likely a taxable event because it is a disposition event that arguably meets both exchange and material different requirements.

Earning stETH staking rewards are taxable at the time of receipt. This is because stETH staking rewards are liquid (unlike ETH2 rewards locked in exchanges) gives you immediate dominion and control over the asset.  

For example, Sarah swaps her 1 ETH (cost basis $1,000, FMV $1,500) with 1 stETH worth $1,400. In 2022, Sarah also earned 0.5 stETH staking rewards. At the time of receipt. 0.5 stETH was worth $500.

Here, Sarah will incur a $400 ($1,400 - $1,000) of capital gain. She will also have to report $500 as ordinary income.

What if Ethereum 2.0 fails?

The transition to Ethereum 2.0 is expected to evolve over multiple phases and may take several years to complete, or may never be completed. Stakers have little to no control over the actual execution of the process. Therefore, if crypto users lose their deposited ether, they may be able to write it off as an abandonment loss on their taxes.

If you have any questions or comments about crypto taxes let us know on Twitter @CoinTracker.

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Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.