Despite Non-fungible Tokens (NFTs) growing popularity, the Internal Revenue Service (IRS) has not yet published specific federal income tax guidance prescribing how NFT transactions should be taxed. Nevertheless, NFT transactions, like cryptocurrency transactions, are generally considered to be subject to federal (and often state) income taxation. This article is limited to federal income taxation. The next article in this series will address the state and local tax implications of NFT transactions.
Investors should expect that the sale of an NFT should be treated as the sale of a capital asset, and some NFTs could meet the definition of “collectibles.” When collectibles are sold or exchanged, the gain is subject to a higher 28% capital gain rate. (See below for more information regarding the definition of collectibles.)
This article is intended as an introduction to NFT taxation and offers the reader our perspective on the federal income tax implications of common NFT transactions.
What are NFTs?
To begin, NFTs are unique digital assets/files that are linked to a certificate of authenticity. NFTs have become mainstream in the online world as gaming awards/add-ons, unique art, music, cards, and other digital files.
Like cryptocurrency, NFTs are products of blockchain technologies. This allows them to be “tokenized,” where the value is not in the token, but in what it represents. A common analogy is a car title to a car, where the title is the token and the original, unique file is like the car. In the case of NFTs, the ownership can be verified using blockchain records.
Existing IRS Guidance Applicable to Cryptocurrency Extended to NFTs
As mentioned above, IRS guidance specific to NFTs does not yet exist. To understand how NFTs might be taxed, specialists begin by looking to the guidance the IRS has published regarding cryptocurrency activity.
According to the IRS guidance, acquiring and holding cryptocurrency through payment of traditional currency is not a taxable event. However, disposing of cryptocurrency generally is a taxable event, even if it’s disposed of in exchange for other digital or non-digital property. That is because cryptocurrency is not treated the same as non-digital forms of fungible currency (e.g., U.S. dollars), instead it’s treated more like owning stock or land.
As an example, let’s say Buyer pays for a purchase of shoes with cryptocurrency on Website. Buyer must track the value of her cryptocurrency when it’s acquired and compare that to the value of the cryptocurrency when it’s exchanged for the shoes. If Buyer’s cryptocurrency appreciated while Buyer held it, the appreciation must be reported as gain in her tax return. This means that both Buyer and the Website seller could have income/gain on the transaction.
Relying on the IRS guidance for cryptocurrency, tax specialists who have published commentary regarding NFT taxation conclude that the sale or exchange of an NFT is also a taxable sale or exchange of property.
What NFT Transactions are Taxable?
Based on the logic of the guidance mentioned above, we provide the following guidance about how we expect basic NFT transactions to be treated for federal income tax purposes. Because the tax result can vary based on actual details of a specific transaction, we recommend that each transaction be reviewed carefully by an informed tax advisor before proceeding. Further, the tax law related to NFT taxation will continue to evolve. As a result, the assumptions we provide here may quickly become outdated should the IRS, U.S. Treasury, or the courts provide additional guidance.
Creating an NFT
While minting (creating) an NFT is not a taxable event, transactions involving the sale of newly minted NFTs by the creator are taxable. The value of any consideration received, less costs to create the NFT and trading fees, is reportable income. Accordingly, any fees associated with creating and selling NFTs and the cryptocurrencies used to trade them should be carefully documented.
What is the federal income tax rate for creators who sell NFTs? Generally, ordinary rates apply to income generated by self-employed artists or creators. Currently, ordinary income rate brackets are graduated, with 37% being the highest rate. In addition to income tax, self-employment tax (the base rate is 15.3%) will also apply.
Investing in an NFT
As mentioned above, using cryptocurrency to purchase an asset generally triggers gain/loss on the disposition of the cryptocurrency when it is offered as consideration in a purchase. Once purchased, the value paid for the NFT and the associated fees become the purchaser’s basis in the NFT. Again, careful documentation of the value of the NFT and any holding or transaction fees is highly recommended.
Selling a Previously Purchased NFT
Disposing of an NFT that was previously purchased (as opposed to an NFT sold by its creator) should be treated like the disposition of stock or land. Any consideration received is offset by the seller’s basis. Resulting gain or loss should be reported as short- or long-term capital gain. Capital gain rates are 0%, 15%, or 20%, depending on the income level of the investor in the year of disposition. However, a higher capital gain rate applies when the NFT meets the definition of a “collectible.” Gain on the sale of collectibles is subject to a 28% capital gain rate. See below for a discussion of collectibles.
