Staking, what you need to know

Introduction

So staking has been all the hype for a while now in the crypto space and for good reason. It can be a great way to accumulate some of your favorite crypto currencies and tokens or even provide a form of passive income, which is great. But have you ever looked into a long term plan or strategy around the idea of staking? Do you understands the tax obligations that comes with it? What if the token your staking keeps dropping in value? What if the token goes up? How long do you plan on staking for? Do you know the difference between staking as a validator or “staking” as a lender?

In this article I’m going to break down these questions to give you a little more insight on things you may have over looked, then give you a few different scenarios and what your tax obligations may look like, granted this is more suited to Australia tax law but it will be very similar and relatable to other country tax laws as well.

Staking

First off, lets explain the difference between validating and lending, as the word “staking” seems to have been thrown around very loosely in the crypto space. Traditionally there was a few different ways to validate transactions on blockchain networks, Proof of work (PoW) and Proof of stake (PoS). Proof of work blockchains like Bitcoin and Litecoin require validators of the block chain to solve complex computer algorithms known as mining. This requires a tremendous amount of computing power, time, and energy consumption to confirm transactions, in return the validators who keep the blockchain secure are rewarded with tokens or coins for their effort. Proof of stake blockchains brought in a whole different way to validate the transactions by requiring nodes or users to lock up a specific amount of coins into there wallets and become the validators to process transactions, in return these validators would be rewarded with coins or tokens for keeping the network running.

Banking

Not all coins are PoS, in fact what most people refer to when they say “they are staking” is not staking at all, well at least not in the traditional sense of Proof of Stake. What they are actually doing is lending there coins to a CeFi platform like Celsius, Crypto.com, Binance or BlockFi who then take your coins and lend them out to third parties much like a traditional bank would with your money, Oh you didnt know that? Thats right, that money you see in your bank account isnt really there, in fact in traditional banking this is what we call M2 and the banks are only required to keep a small % of your balance available at all times, the rest of your money can actually be lent out. The banks make money from lending your money out to private and corporate sectors who then pay the banks back with interest and this is how the banks are able to offer you a few % for leaving your money in their bank.

This is the exact same way a lot of the CeFi platforms we know and use like Celsius and BlockFI operate, they are the modern day crypto banks who lend out your coins on a secondary market to people taking out loans or even to other exchanges to provide liquidity as market makers or market aggregators. They then make money on there interest paid on loans or from fees and spreads on other exchanges, then give you “the lender” a piece of the pie in the form of interest…..just like your traditional bank. If you read the terms and conditions on a lot of these platforms, you will find similar wording in there where they mention that they may only be required to retain a small % liquidity of your assets at any given time. Their systems are built on a bunch of levers to ensure there is enough money/crypto staying in lending compared to the payouts or withdrawals, to avoid a “bank run” where everyone wants to withdrawal there money at once. If that where to happen and everyone’s funds where actually lent out in the 2nd layer this could become a concern. It is also worth doing a little research into which ones you really want to trust with your money/crypto, so having a good read of the terms and conditions and looking for details on there insurance funds, might be a good idea.

Now dont get confused here this isnt a doom and gloom screw the crypto banks situation, in fact quite the opposite this is an amazing leap forward in the finance world as these companies and projects have now put a lot more power and opportunity back into the hands of us plebs with the ability to earn substantial more interest than any old bank would have given us. Some platforms give us the options to remain liquid in flexi plans or lock up periods much like a traditional term deposit that may offer a much higher interest rate. I personally use Crypto.com for earning interest on crypto currencies and stable coins but there are others around. Each have there own pros and cons and I wouldn’t say any is better than the other. I think its a good idea to spread risk by using multiple products rather than leaving all funds in one place…this is crypto after all and shit happens so its important to manage your risk.

Ok, so now you get there is a difference here when it comes to staking and lending but your probably asking why does it matter? well thats a good question and this brings us to the next subject which is tax obligations.

Tax Obligation

So lets start off with the lending side, which is similar to keeping money in your bank account, the coins you earn are considered interest which in the eyes of the ATO is considered income. Just like how you have to declare interest from your bank account at the end of the financial year, you also have to declare the interest earned on your coins from these lending platforms.

But here is the kicker that most people dont consider……… the amount or dollar value you have to declare for tax purposes is the AUD value of the coins when you received them. I’m going to show you a few scenarios shortly, of how this can really cause some issues for people who arnt aware. Now when it comes to PoS or earning rewards as a validator, things can get a little interesting. If you are a little savvy when it comes to Business and finance and have a good accountant, you can actually run a node as a business and this “interest” you earn from staking is actually considered revenue. It also means you can claim a portion of operating costs as business expenses, as these are all part of the costs of doing business as a crypto currency validator. Things like your electricity, computers, internet, accounting costs even the original capital used to set up the node. Basically anything you have to pay for that enables you to conduct business and earn revenue as a validator of a blockchain is essentially a tax deduction. This can have a beneficial impact on your overall PNL at the end of the financial year, as you may be taxed at a lower rate through the business structure and the deductions could really help your tax obligations. Please speak to your tax professional to get advice and confirmation on the best avenue for you as everyone’s personal circumstances will be different.

