How Does Earning With Cryptocurrency Work?

Cryptocurrency offers various avenues for individuals to generate returns beyond simple trading. These digital assets can participate in blockchain network operations or engage with decentralized financial applications. The Internal Revenue Service (IRS) generally treats virtual currency as property for federal income tax purposes. Earning new cryptocurrency is typically considered ordinary income, taxed at its fair market value when received. Subsequent sale or exchange of cryptocurrency can result in capital gains or losses.

Earning Through Core Network Activities

Individuals can earn cryptocurrency by directly contributing to blockchain network operations, primarily through staking, mining, and operating masternodes. These methods secure the network and validate transactions in exchange for rewards. Earned cryptocurrency is generally considered taxable ordinary income at its fair market value when received.

Staking

Staking involves locking up cryptocurrency assets to support a Proof-of-Stake (PoS) blockchain network. Participants pledge their coins to help validate new transactions and maintain blockchain integrity. In return, stakers receive rewards, which can be newly minted coins or a portion of transaction fees. The amount of rewards often correlates with the amount of cryptocurrency staked and the duration of the staking period.

Staking rewards are considered ordinary income. If the staked cryptocurrency is later sold, any difference between its sale price and the fair market value at the time of receipt is subject to capital gains or losses.

Mining

Mining involves solving complex computational puzzles to validate and add new blocks of transactions to a Proof-of-Work (PoW) blockchain. Miners use specialized hardware and computing power to compete in solving these puzzles. The first miner to successfully solve a puzzle for a new block receives a reward, typically consisting of newly minted coins and transaction fees.

Cryptocurrency received from mining is taxable as ordinary income based on its fair market value on the date it is received. Any subsequent sale of mined cryptocurrency triggers a capital gains or losses event, calculated from the fair market value at the time of original receipt.

Masternodes

Masternodes are full nodes on a blockchain network that perform specific, advanced functions, such as enabling instant or private transactions, or participating in network governance. To operate a masternode, an individual typically holds a significant, fixed amount of the network’s native cryptocurrency as collateral. The masternode operator receives rewards for providing these services, often a share of block rewards or transaction fees.

Income generated from operating a masternode is generally considered ordinary income. The fair market value of any cryptocurrency received as masternode rewards at the time of receipt is subject to income tax. Maintaining detailed records of all transactions, including the date and U.S. dollar value of rewards received, is important for accurate tax reporting and calculating any future capital gains or losses upon disposition of the earned assets.

Earning Through Decentralized Finance Applications

Decentralized Finance (DeFi) applications offer various opportunities to earn cryptocurrency by participating in financial services built on blockchain technology without traditional intermediaries. These methods often involve contributing assets to liquidity pools or lending protocols, facilitating decentralized financial activities.

Lending

Crypto lending involves providing digital assets to borrowers through decentralized protocols, earning interest in return. Lenders deposit cryptocurrency into a lending pool, which makes these assets available to borrowers who typically provide collateral. Interest rates can vary depending on market demand or the protocol’s design.

Interest earned from crypto lending is generally considered ordinary income at its fair market value when received. If a lender receives a token representing their stake in the lending pool upon depositing assets, this could be interpreted as a crypto-to-crypto trade, potentially triggering a capital gains tax event at the time of deposit. Careful record-keeping of the fair market value of interest received and the initial cost basis of deposited assets is important for accurate tax reporting.

Liquidity Provision and Yield Farming

Liquidity provision involves depositing pairs of cryptocurrency assets into liquidity pools on decentralized exchanges (DEXs). These pools facilitate decentralized trading by providing liquidity for users to swap tokens. In exchange for supplying assets, liquidity providers earn a share of the trading fees generated by swaps within that pool.

Yield farming builds upon liquidity provision by seeking to maximize returns from various DeFi protocols, often by moving assets between different platforms for higher yields. Participants might receive additional governance tokens as rewards, beyond trading fees, for their liquidity contributions. These governance tokens often grant holders voting rights within the protocol and can have their own market value. A concept known as impermanent loss is inherent to liquidity provision; it occurs when the price of deposited assets changes relative to each other, potentially leading to a lower dollar value upon withdrawal than if the assets had simply been held outside the pool.

