Whether you’re a fan of digital assets or not, I’m sure you’ve noticed something about them: they don’t generate any income.
The only way you make money is if they rise in value. Well, that stinks. After all, a big benefit of owning stocks is that you get growth and dividends. In fact, as I’m sure you know, about half of the profits earned by the stock market over the past 100 years came from dividends, not growth. And that’s not just true for the stock market; it’s also true for real estate, which offers both growth and rental income.
Investment income is a lot more certain than investment growth. Your stock might fall in value, but you can probably still count it paying its dividend. And your rental property might fall in value, but you can probably still count on collecting the rent.
But crypto pays no income. So, wouldn’t it be cool if it did?
Well, you can earn income by owning digital assets. You can do this through something called staking.
From a technology standpoint, staking is an important part of how many blockchains work. We covered this in my book, The Truth About Crypto, which you’re reading (since doing so is the only way you know about this secret web page!), but that’s a big book with lots of content, so it might be helpful to provide you with a quick refresher here.
So here’s a bit of background. There are two primary types of blockchains: Proof of Work and Proof of Stake. These protocols are the mechanisms that let data get added to a blockchain.
Proof-of-Work is the original method for making blockchains work; it’s the process used by the bitcoin blockchain. Here’s how Proof of Work, uh, works. To add data to the blockchain, your data must first be verified. That authentication process is done by people we call miners. They use their computers to solve a complex mathematical puzzle, and by doing so, they prove that your data is valid. It takes a lot of work to solve those puzzles – and that’s why this protocol is called Proof of Work.
This process keeps the network secure. But why would anyone bother being a miner? It’s simple: if you, as a miner, complete that mathematical puzzle, you get paid. Your payment is in the form of bitcoin, and the bitcoin you earn is called a block reward. It takes about 10 minutes to solve each puzzle, and the reward (until 2024) is 6.25 bitcoins. If the price of a single bitcoin is $40,000, miners earn about a quarter of a million dollars to solve just one puzzle! Pretty good incentive to be a miner, huh?
No wonder there are so many bitcoin mining farms all over the world! Millions of computers whirring 24/7 in an effort to win the next block reward. And every 10 minutes, there’s a new winner!
The Proof-of-Work protocol has worked really well throughout bitcoin’s existence. But, over time, many in the crypto community began to notice two problems. The first is scalability. As the Bitcoin blockchain has gotten bigger, it’s also gotten slower. Putting data onto it can now take as long as an hour. Imagine standing at the cash register at Starbucks and waiting 60 minutes to pay for your latte. Bitcoin was invented to be digital money, but if we can’t do transactions in milliseconds, there’s no way people will use it as money.
The second problem is that all those mining computers consume a lot of energy – more than is used every year by Thailand! This has raised many questions about bitcoin’s environmental impact.
Given between the slow speed and the energy cost, can blockchain technology survive?
Yes, for two reasons. First: that energy worry is overblown. That’s a whole other conversation, covered in The Truth About Crypto, so I won’t delve into that here. As for the speed problem, that slow pace is what makes bitcoin so safe. In its entire history, the bitcoin blockchain has never been hacked. No other warehouser of data can make that claim.
But, I won’t try to convince you here that you should use the Bitcoin blockchain and its Proof of Work protocol. Instead, I’ll just tell you that there’s another way that you can authenticate data on a blockchain: it’s called Proof-of-Stake.
And you thought we’d never get to staking.
With Proof-of-Stake, people pay network fees, sometimes called a gas fee, to put their data onto the blockchain. As with Proof of Work blockchains, you first have to get your data validated. That work is done by a validator node. There are thousands of nodes on a Proof of Stake blockchain, just like there are thousands of miners on a Proof of Work blockchain.
Now, with Proof of Work, we know that the first miner to solve the puzzle wins the block reward. With Proof of Stake, the validator node wins a staking reward, a.k.a. gas fee. But which validator node wins that staking reward? The answer: it’s completely random – just like winning a lottery or raffle. Indeed, every time new data has to get validated, the Proof of Stake blockchain randomly chooses a validator node, and the one selected earns the staking reward.
So, if you want to earn a staking reward, you must create a validator node. To do that, you post your digital assets onto the Proof of Stake blockchain, and it creates your validator node for you. The more coins you put up, the more nodes you get – and the more nodes you have, the more likely you’ll win the lottery and collect the staking reward.
Staking rewards have been as high as 20% – but because gas fees vary based on transaction traffic, there’s no guarantee how much you’ll earn from staking.
