When it comes to the taxes that the Internal Revenue Service (IRS) collects, they are largely divided into two categories: income and investments. Income comes from employment or self employment. In addition, the IRS also classifies royalties, dividends, and interest as income—and not investments. Income taxes range from 10 – 37% and increase as one’s income increases. Investments that are profitably sold are subject to either short- or long-term capital gains taxes. Long-term capital gains tax rates range from 0 – 20% (again based on your income) while the short-term capital gains tax rates mirror those for regular income. Any monetarily significant asset is classified as a capital asset, including: real estate, artwork, stocks, and yes—cryptocurrency.

If you receive crypto as a salary, it is taxed as income (but any price appreciation when converted to USD would be taxed as capital gains). If you bought cryptocurrency and later sold it for USD, traded it for another crypto, or used it to make a purchase — it would be taxed as a capital asset. Beyond these two scenarios, there are a number of other ways that one could receive crypto. For many, how the IRS taxes them is somewhat confusing and obtuse–partly thanks to the lack of clarity over the years from the IRS itself. Let’s dive into how airdrops, hard forks, and various other blockchain-based processes are classified for tax purposes.

What Is Classified As Crypto Earned Income?

A good starting guideline is that anything other than directly investing in crypto is classified as taxable income—and not investment income. While receiving a salary in crypto is obviously income, so are a bunch of other crypto and blockchain processes. Let’s get started!

Crypto Airdrops and Hard Forks

Sometimes you have to put in some work or meet some specific requirement to receive an airdrop—and sometimes you don’t. You may receive an airdrop for merely downloading a wallet or using a specific decentralized finance (DeFi) protocol. Regardless of the specific circumstances, airdrops are similar to winning a giveaway or lottery. 

Hard forks result when a blockchain protocol is split into two separate networks and is treated in the same way; examples include the Bitcoin fork that created Bitcoin Cash and the Ethereum fork that created Ethereum Classic. Airdrops and hard forks are both taxed as crypto earned income. The tax is calculated based on the fair market value (FMV) when the airdrop was received. For all of the following scenarios, the FMV will be calculated in this way as well.

Crypto Mining

Some earn crypto by mining it on Proof-of-Work (PoW) blockchains. This acquired crypto is considered regular income. For those mining crypto as a hobby, you can list mining expenses like hardware and electricity costs as itemized deductions. Crypto income is filed as “Additional Income and Adjustments to Income” on Form 1040. For professional miners, both expenses and income are reported on a Schedule C or on business-specific Forms 1065, 1120, or 1120S.

NFTs and Play-to-Earn (P2E) Gaming

Those who invest in non-fungible tokens (NFTs) would have any profitable sales treated the same way as profitable sales of bitcoin (BTC), ether (ETH), or any other cryptocurrency. Creating NFTs themselves through minting is taxable if the minting involves a gas fee or has a mint cost associated, as this would be considered a crypto-to-NFT trade. Those who release NFTs professionally and sell them would be subject to earned income taxes and should also report business expenses. Any secondary sales royalties would also be subject to taxes. How play-to-earn (P2E) gaming rewards are taxed can vary based on how rewards are acquired as well as the specific gameplay mechanics of a specific title. The earning of in-game crypto assets—tokens or NFTs — would likely be considered income in most instances.

DeFi Lending, Borrowing, and Wrapping

Using DeFi protocols as a banking alternative, you can both lend and borrow money. If you’ve earned interest by depositing crypto collateral and participating in a crypto lending operation, this interest is taxable and considered income. While any accrued interest is taxable, the crypto you used to put up as collateral is generally not taxable. However, if you deposited ETH as collateral and received a different coin when you withdrew your collateral, that would be a taxable event as this would fall under the category of a crypto-to-crypto trade.

If you put up collateral to receive a loan (such as depositing ETH to receive stablecoins), that is typically not a taxable event—provided the collateral you deposit is the same collateral you receive upon loan repayment (in this case ETH). Certain DeFi protocols have self-repaying crypto loans that use the yield your collateral earns to repay the loan over time. For this type of loan framework, it would create an income event as this would likely be considered debt cancellation income.