Exchanging an NFT for an NFT
If two parties decide to exchange NFTs, both could be required to recognize gain, loss, or ordinary income on the transaction. Each would need to determine the value of the NFT given up in the exchange.
When determining the gain or loss on the transaction, the value of the NFT should be offset by the holder’s basis. Such gain will be subject to tax at the applicable short-term or long-term capital gains rate (including the collectible rate), depending on how long the NFT was held by each party to the transaction.
Determining the NFT’s value in an NFT-for-NFT exchange may be difficult, depending on the circumstance. There may be little market value information available, such as comparable transactions, and determining what the IRS will accept as documentation of value is hard to predict. Substantiating the value for tax purposes may warrant obtaining a third-party appraisal/opinion (or the equivalent) when the value is significant.
The nature of the gain recognized will depend on the type of parties involved in the transactions. Investors should recognize short- or long-term capital gain. Those who created the NFTs exchanged should be subject to ordinary income and self-employment tax as noted above.
Receiving an NFT in a Game or Similar Activity
Receiving an NFT as a reward in a game or other entertainment activity presents potentially ambiguous issues. If the NFT is valuable outside of the game, then it’s likely to be considered ordinary income upon receipt. But what if the NFT only entitles the player to more game advantages, i.e., a game add-on? If the value can be readily established, recipients should expect the IRS to consider the receipt of the NFT to be taxable income. This is especially likely if the same NFT can be purchased for cryptocurrency for a disclosed amount as a game add-on. If it’s not offered as a separate transaction, determining the value of the NFT at the time it is received could be difficult.
We can expect the variety of ways to obtain NFTs to proliferate in the near and extended future. Each situation will require careful analysis to determine if and when income is reportable.
Again, under general tax principles, any value reported as income and any fees associated with receiving the NFT become the recipient’s basis available to offset the recipient’s gain when the NFT is sold or exchanged. We can only hope that the IRS prescribes reasonable rules, i.e., allowing for deferral of income until the NFT can be easily valued or until it’s disposed of, in the interest of keeping compliance simple and understandable.
Are NFTs Considered Collectibles?
As mentioned above, concern exists that NFTs may fall into a category of assets specifically defined as “collectibles” by the Internal Revenue Code. If the IRS takes this position, any gain realized on sale could be subject to a 28% capital gain tax rate. Collectibles are defined capital assets held for more than one year that are:
“(A) any work of art, (B) any rug or antique, (C) any metal or gem, (D) any stamp or coin, (E) any alcoholic beverage, or (F) any other tangible personal property specified by the Secretary for purposes of this subsection.”
How do each of the different forms of NFTs square with that definition? Further clarification from the IRS is required before any definitive determination can be made as to when or if an NFT is a collectible. In the meantime, conservative taxpayers are advised to report NFT gain as collectible gain when the NFT involves an image that can reasonably be considered “art.” The determination becomes more difficult for other types of NFTs.
Recent Tax Legislation Concerning NFTs
On November 15, 2021, the Infrastructure Investment and Jobs Act became law. The new law contains several changes to the taxing of digital assets, including NFTs. The changes will be applicable to information returns required to be furnished after December 31, 2023.
Under these rules, “brokers” will be required to file Form 1099-B with respect to NFT transactions. As a result, investors and creators who invest, sell, or exchange NFTs should realize that proceeds from these transactions will likely be reported to the IRS.
The definition of a broker is beyond the scope of this discussion, but it includes most parties that facilitate exchanges of cryptocurrency and NFTs. In some cases, it could also include companies that issue NFTs in the context of games and other forms of entertainment.
Artists, investors, and gamers who create, purchase, or exchange NFTs should carefully document the details of these transactions, including any associated fees. While the IRS has not yet published specific guidance on the income tax treatment of NFTs, you can expect that reporting of the transaction, including the cryptocurrency exchange associated with the transaction, to be carefully scrutinized if you are subject to audit. The IRS will ask for documentation.
Artist and creators generating income from the creation/sale of NFTs are subject to ordinary income tax and self-employment tax. It appears that some NFTs are likely to be considered “collectibles” and will subject investors who realize gain from NFTs held for more than one year to capital gain rates of 28%. In 2024, 1099-B reporting will begin.
If you are in the business of creating and selling NFTs, you should also be aware that these transactions may be subject to sales tax collection. Many factors may be relevant to determining which jurisdiction’s rules apply. Our next article in this series will cover state and local tax implications of creating and selling NFTs.
If you need help navigating your cryptocurrency or NFT investments, please contact one of our professionals.
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