How to Earn Passive Income With Cryptocurrency

Passive income refers to earnings from investments or ventures requiring minimal ongoing effort. It allows individuals to earn money without actively trading time for direct compensation, unlike traditional employment. This offers the potential to create independent financial streams. In cryptocurrency, this means using digital assets to generate returns without frequent buying and selling. Various strategies enable crypto holders to earn yield by committing their holdings to financial protocols or network operations.

All income earned from passive crypto activities, including rewards, interest, and fees, is considered taxable ordinary income in the United States. This income is taxed at its fair market value in U.S. dollars at the time it is received and the taxpayer gains control over it. It must be reported as part of gross income for the taxable year, typically on Schedule 1 (Form 1040).

Staking Digital Assets

Staking digital assets involves committing cryptocurrency to support blockchain network operations, primarily those using a Proof-of-Stake (PoS) consensus mechanism. In this system, participants, called “validators,” verify transactions and create new blocks based on their staked crypto. By participating, stakers contribute to network security and efficiency, earning rewards.

Rewards are tied to the network’s need for security and transaction validation. Validators are compensated for confirming blockchain integrity, and rewards are distributed to those who stake assets with them. Reward amounts correlate with the cryptocurrency staked and the staking duration. Common cryptocurrencies for staking include Ethereum (ETH) following its transition to PoS, Solana (SOL), Cardano (ADA), and Polkadot (DOT).

Before staking, users acquire the desired cryptocurrency and set up a compatible digital wallet. Wallet type depends on the staking method; direct staking may require a non-custodial wallet, while centralized exchanges use integrated wallets. Some methods may have minimum asset requirements.

Staking Methods

To initiate staking, users select a platform or method. This can be a centralized cryptocurrency exchange, a dedicated staking service provider, or direct staking via a self-custody wallet.

Centralized exchanges offer user-friendly interfaces for choosing and committing assets, handling validator node complexities.

For delegated staking through a self-custody wallet, users connect their wallet to a blockchain’s staking interface or a third-party staking pool. They browse validators, review performance and commission rates, then delegate assets. Confirming the delegation transaction on the blockchain incurs a small network fee. Staked assets then begin earning periodically distributed rewards.

Liquid Staking

Liquid staking is an alternative where users receive a liquid staking token (LST) representing their staked assets. This LST can be used in other decentralized finance (DeFi) protocols, providing additional utility while original assets remain staked. Engaging in liquid staking involves depositing cryptocurrency into a liquid staking protocol and receiving the LST. Rewards are accrued within the LST’s value or distributed separately.

Lending Digital Assets

Lending digital assets involves providing cryptocurrency to borrowers for interest payments, similar to traditional finance. This allows crypto holders to earn returns on idle assets. Crypto lending occurs on Centralized Finance (CeFi) platforms or Decentralized Finance (DeFi) protocols, each with distinct operational models.

CeFi platforms act as intermediaries, taking custody of assets and managing the lending process, like traditional banks. DeFi protocols use blockchain and smart contracts to automate lending without intermediaries. This decentralized approach offers users more asset control and transparent transactions.

Commonly lent cryptocurrencies include stablecoins like USDT or USDC, and major assets such as Bitcoin (BTC) and Ethereum (ETH). Interest rates are influenced by market demand, the specific cryptocurrency, and the platform’s supply. High demand for an asset leads to higher interest rates for lenders.

CeFi Lending

To initiate CeFi lending, users navigate to the lending section of their chosen exchange or platform. They select the cryptocurrency to lend, specify the amount, and review the offered interest rate and terms. After confirmation, funds are deposited into the platform’s lending pool. The platform manages the loan, and interest payments are accrued and distributed to the lender on a set schedule.

DeFi Lending

For DeFi lending, users connect a compatible non-custodial wallet to a decentralized lending protocol’s website. They identify the lending pool for their desired cryptocurrency and review the current Annual Percentage Yield (APY). Users approve the protocol to interact with their wallet and deposit the specified amount into the smart contract. Deposited assets immediately begin earning interest, calculated and accumulated by the smart contract.

Interest earned in DeFi lending can be compounded automatically or claimed periodically. Users can retrieve their lent assets and accumulated interest by initiating a withdrawal transaction through the protocol’s interface, executed by the smart contract. This direct interaction with smart contracts eliminates intermediaries, providing a transparent and flexible lending experience.

Providing Liquidity to Decentralized Finance

Providing liquidity in Decentralized Finance (DeFi) involves supplying two or more cryptocurrencies to a liquidity pool on a Decentralized Exchange (DEX). These pools facilitate trading on DEXs, allowing users to swap digital assets without traditional order books. Liquidity providers contribute by depositing an equivalent value of two different tokens, forming a trading pair.

Providers earn income primarily through trading fees generated by the pool. A small percentage of each transaction value is collected as a fee, distributed proportionally to providers based on their share. Some protocols also offer extra rewards, such as native governance tokens, to incentivize liquidity provision.

Impermanent Loss

A key aspect of providing liquidity is “impermanent loss,” a temporary loss of funds due to price changes of deposited assets. This occurs when the price ratio of the two tokens in the pool deviates significantly from their initial deposit. If one asset’s value changes relative to the other, arbitrage traders rebalance the pool. This can result in the liquidity provider holding more of the depreciated asset and less of the appreciated one than if they had simply held the tokens. This loss becomes permanent only if liquidity is withdrawn before prices return to their original ratio.

Common token pairs involved in liquidity pools include a stablecoin paired with a major cryptocurrency (e.g., USDC/ETH) or two major cryptocurrencies (e.g., ETH/BTC). Users need a compatible DeFi wallet and both specific crypto assets for the chosen pair.

Adding Liquidity

To add liquidity to a decentralized exchange, the user begins by connecting their compatible non-custodial wallet to the DEX’s website. They navigate to the “Pool” or “Liquidity” section, find available pools representing trading pairs, and select the desired one.

The user inputs the amount of one asset to deposit, and the interface calculates the corresponding amount of the second asset needed. The user then confirms the deposit transaction, approving the smart contract to access their tokens and confirming the deposit. Upon successful transaction, the user receives “LP tokens,” representing their share of the liquidity pool and serving as a receipt for deposited assets and accrued fees.

LP tokens can be staked on the same or other platforms for additional yield. To withdraw liquidity, users return their LP tokens to the DEX. The smart contract calculates their share, including accumulated trading fees, and returns the corresponding amounts of the underlying assets to their wallet. This withdrawal incurs a network transaction fee.