The wrapping of a coin or token is still a somewhat ambiguous action as the tax guidance is currently laid out. For example, you can take ETH and wrap it so it can be used in certain DeFi protocols. Called wrapped ETH (wETH), it is essentially the same thing but allows for more functionality with Ethereum’s ecosystem. Some crypto tax software automatically classifies these processes as taxable events; other tax professionals interpret the wrapping of crypto as a non-taxable event. In the absence of clear-cut guidance from the IRS, the more conservative approach would be to label wrapping and unwrapping transactions as taxable events.

CryptoTaxCalculator allows you to choose the tax treatment for wrapping as either taxable or non-taxable, right down to the individual transaction.

Staking

How staking rewards should be treated is also somewhat ambiguous. While the IRS issued guidance on mining, it has yet to issue definite guidance on staking. Some view staking rewards as taxable income in the same way mining rewards are. Others argue that staking is creating new property and these coins should not be taxed when received—but rather when they are sold or traded. The rationale is that this is newly created property. For example, a woodworker wouldn’t be taxed upon finishing a bookshelf or a baker taxed after baking some cookies; they are only taxed when these items are sold.

At the time of writing, Jarrett v. USA is working its way through the courts via the appeal process. The plaintiffs argue that staking isn’t income. If they get a favorable ruling, it would set a precedent that would see staking rewards viewed as property. If the ruling goes the other way, it would see staking rewards treated as income. Until regulatory clarity is established, many tax advisors recommend treating staking rewards as income upon receipt and as capital gains when sold for a profit. CryptoTaxCalculator can automatically detect staking rewards, and gives users the option to treat them as income or non-taxable capital acquisitions depending on which treatment you decide is right for you.

Crypto Income Can Also Incur Capital Gains Taxes

The list above includes an assortment of processes and actions that are considered crypto earned income, but keep in mind you could be required to pay capital gains taxes in addition to income taxes. This would happen if your crypto appreciated between the time you received it and the time you sold it. It doesn’t matter if it was a crypto salary, airdrop, or mining rewards—any price appreciation would be taxed as capital gains based on the price differential. If the price depreciated prior to sale, you wouldn’t owe capital gains—but you would be able to harvest capital losses to lower your tax bill.

The only likely way that you wouldn’t incur capital gains in these situations is if you were to immediately sell the crypto as soon as you received it so there wouldn’t be time for the asset’s price to move (or you received stablecoins that don’t fluctuate in value in comparison to USD). So while the IRS expects you to classify the above processes as income, you’ll still need to pay capital gains taxes on the delta (the difference) between the received price valuation and the sale price for profitable trades.

The reality for many crypto investors is that they may have hundred or even thousands of crypto transactions that could fall into multiple of these categories. Couple this with multiple wallets across different blockchains, different exchange accounts and murky blockchain data, the situation quickly turns into a full blown tax nightmare. Using reputable tax software that can handle complex on-chain transactions across DeFi and NFT protocols, such as CryptoTaxCalculator, can make the whole process a lot smoother and help you sleep soundly at night. You can use DECRYPT20 for 20% off all plans with CryptoTaxCalculator.

Cheat Sheet:

• If you earned crypto from a job, crypto mining, lending, airdrop, hard fork, or any other non-investing activity, the IRS likely considers these crypto earnings to be regular taxable income.
• Crypto income will also be subject to capital gains taxes if it appreciates in value between date of receipt and the date of disposal (sale, trade, or purchase).
• There is some regulatory uncertainty for taxes related to wrapping/unwrapping tokens, staking rewards, and other nascent processes. The conservative approach would be to label (un)wrapping events as taxable events and staking rewards as earned income.

Disclaimer: This crypto tax series is merely for informational purposes and should not be considered legal or tax advice. Please solicit the services of a crypto knowledgeable certified public accountant, tax professional, or lawyer should you need further guidance.