Rewards received, such as trading fees or governance tokens, are typically considered ordinary income at their fair market value when gained. The act of depositing cryptocurrency into a liquidity pool, especially if an LP (Liquidity Provider) token is received, may be viewed as a crypto-to-crypto exchange, potentially triggering a capital gains event. Similarly, withdrawing liquidity may also be a taxable event. Careful tracking of cost basis and fair market value for all assets involved is important.

Borrowing (as a mechanism to earn)

While borrowing cryptocurrency typically involves taking on debt, certain advanced DeFi strategies allow borrowing to become an earning mechanism. One example is a flash loan, which allows a user to borrow a large, uncollateralized amount of cryptocurrency, provided the loan is repaid within the same blockchain transaction. These loans are often used for arbitrage opportunities.

Another strategy involves borrowing cryptocurrency to immediately use it in a yield farming or staking protocol that offers higher returns than the borrowing cost. This leveraged approach aims to amplify potential earnings. The act of borrowing itself is generally not a taxable event, as it represents a liability. However, any tokens received as incentives for borrowing or earnings generated from the borrowed funds are considered taxable income at their fair market value upon receipt. Subsequent sales or exchanges of these earned tokens would then be subject to capital gains tax.

Other Methods for Acquiring Crypto Assets

Beyond core network activities and decentralized finance, various other methods exist for acquiring cryptocurrency assets, often with lower capital requirements. These opportunities range from receiving free distributions to earning rewards for specific tasks or participation.

Airdrops

Airdrops involve the free distribution of cryptocurrency tokens to wallet holders, typically as a marketing strategy by new projects or as a reward for early adopters. Projects may distribute tokens based on a snapshot of users holding a certain cryptocurrency or to those who have interacted with their protocol.

Airdropped tokens are considered taxable ordinary income at their fair market value on the date they are received. If these airdropped tokens are later sold, any gain or loss from that sale is subject to capital gains tax, with the initial fair market value serving as the cost basis.

Bounties and Bug Bounties

Bounties offer cryptocurrency rewards for completing specific tasks that benefit a project, such as content creation, marketing campaigns, or community management. Bug bounties are a specialized type of bounty where individuals are rewarded for identifying and reporting vulnerabilities or security flaws in a project’s code or smart contracts.

Cryptocurrency received from bounties and bug bounties is considered taxable ordinary income. The fair market value of the tokens at the time of receipt is the amount that must be reported as income. Any subsequent sale of these tokens will trigger a capital gains or losses event, with the initial fair market value establishing the cost basis for tax calculations.

Play-to-Earn (P2E) Gaming

Play-to-Earn (P2E) gaming integrates cryptocurrency and non-fungible tokens (NFTs) into video games, allowing players to earn digital assets through in-game activities. Players might earn cryptocurrency by winning battles, completing quests, breeding digital creatures, or trading in-game items as NFTs. These earned assets often have real-world value and can be sold or traded on external markets.

Cryptocurrency and NFTs earned through P2E games are generally considered taxable ordinary income at their fair market value when acquired. If players later sell or trade these in-game assets, any profit or loss realized from that transaction is subject to capital gains tax. This dual taxation event necessitates careful record-keeping of the fair market value at acquisition and the sale price for proper tax reporting.

Crypto Faucets

Crypto faucets are websites or applications that distribute small amounts of cryptocurrency to users for completing simple tasks, such as solving captchas, watching advertisements, or playing basic games. These platforms introduce new users to cryptocurrency and allow them to acquire small fractions of coins without significant investment.

The minuscule amounts of cryptocurrency obtained from faucets are generally considered taxable ordinary income. The fair market value of the crypto received at the time of acquisition is subject to income tax. Any subsequent sale of these small crypto holdings would then be subject to capital gains or losses based on the initial acquisition value.

Affiliate Programs/Referrals

Many cryptocurrency platforms and exchanges offer affiliate or referral programs that reward existing users for inviting new participants. When a new user signs up through a referral link and meets certain criteria, the referrer receives a commission or bonus in cryptocurrency.

Cryptocurrency received through affiliate programs and referrals is generally treated as ordinary income. The fair market value of the earned crypto at the time it is received is the amount that must be reported for tax purposes. If the referred tokens are later sold, any gain or loss from that sale would be subject to capital gains tax. Maintaining clear records of referral earnings, including the date and value of receipt, is important for tax compliance.