NFT Tax Guidance
What are NFTs?
Nonfungible tokens (NFTs) are a cryptographic asset used to digitize intellectual property such as artwork, images, videos, music or text. It is authenticated and exchanged using blockchain technology. They are a fairly new type of asset, and the IRS has yet to issue any official guidance on the tax treatment of NFTs that differentiates it from other digital assets.
Artists use NFTs to digitize their original works, and accordingly sell an autographed copy of a particular piece. The artist still has rights to the work, and they can still produce and sell other copies or versions. However, the digital code assigned to the unique NFT acts as a sign of authenticity for the buyer.
Important takeaways
- NFTs are a new type of asset and the tax authorities have not provided specific guidance on their taxation that differentiates them from other digital assets.
- Until further guidance is provided specific to NFT transactions, taxpayers must apply general principles of applicable tax law to their NFT transactions.
- NFTs differ from cryptocurrencies; Taxpayers should not mistakenly treat NFTs in the same way as cryptocurrency.
- Seek guidance from a Certified Public Accountant (CPA) who can guide you through the complexities of current tax laws.
NFT Tax issues
The IRS has issued specific guidance on the tax treatment of cryptocurrencies in recent years, in Notice 2014-21 and Revenue Ruling 2019-24]and it has included NFTs in discussions of digital assets. However, it has yet to address the tax treatment of NFTs specifically, and NFTs have some important differences from cryptocurrencies.
The key difference: Unlike cryptocurrencies like Bitcoin and Ethereum, which are fungible, NFTs are not interchangeable with each other. They cannot be exchanged directly for other currencies, goods or services.
As such, the rules that apply to cryptocurrencies may not necessarily apply to NFTs. Taxpayers who have invested in NFTs should seek the help of an experienced Certified Public Accountant (CPA) to decipher the complex tax code and ensure they are following the general tax principles that exist today.
Because each individual NFT is unique and distinguishable from others, they have characteristics similar to physical collectibles. The taxation of NFTs will fall somewhere between cryptocurrencies, which are taxed like property and have a long-term capital gains rate of 0-20% depending on income, and collectibles, which have a higher maximum capital gains rate of 28%.
NFT life cycle and possible tax treatment
The tax treatment of an NFT varies at each stage of the life cycle, from creation to purchase to sale, and if the NFT becomes worthless. There are important tax differences at each stage.
NFT creation
Like an artist autographing their artwork, when a person “tokenizes” or “coins” a piece of work in an NFT, it does not create a taxable event. NFT makes the work more valuable, but the tax authorities do not attribute income at this time. But when the work is sold to a buyer, the premium paid for NFT is also included in the purchase price and taxed to the seller.
NFT purchases
When an NFT is sold, it is taxed to the seller. However, the buyer may also have to pay tax at the time of purchase. The taxes must not be paid directly at NFT; they may be liable if the buyer buys NFTs using cryptocurrency. Most NFTs are bought with Ethereum, a cryptocurrency.
Why do they owe taxes? Because cryptocurrency is not the same as fiat currency – such as the dollar. Buying with cryptocurrency is more like selling a stock to get money to buy a painting. When an NFT is purchased with a cryptocurrency, the gain or loss on the cryptocurrency that was used must be calculated and taxed.
Depending on how long the taxpayer held the cryptocurrency – and whether it has increased in value – it may be taxed as a short-term or long-term capital gain. Short-term capital gains are the result of holding the cryptocurrency for less than a year; they are taxed at the taxpayer’s ordinary income rate. On the other hand, if the taxpayer has held the cryptocurrency for longer than one year, the long-term gain rate of 0-20% (depending on the taxpayer’s income) will apply. Most taxpayers are subject to a long-term capital gains rate of 15%.
If a person were to buy Ethereum with the intention of using it to buy an NFT, it would be wise to hold onto the cryptocurrency for more than a year. Ordinary income tax rates are as high as 37% in 2022, depending on income and tax bracket.
After the original creator sells the NFT, it can still generate taxable income for the creator in addition to the new owner. Depending on the intellectual property license terms, the creator and new owner may receive royalty payments when others view the NFT. It is also possible that the creator may receive part of the purchase price in the event of a subsequent sale of the NFT.
In addition, NFTs have features of intangible assets. An NFT created by or for the taxpayer must not be amortized. However, a purchased NFT may be subject to the tax provisions in section 197 relating to amortization of intangible assets. If the NFT is not excluded as self-generated and is held by the taxpayer to generate income in a trade or business, they may have to amortize their adjusted basis in the NFT and take straight-line depreciation deductions over 15 years.
NFT sales
The sale of an NFT gives different tax consequences, depending on whether the seller held the NFT as a capital asset or a non-capital asset. As discussed in the previous section, an NFT that was created by a taxpayer is a non-capital asset. NFTs owned by taxpayers other than the original creator are likely to be capital assets. Gains and losses on the sale of an NFT held by the creator will generate ordinary gains or losses. Gains and losses on the sale of an NFT held by subsequent owners will generate capital gains and losses.