Two more points: First, staking rewards are not paid in dollars. Instead, they’re paid in a digital asset – typically, the same digital asset that you staked. In other words, if you stake Polkadot, you get more Polkadot. (In some cases, the blockchain you’re staking pays a different token than the coin you’re staking so, before you stake, make sure you know how your staking platform works.) Second, selling the coins and tokens you’ve earned from staking creates a tax implication, and we’ll get to that in a bit.
Proof of Stake doesn’t involve solving any math puzzles, and that means it can verify blocks of data much faster than Proof of Work blockchains. It doesn’t consume as much energy, either. This is why Proof of Stake is popular. Ethereum for example, is the second largest digital asset after bitcoin, started as a Proof of Work blockchain, but as I write this, it’s planning to switch to Proof of Stake in 2022.
Now, let’s go back to that notion of staking your digital assets. I’ll skip the details about how Validator Nodes get created, and just say the key point: You usually need to commit thousands of dollars, and sometimes hundreds of thousands of dollars, to create a validator node. Yikes.
So, there’s an alternative approach: simply join a staking pool. Think of them as kinda like mutual funds: you pool your digital assets with a bunch of other people, so the pool has enough to meet the minimum required to be a validator node.
Staking pools charge commissions, usually 5-10% of the gas fees earned, but some charge much more, so find out before you join a pool. Some blockchain networks vet these pools, but some don’t. So go to the official websites of Proof of Stake blockchains, where you’ll usually fund vetted pool operators listed.
Joining a pool can be cumbersome. You usually need to set up a specific hot wallet, transfer assets into it, then use the staking pool’s interface to commit your assets to the pool. What a hassle.
So, try this instead: do your staking on an exchange. Coinbase, Kraken and other digital assets exchanges let you stake if you have an account with them. In some cases, the exchange itself is the validator, and it has created its own pool. In other cases, the exchange chooses an outside validator for you. The yield you can expect to earn is typically listed on the exchange’s website.
Exchanges make staking easy. But there are a couple of things to keep in mind. First, you’ll earn a lower yield if you stake via an exchange, because they charge higher commissions than other staking pools – as much as 25%. They get away with these charges because they’re doing all the work, providing you with lots of convenience, and confidence. Also, when you have assets on an exchange, they keep the private keys, not you, so make sure you’re using a reputable exchange.
What assets can you stake? You can’t stake with bitcoin – that’s a Proof of Work blockchain, not Proof of Stake. So, you must use a coin that’s on a Proof-of-Stake blockchain – and it has to be available on U.S. exchanges. As of this writing, coins with the largest market values that you can stake are Algorand, Cardano, Polkadot, Solana, and Terra. And as I mentioned, Ethereum is supposed to be moving to Proof of Stake in 2022.
Which coin should you stake? Well, there are two main considerations. First, obviously, you can’t stake a coin that you don’t own. So, if you want to stake a coin, you must first buy it. Duh.
But don’t buy a coin just so you can stake it. Buy coins that you think will rise in price. If you lose money on the coin, the fact that you earned income from staking will be small consolation.
Second, many staking pools are based on the number of coins you stake, not the amount of money you invest. So, coins with lower prices let you get more coins per dollar, increasing your chance for bigger staking rewards. But if the price is low, does that mean there aren’t many people interested in buying the coin? And does that mean the price might not rise much – or might even collapse when the lack of engagement causes the coin to fail? You’ve must consider all this. And remember: there’s no FDIC or SIPC to protect you.
There’s more to think about, too. When you stake, you are posting your digital assets to the system as collateral. Depending on where you’re staking, you might be able to withdraw what you’re staking any time you want. In other cases, though, you must leave your assets for a specific length of time. (In exchange, you’ll get a bigger staking reward.) So, don’t stake unless you plan to hold your coins for at least as long as the lockup period – because during the lockup, you can’t get your coins back, and you can’t sell them. Redeem your coins can take days or even weeks – and you might even incur a fee.
I mentioned earlier that there’s no guarantee about how much you’ll earn from staking. With the Bitcoin blockchain, you’re guaranteed to get 6.25 coins when you win a block reward. But there’s no such guarantee with staking. So, make sure you’re being realistic about how much you’ll earn from staking. The staking rewards are based on the number of blocks you validate. If you join a pool that has a lot of coins in it, you’ll get more income than you’d get from a pool that has relatively fewer coins. But don’t assume you’ll do well merely because you’ve joined a large pool. If people redeem their coins from your pool, it will shrink – and that means your returns will shrink. And if you’re in the middle of a lockup period, there’s nothing you can do about it.
