NFTs and Taxes

NFTs, short for Non-Fungible Tokens, have become a hot commodity. Built on the same style of blockchain networks that power cryptocurrencies like Ethereum and Bitcoin, NFTs are unique pieces of virtual art that are easy to buy and sell. What is substantially less easy, though, is understanding NFTs and taxes. Indeed, at the time of writing, even the IRS struggles to categorize and tax NFTs. NFTs are usually evaluated as collectibles under Internal Revenue Code § 408(m)(2). However, this can create higher tax burdens, so there is also a push to evaluate NFTs as investments subject only to simple capital gains tax. While more guidance is forthcoming, tax obligations wait for no one.

The NFT Ecosystem and Taxation
NFTs are created by attaching a unique, random string of letters and numbers to an image, short video, or other digital asset. This identifier marks the asset as “genuine” and creates value in the unique asset. This process is known as minting and is done on a specialized website with a connection to an existing blockchain network.

Once an NFT is minted, it may be sold, traded, or exchanged via direct peer-to-peer communication, either in person or virtually. Most NFTs are bought using cryptocurrency at auction. They are also given away, bartered for, and donated. Almost every movement of an NFT within the online ecosystem is taxed, and trading in NFTs is not monitored by the IRS. Like crypto, people are expected to report their NFT movements proactively—and the IRS is working hard to find those who do not.

A good rule of thumb is to assume moving money and assets into, out of, or within the virtual cryptocurrency and NFT ecosystem will likely be a taxable event.

So, You’ve Decided to Work with NFTs—Where Are Your Tax Liabilities?
Congratulations! You have a brilliant idea for the first of a series of image-based NFTs, called TaxGiraffes. You get to work on Opensea, a leading NFT website. To mint your NFT, Opensea requires a payment of .01 Etherium cryptocurrency (ETH) as “gas” or a transaction fee, which creates your first tax liability. The IRS treats any exchange of cryptocurrency as divestment of an asset and subject to the capital gains tax. If you have held this cryptocurrency for less than one year, any gains are subject to a short-term capital gains tax at a higher tax rate.

After recording the change in value of your ETH, you have successfully minted your first TaxGiraffe! It looks cuddly, adorable, and well-versed in protecting you from tax liability. You put it up for auction on Opensea’s marketplace. The actual minting of the NFT has not created any tax liability for you yet, but when the auction concludes, and you receive payment, you trigger another interaction between NFTs and taxes. The initial sale of your NFT is taxed as ordinary income tax based on your tax bracket. You are also smart enough to put a creator’s commission of 5% on your NFT. Every time your NFT is sold, you get 5% of the purchase price. This is also taxed as income.

Having sold your TaxGiraffe, you now want to buy a SolutionLion, another image-based NFT. You win the auction for SolutionLion #5467 and pay 50 ETH for it. This triggers your next tax obligation. Despite this being a purchase, it is taxed as divesting an asset and is subject to a capital gains tax based on the change in value of your ETH from the time you received it until you spent it. Because SolutionLions are in demand, you bought one as quickly as you could—within two weeks of receiving your ETH—and are once again subject to the short-term capital gains tax.

Now that you have your SolutionLion, you let it appreciate for over a year. You begin to miss your TaxGiraffe, which has gone through several hands since you first sold it and has appreciated in value dramatically. Luckily, your SolutionLion has also equally appreciated in value, and both NFTs are worth about 100 ETH. You propose and engage in a trade with the current owner. Despite this being a barter, you still have a tax liability for the amount your NFT has appreciated. This amount must be calculated carefully, as it will involve converting the cryptocurrency-denominated value of your NFT’s appreciation to traditional, government-issued currency. You have held your SolutionLion for over a year and are subject to a lower, long-term capital gains tax, but because the asset has doubled in value, you could still be facing a large tax bill.

You decide to sell your TaxGiraffe one final time. After holding it for over a year, you sell it at auction for a whopping 1,000 ETH—likely over $1 million! You then sell the ETH for American dollars, ending your adventure with a sizeable chunk of change. However, before you set off for the Bahamas, you still have one more tax liability: the final transactions from your NFT to dollars. The first taxable event is the appreciation of your NFT’s value when you sell it. The second is the change in value of your ETH when you convert it to dollars. The sale of the NFT will be taxed at the long-term capital gains rate, the ETH to dollars transaction at the short-term unless you hold it for longer than one year.

Donations, Giveaways, and Loss in Value
There are three other situations that create tax burdens. Donating an NFT, like donating any other asset, may allow for tax write offs if donated to a qualifying nonprofit. Giveaways are taxed similarly to other sweepstakes, with the value of the giveaway being assessed using either a floor price set by the contest operator or an analysis of comparable items. Loss in value can be deducted depending on whether NFTs are classified as collectibles or analyzed solely under capital gains tax. Losses on collectibles are nondeductible personal losses and cannot be used to offset tax obligations.

Conclusion
The interaction between NFTs and taxes is complex, but not insurmountable. As the IRS and local governments adapt to the virtual world, regulations will become clearer and tax obligations may become more streamlined. The most important takeaways are to (1) keep track of your cost basis (what you bought your asset for, including “gas” fees), sale price, and every transaction you make; and (2) plan for any transaction by evaluating the taxable income it may generate. If you are unsure of your tax obligations, be sure to consult with a licensed financial professional.

Contact us to schedule a free confidential, no-obligation consultation with our RJS LAW team (619)-595-1655 and learn more about NFTs and Taxes.

Published by Zachary K. McDaniel