Liquid Staking Taxes

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This is the first in our series on digital asset taxes. We are hoping to shed more light on this topic and push the industry forward. What better way to start than to address one of the biggest gorillas in the room? Staking income.

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What is Liquid Staking?

Liquid staking platforms such as Lido help you earn ETH staking rewards by running validator nodes on your behalf. You get a tokenized version of your staked ETH, stETH tokens in this case, which you can then use in other DeFi protocols. 

Following “The Merge” upgrade to the Ethereum blockchain in Sept 2023, liquid staking of ETH has grown tremendously with Lido staked ETH touching $35BN as of the time of writing. Needless to say, it’s been a popular way to make money on your ETH assets without having to run a validator node and deal with all the technical hassles. It seems you can have your cake and eat it too.

But there's a catch. Liquid staking also creates some tricky tax issues that you should be aware of. Depending on how you look at the transactions involved in liquid staking, you may have different tax obligations and reporting requirements.

The Tale of Two Taxes

So you’ve staked your ETH, now what? There are two main ways to look at liquid staking for tax purposes:

As a Swap: The first way is to treat every swap between two tokens as a trade and a taxable event. This means that when you convert your ETH to stETH, or when you wrap stETH into wstETH, you are realizing a capital gain or loss based on the difference between the fair market value of the tokens at the time of the swap. This is how most crypto tax software treats the exchange of tokens, no matter what the reason or intention behind the transaction. You sent one token, you got another token? Boom! It’s a trade.

As a Receipt: The second way is to consider the intention of the transaction. This means that when you convert your ETH to stETH, you are not trading your ETH for a new token, but rather hiring Lido to stake your ETH on your behalf. In this case, stETH is not a new token, but just a receipt to show the agreement. Similarly, when you convert your stETH to wstETH, you are not trading your stETH for a different token, but just changing the format of the same asset from a rebasing token to a non-rebasing token. This is like having a gold coin certified and put into a hard plastic container with a certificate. It does not change who owns or values the coin.

The Tax Implications

The difference between these two ways of looking at liquid staking can have huge implications for your tax bill. For example, if you bought 10 ETH at $1000 each and converted them to 10 stETH when ETH was worth $2000 each, you would have a $10,000 capital gain if you follow the “swap” interpretation, but no taxable event if you follow the “receipt” interpretation. Likewise, if you then converted your 10 stETH to 10 wstETH when ETH was worth $3000 each, you would have a $10,000 capital gain if it were viewed as a “swap”, but no taxable event if viewed as a “receipt”.

The problem is that there is no clear guidance from the IRS on how to treat liquid staking transactions. The IRS has only issued general principles on how to report crypto income and gains, but has not addressed specific situations such as these. The devil is in the details as even established players have gotten it wrong. Kraken settled a suit with the SEC with regards to offering staking services, whereas Coinbase is currently fighting the SEC over their own version of the product. Therefore, it is up to you to decide which way to look at liquid staking and how to document your transactions accordingly.

This is why it is important to have a reliable and flexible crypto tax software that can transactions flexibly. PennyWorks can report your activity under either interpretation of the tax rules. You can also generate accurate accounting journals that reflect your chosen way of looking at liquid staking.

Tax on the Staking Income

If you look at the stETH and wstETH smart contracts, they are like 2 sides of the same coin. wstETH relies on stETH for a lot of its computation, and you can seamlessly convert between either format. Abstractly they are functionally the same thing, a container that keeps track of your staked ETH and staking reward.

But as for the income itself there’s two dramatically different paths to follow. stETH is a rebasing token which means you get more units of it over time to reflect the staking income, kinda like an in-kind dividend in traditional finance. wstETH on the other hand is not rebasing, the value of each token slowly increases over time to reflect the staking income, similar to a stock buyback reducing outstanding shares, thereby increasing value that accrues to each share.

Conclusion

So while keeping track of coins on a ledger is easy, accounting for them is anything but. With interest growing every day due to the possibility of an ETH ETF on the horizon, it is only natural to wonder if and when a native-yield bearing digital asset will come to market. Hopefully we’ll have everything sorted out by then. Certainly liquid staking will be a huge part of that conversation as it already involves billions of dollars worth of assets and rewards. It is also a complicated and evolving issue that requires careful attention and analysis. If you are involved in liquid staking or plan to do so in the future, make sure you understand the tax implications and use a trusted crypto bookkeeper service like PennyWorks to help you with your tax reporting.