That’s just one risk of staking. Let’s look at two other risks.
The first is Validator Risk. The validator could be penalized if it goes offline, or if it tries to verify bad information. The penalty could be a forfeit of the entire stake – meaning you lose your coins! So, make sure you choose your validator carefully – going through an exchange can help because they do due diligence for you.
Another risk is what I call Horse and Cart Risk. Don’t merely buy the coin that’s paying the most to stakers, because you could end up with a worthless coin. That’s putting the cart before the horse. Remember: the primary reason you’re buying a digital asset is because you think it will rise in price – not because you think you can get income from staking.
You can reduce these risks the same way you reduce your risks when investing in the stock market – by diversifying. Stake several coins, not just one, and stake each on a different exchange.
And it can pay to shop around – just like you would shop around for the best bank CD rate. The other day I saw that one exchange was paying 4.5% as a staking reward, while different exchange was paying 6.5% for the same coin.
Now, let’s talk about taxes. As I write this, the IRS has not provided much clarity about how staking rewards are taxed. But we do know that staking rewards are not same as earning interest. Instead, they’re compensation for helping to grow and secure the blockchain network.
For this reason, some people argue that staking rewards are newly created property that shouldn’t be taxed right away. After all, farmers aren’t taxed when they grow crops; they pay taxes when they sell those crops. An artist isn’t taxed when they create a painting; they pay taxes only when they sell a painting. By this theory, you shouldn’t owe pay taxes on your staking rewards until you sell the tokens you earn.
At least four members of Congress think this way. In 2021, they said so in a letter to the IRS Commissioner. The IRS hasn’t published an official response yet – maybe because it’s in middle of a lawsuit over this.
Yep. In 2019, a married couple paid taxes on income they got from staking that year. They then decided that they shouldn’t have had to pay taxes on their staking rewards because they hadn’t sold the coins they got from staking. So, they asked the IRS for a refund – and they got one, in 2021. This would seem to suggest that the IRS agrees with them. But the IRS didn’t explicitly say so. The world of tax compliance, the fact that the IRS sends someone a refund doesn’t mean that others can rely on this as official IRS policy – the IRS’ action does constitute precedent for the rest of us. So, the couple refused to accept their refund. Instead, they sued the IRS, demanding that the agency state that staking income is not taxable. A court ruling in their favor would be the legal precedent we all want – and the crypto community is watching this case closely. It’s set to be heard in March 2023, so stay tuned.
In the meantime, you can take the approach that those members of Congress are taking, and which that married couple is taking: staking is the creation of property, and therefore no taxes are due until you sell the property. If you take this approach, you must hope that the IRS agrees with you. Because if it doesn’t, you’ll owe penalties and interest.
Or, you could take a more cautious approach: treat your staking reward as Ordinary Income as of the date you receive it. Then, treat the coins and tokens you get from staking as a capital asset, priced as of the day after you receive it. When you sell those coins, any gain or loss would be a capital gain or loss.
And here’s another idea, which might help you pay less tax overall, depending on the rest of your tax return: Treat staking rewards the same way you treat rentable property. That means staking rewards would be regarded as rental income, using Schedule E. This could affect the rest of your return, resulting in less overall tax. I’m not sure the IRS would approve of this approach, but it’s worth a conversation with your tax advisor.
With the lack of clarity from the IRS, one thing is clear: keep good records. Staking rewards can produce new coins and tokens on a frequent basis, and that means a new cost basis for each set of coins and tokens you get. That could be a paperwork nightmare. You can make life easier for yourself by using a crypto tax tracker service. These firms are focused on digital assets, and they manage all the record-keeping and tax-reporting chores – and not just for staking, but for all your crypto trading, mining, and interest. Some services even prepopulate the IRS forms for you. You can find a list of tax trackers at the DACFP Yellow Pages at www.dacfp.com.
Now that you understand what you need to know about staking, we’re left with just one more question. Should you engage in staking?
Let’s face it, with low interest rates and high inflation, bank accounts are a money-losing idea. Bonds provide higher yields, but rising interest rates cause bond prices to fall – sometimes by double digits. And if credit ratings fall, bond prices fall even further. This is why financial advisors often recommend alternative income strategies, such as bond ladders, annuities, dividend-paying stocks, Master Limited Partnerships, Real Estate Investment Trusts, and more. And it can be wise to invest in many of these asset classes to get the benefits of diversification.
In that light, adding staking to your list of income-producing strategies might not be a bad idea.