Ethereum just completed its long awaited update. Code named Serenity, Ethereum 2.0 is a total overhaul of the world’s second largest blockchain. Along with significant speed and scalability improvements, the underlying transaction processing algorithm now operates in a completely different way. While all these upgrades certainly are exciting, the changes have some important tax implications. Keep reading to learn everything you need to know to get ready for tax time.
What is Ethereum?
Ethereum has some similarities to Bitcoin. Its native cryptocurrency Ether can be used as a store of value. As is the case with Bitcoin, all Ether transactions are stored on a publicly accessible, distributed blockchain. It’s the second largest cryptocurrency in the world in terms of market capitalization. One Ether is now worth about $1400 USD.
However, cryptocurrency is just one use case of Ethereum. Ethereum is sometimes called a “world computer” because it runs a programming language called Solidity. One of the most exciting things about Solidity is that it can be used to create smart contracts– cryptographically secure computer programs that trigger when certain verifiable conditions are met. Ethereum programmers have been using this feature to create all kinds of innovative dApps (distributed applications) since the blockchain debuted in 2015.
A short history of Ethereum
Ethereum was created by Canadian-Russian computer programmer Vitalik Buterin. Buterin took an interest in Bitcoin shortly after its release in 2009 and began to analyze it from a computer engineering perspective. He noticed that Bitcoin creator Satoshi Nakomoto had placed many restrictions on Bitcoin’s scripting system. Nakamoto felt that these limitations were necessary for security reasons, but Buterin disagreed.
Buterin’s blueprint for a blockchain that could do more than just function as a store of value quickly gained attention from investors, who poured a total of $18 million into the project. Ethereum went live in 2015, and the rest is history. After Bitcoin, Ethereum is the most popular cryptocurrency in the world. Its corporate sponsors include Microsoft, Cornell University, JP Morgan Bank and many others.
A new way of incentivizing transaction processors
Like all cryptocurrencies, Ethereum uses financial incentives to motivate people to help run its distributed network. Ethereum’s transaction processors, called nodes, are the backbone of the system. They compete for the opportunity to write a new block into the blockchain. Whichever node wins the race receives a financial reward.
In the original version of Ethereum, computing power was used to determine the winner of the competition to insert the next block. The rules of this competition are dramatically different in Ethereum 2.0. Computing power is no longer a factor. Instead, the size and age of one’s stake now determines the likelihood of receiving a reward. The more Ethereum the transaction processors buy and the longer they hold onto their positions, the better their odds of winning become.
Ethereum 2.0 tax implications
Eth2 is so radically different from Eth1 that it’s almost like an entirely new cryptocurrency. Fortunately, all the heavy lifting involved in the upgrade is happening behind the scenes. If you own Ether, you don’t have to complete any manual steps on your side. In other words, your Ethereum 1.0 Ether will automatically become Ethereum 2.0 Ether and your cost basis will carry over without resetting.
However, if you decide to become an Ethereum staker, then you will have to pay taxes on any staking rewards that you receive. The main unanswered question about this is: when will that taxation occur?
The most conservative approach would be to add your staking rewards to your annual ordinary income as soon as your ETH rewards land in your wallet. This method seems to make the most sense, since this is how the IRS has specified that airdrops should be treated according to Rev. Rul. 2019-24. A more aggressive tactic would be to wait until you sell your rewards to record your staking income. Crops, mined minerals and other similar assets are treated this way.