Example 1

Now lets look at some examples of how things can go bad in the case of lending when considering tax obligations and an asset that underperforms the market. I’m just going to make a coin up in this example and call it X coin and lets say the current value per coin is $100 and every month you earn 10 new coins as interest. Basically every month thats another $1000 you need to add onto your taxable income. So at the end of the financial year you now have to add a further $12,000 to your taxable income. Lets say your current income is around $45,000 for the year, your currently paying 19 cents in tax for every dollar over $18,200, which is roughly $5,092 per year (minus deductions). If you add $12,000 to this total, that puts you into the next tax bracket and that additional $12,000 is actually taxed at 32.5 cents which is another $3,900 on your end of year tax bill, leaving your overall PNL at roughly $8,100 from your original $12,000 earned.

You now have the option to sell 39 of your X coins in order to cover your tax bill leaving you with 81 coins (Or you can pay it another way and keep your coins) Now this is all on the assumption that the price of the coin stays still….. but this is crypto and we know that doesnt happen. What happens if in the last month the price of X coin drops to only $50 per coin…..now all the sudden you will need to sell 78 of your X coins in order to cover the tax bill, which leaves you with only 42 coins valued at 50 dollars each which leaves you with a total profit of $2,100. You can see all the sudden that $12,000 worth of coins you earned isnt all that attractive any more after this mess, now there is a little hail Mary here so read on. By selling 78 of your coins at $50 you actually incurred a capital loss, because when you received the coins they had a base value of $100 each. Selling 78 at $50 has essentially incurred a $3,900 capital loss which can be used to offset the tax obligations on a capital gain from something else. Its worth noting, you cant use this capital loss against the interest you earned, as the interest earned is considered income tax not capital gains tax, these are taxed differently, so you will still have to pay that same income tax bill. However if you made a nice $10,000 capital gain on something else that you sold, you could use that $3,900 capital loss against that capital gain which means you would only need to declare a capital gain of $6,100. If that gain was not subject to any CGT discounts then this also gets added to your taxable income, which will come with a further $1,982 onto your tax bill, based on the 32.5 cents to the dollar bracket. If you had to declare the entire 10k as a gain, then it would have been a tax bill of $3,250, so you essentially saved $1,268 in tax by taking a capital loss of $3,900 on your X coin sale. Your still at a net loss of $2,632 + your $3,900 tax bill from your interest earned from staking, which is a total cost of $6,532 from your original $12,000 you thought you made from “staking”.

Example 2

Ok so lets go through another scenario, This is crypto after all, so lets say instead of the price staying at $100 a coin the whole time it actually sky rocketed to $500 a coin right after you decided to start “staking” it. Every time you get a reward your base cost per coin is $500. If you earn 100 coins over the 12 months at $500 a coin you have essentially earnt another $50,000 of income that year that needs to be declared at 32.5 cents to the dollar which is another $16,250 in tax. Thats only 32.5 of your coins and you have 100 of them so its no biggy…… but lets say in the last month leading up to tax time, we get some fud, or the price of bitcoin drops which brings the entire market down with it and the price of X coin dumps back to $100.

In order to cover your tax bill, you will need to sell 162.5 X coins at $100 each, the problem is you didnt even make that in rewards and are now forced to either sell some of your original capital or come up with money from some where else in order to cover your tax obligations. You might say things like “I dont want to sell them in a loss, ill just HODL” thats fine, its your decision, but you still need to come up with that $16,250 to pay your tax from some where so just keep that in mind.

Now there is another reason this can be super risky, the boom and bust cycles that crypto has experienced in past years, means that some of these coins can have an 80-90% drawn down from there ATH during a bear market. If you where receiving interest payments on these coins at the peak of the bull market, at say $500, and then 6 months later the coin is at a 90% loss at say $50, you are basically screwed and have to cover an expensive tax bill for something that’s more or less worthless right now. Even realising the capital loss wont help you, as it wont reduce the obligations of your income tax and wont even be enough to cover the entire bill.

Example 3

Lets look at it from a positive perspective and see what the tax obligations would be like in the best case scenario. Lets say the price stays still at around $100 a coin and towards the end of the year the price sky rockets to $500 a coin, you will still have the tax bill of $3,900 from the original example how ever your 100 coins are now worth $50,000 which makes paying this tax bill a piece of cake lol Just remember there is also capital gains tax on the rise of these coins from the base price that you received, so lets say you decide to sell all of the coins you earned and realise a profit of $38,000 then this gets added to your income and you will owe a further $12,350 in tax (Unless you can claim a CGT discounts) leaving you with roughly $25,650 in profit and that is the best case scenario when it comes to a lending style staking which is what most people do.

Summary

Now this is kind of a best and worst case scenario and the complete ends of the spectrum. In reality, the base price of the asset your staking will fluctuate all the time, making record keeping a very important part when it comes to the end of the financial year. It is very important that you consider the taxation of interest/income into your long term plan while staking your favorite crypto. Weather it be regularly realising profits, in order to make sure you can meet your tax obligations at the end of the financial year or keeping an eye on the market to ensure your not holding these coins during bear market conditions. Ideally the best time to be staking/lending a coin is whilst the price is trending up, this ensures that your tax obligation for rewards is lower than the current price of the token, you will also have capital appreciation from your original stake and any rewards gaining value over time. The worst time to stake is whilst a coin is trending down, this will basically mean your tax obligation from your rewards will be higher than what the coins are worth by the time you have to pay your tax, in other words you are signing up to a contract to lose money. This article is really just to highlight some important factors you may want to consider when going down the path of earning interest on your crypto. If you’re new to the investment world, then a lot of this will be unknown for you and may have cost you a lot of money come tax time if you didnt consider it.

I hope this article has cleared up some questions for you and helps you in your quest for financial gain, if you found value from this article feel free to share it with others, Peace.