The Ethereum Shanghai Upgrade: Tax Implications

José Beteta

Written by José Beteta, Reviewed by David Canedo, CPA

May 11, 2023

The Ethereum Shanghai upgrade has turned into an exciting and much-anticipated event in the Ethereum ecosystem. We dive into the details of the upgrade and explain the tax implications of the changes.

Last Updated: May 11, 2023

What is the Shanghai Upgrade?

The upcoming Shanghai upgrade to Ethereum, a fork scheduled to start at 22:27:35 UTC on April 12, 2023, is generating a lot of anticipation. Among the most exciting changes is that stakers and validators will be able to withdraw assets from the Beacon Chain when the fork takes effect.

What Else is Included in the Shanghai/Capella Upgrade?

The Shanghai upgrade will only affect the execution layer of Ethereum, which handles protocol rules and smart contracts. However, another set of upgrades will be applied in parallel to the Shanghai upgrade. These are called the Capella upgrades, which aim to improve the consensus layer, ensuring validators follow the execution layer's regulations. 

The Ethereum Improvement Proposals (EIP) that made the cut and will serve as the basis for the upcoming upgrades include EIP-4895, EIP-3651, EIP-3855, and EIP-3860. The implementation of the EIP-4895 will allow validators to withdraw staked ETH, with the goal of increasing liquidity for long-term holders and validators. 

The Warm Coinbase proposal (EIP-3651) focuses on reducing costs. The term “Coinbase" alludes to the brand of the program that developers employ to access fresh tokens on the network. Its objective is to make block building cheaper by cutting the gas fees for participants and eliminating the need for traders of using builders to pay for failed transactions. Then, the PUSH0 Instruction (EIP-3855) adds a new EVM instruction to optimize smart contracts by making them smaller and enhancing the code. Finally, the Limit and Meter Initcode (EIP-3860) expects to solve the out-of-gas exceptions on Ethereum by limiting the max size of the init code.

What Does the Shanghai Upgrade Mean for Validators and Investors?

As soon as the upgrade is completed, two types of investors will be able to withdraw funds: validators who invested ETH 32 or more, and regular investors who entrusted their funds to validators. Nevertheless, there are limitations in place with Shapella. Validators can only withdraw a certain amount of rewards each day. Glassnode's on-chain analysts have projected in their in-depth report that only 100k ETH (or $190M) of the total rewards will be withdrawn and sold, out of which roughly 70k ETH (or $133M) will become available for trading.

What are the Tax Implications of the Shanghai Upgrade?

The upcoming Shanghai upgrade presents a unique chance for those involved in staking and validating Ethereum nodes. However, it's important to plan carefully and take into account the potential tax consequences.

In general terms, rewards earned from staked ETH will be taxable as income at the Fair market value (FMV) on the day when the underlying rewards are withdrawn. In summary, any income derived from staking ETH (paid out in Ether or a liquid token like stETH) is subject to ordinary income tax based on the market value when received.  

On the other hand, selling these rewards or swapping ETH for other cryptocurrencies is subject to capital gains tax if you realize a gain or loss based on the market price of ETH at the specific disposal time.  

Finally, in case you converted your staked ETH into wrapped ETH, you have most likely triggered a taxable event. Even though the tax rules for wrapped coins are complex, the most conservative approach is that trading ETH for wrapped coins is taxable. As a result, any trade, sale, or conversion of ETH will be subject to capital gain tax.

It's important to keep track of all relevant records such as dates and amounts of transactions, as this information may be required for tax purposes in the future. Ultimately, it's best to consult a qualified tax professional if you have any questions regarding your specific situation.

Is Earning Staking Rewards Taxable in the US?

Earning staking rewards is taxable. The Internal Revenue Service (IRS) classifies staking rewards as income, making them subject to taxation. This is true whether you receive the rewards directly or indirectly, such as through a staking pool. Additionally, any gains realized when converting ETH into stETH or any other Ether wrapped asset will also likely be considered a taxable disposal.

Token wrapping is an act of conversion of tokens that hold the same value (like ETH and stETH). Trading wrapped tokens for other cryptocurrencies can be viewed as a disposal of assets, prompting the need to file a crypto-to-crypto trade report. Since it grants access to other protocols, wrapping a token often results in a benefit for the holder different from the advantage provided by the original asset. 

How Do You Report Staking Rewards in the US?

If you're staking ETH through a centralized platform like Coinbase, then your staking rewards will be reported to the IRS on Form 1099-MISC, which Coinbase issues annually. Coinbase considers all rewards earned from staking ETH and holding cbETH as taxable income. However, prior to 2023, Coinbase has not reported any income from ETH and cbETH staking as customers were not able to cash in or reap the benefits of their ETH rewards.. 

If you're staking your ETH on a decentralized platform like Lido, the staking rewards are considered taxable income as well. However, you decide when to report it for tax purposes. Some people file when the rewards are given, even if the ETH is still locked, while others wait until the ETH can be unlocked.

Why would you want to report income earned from staking while the funds were locked?

  1. If the value of your ETH increases after the Shanghai upgrade, it could result in increased taxable income when you dispose of it.
  2. Once you sell, convert, or dispose of your ETH, you realize either a capital gain or capital loss. If you have held the asset for more than one year, you can benefit from a lower tax rate. Reporting the income earlier could determine whether you have long-term or short-term gains when you sell.

How Can Accointing Facilitate Your ETH Staking?

The Accointing tax and portfolio tracking platform helps you accurately track all your holdings on the Ethereum network. You can let the tool trace your assets allocation 24/7, stay up to date with your portfolio movements, and generate a reliable tax report while dealing with DeFi/CeFi transactions involving Ethereum staking. 

The best way of handling your transactions when entering/exiting a staking pool is by classifying them as internal transactions. By doing so, the coins never leave your possession. This is important for tax reasons, and for preserving the value of your portfolio.

To use Accointing, simply connect all your wallets containing ETH staking transactions and the software will automatically keep track of your cost-basis and review the imported data. Rely on a trustworthy tool to help you decipher all transactions in your portfolio, and reduce your crypto taxes, using the crypto tax loss harvesting tool to offset your losses during a specific period.

Disclaimer: The information contained in this guide, including any supplemental materials, is for general information purposes and does not constitute financial, investment, legal or tax advice. The present content is not intended as a thorough, in-depth analysis, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties and does not represent investment advice.