If NFTs are used in a trade or business for over a year, it will usually fall under Sec. 1231 provisions for operating assets. If a taxpayer sells a Sec. 1231 asset used in a trade or business, net Sec. 1231 gains are classified as long-term capital gains. Net sec. 1231 losses are classified as ordinary losses. In case of Sec. 1231 gains, sec. 1245 recapture rules related to amortization of intangible assets may also apply.
Capital gain or collector’s item? There is an additional tax aspect that sellers of NFTs that have increased in value must consider. Works of art are considered collectibles and are taxed at a rate of 28% higher than capital gains. It would be wise to get advice from a tax professional as to whether you will be subject to the capital gains rate or the collectibles rate if you make a profit on the sale of an NFT you have purchased. If the NFT was purchased for business use, it may qualify for capital gains treatment.
Worthless NFTs and loss treatment
If an NFT becomes worthless, the tax treatment depends on its use. If the owner purchased the NFT as an item for personal use, equivalent to art that hangs in the taxpayer’s house, a loss deduction is allowed. However, if the NFT was held for business use before it became worthless, the taxpayer may be able to take a deduction for the worthless asset under section 197.
Examples of potential NFT tax treatments
Let’s explain how these tax rules might work in two contrasting NFT buying and selling situations.
Profits from buying and selling NFTs
Susan, a single taxpayer who earns $250,000 per year and is in the 35% tax bracket, bought $5,000 in Ethereum. Two years later, she uses Ethereum to purchase an NFT worth $8,000. The transaction results in a long-term capital gain of $3,000 from the disposition of her cryptocurrency, taxed at 15%. If Susan had held Ethereum for less than a year, it would have been taxed at her ordinary rate of 35%.
If Susan sells the NFT after six months for $10,000, the $2,000 gain is considered a short-term capital gain, taxed at her 35% marginal tax rate. Had she held the NFT for more than one year, the $2,000 gain would have been considered a long-term capital gain. Her income falls within the 15% long-term capital gain. However, if the NFT qualifies as a collectible, she will be subject to the higher 28% rate for collectibles.
Losses when buying and selling NFTs
Mike, a single taxpayer who earns $125,000 per year and is in the 24% tax bracket, bought $12,000 in Ethereum. One year later, he uses Ethereum to buy an NFT worth $8,000. The transaction results in a capital loss of $4,000. If he has no other sale of capital assets to offset the loss, he will only be able to deduct $3,000 to offset the income in the first year. The remaining capital loss of USD 1,000 will be carried forward to future tax years.
If Mike sells his NFT in two years for $7,000, he has a capital loss of $1,000. Mike had no other capital transactions. If Mike is considered an investor, the $1,000 loss can be deducted from his income. Note that if the loss had been greater than $3,000, only $3,000 can be taken in the first year and any additions must be carried forward to future tax years. On the other hand, if Mike was not considered to be an investor, his loss would be a personal loss and capital loss treatment is not allowed.
How do I buy NFTs?
NFTs are primarily purchased with the cryptocurrency Ethereum. You can buy Ethereum on a crypto exchange, transfer it to a crypto wallet and then buy your NFTs with it. Only limited places allow you to buy NFTs with fiat currency, such as dollars, instead of digital currency.
How do I avoid NFT taxes?
You will probably have to pay tax on the sale of NFT. If you are the creator, it is taxed as ordinary income. As a subsequent owner, you are taxed differently depending on the use of the NFT, how long you have held it, and whether the tax authorities ultimately classify the NFT as collectibles.
In addition, you may have to pay tax on the purchase of NFT also due to the disposal of cryptocurrency. When you buy your NFT with cryptocurrency, like Ethereum, it creates a taxable event. You must pay tax on any capital gains from your cryptocurrency upon purchase.
How do the tax authorities classify NFTs?
The IRS has not issued clear guidelines around NFTs yet because it is a new type of asset.
If it is eventually classified as a collectible, which is possible, it will be subject to the higher 28% capital gains rate like other collectibles such as stamps, artwork and precious metals. The maximum capital gain for non-collectibles is 20%.
How does net investment income tax affect NFTs?
The net investment income tax, also known as the Medicare surtax, is an additional 3.8% tax on the investment income of higher-income individuals. It is used to fund Medicare expansion.
If your modified adjusted gross income (MAGI) is above a certain threshold, you must pay an additional 3.8% on any gains you make from the sale of an NFT. The MAGI thresholds are $250,000 for married filing jointly or qualifying widow(er), $125,000 for married filing separately, or $200,000 for single or head of household.
For example, collectibles will have a maximum federal tax rate of 31.8% (28% + an additional 3.8%), while non-collectibles will have a maximum federal tax rate of 23.8% (20% + an additional 3.8%) .
The bottom line
NFTs are a new type of asset. Current tax law does not have provisions specifically related to the tax treatment of NFTs, so any tax treatment outlined in this article is speculative based on existing tax law. If you invest in NFTs, be sure to keep good records of your transactions. Seek the help of a tax expert who can guide you through the applicable tax laws applicable to NFT transactions. As the IRS issues additional guidance, the taxation of NFTs will become clearer. With the correct documentation of your purchases and sales, you can avoid penalties.
