The market for NFTs, or non-fungible tokens, has exploded in 2021 and shows no signs yet of abating in 2022. According to Dapp Radar, sales volume in NFTs reached $22 billion in 2021, up from just $100 million in 2020. This is an eye-watering 220-fold increase in sales volume year-on-year. Whilst this may have been good news for early investors and creators to this space, it will also have certainly caught the eyes of the tax authorities around the globe, who are eager for a slice of the pie.
The IRS is no exception to this and the acting executive director of cyber and forensic services at the IRS’s criminal investigation division, Jarod Koopman, has recently said that “We subsequently will probably see an influx of potential NFT type tax evasion, or other crypto-asset tax evasion cases coming through” signaling to the NFT industry that a spotlight is now being shone on a market that by some estimates rivals the physical art market (which totaled $50.1 billion in 2020).
Given this swirl of interest in NFTs, you might be wondering what an NFT is? Well, a NFT or “non-fungible token”, is a non-interchangeable unit of data stored on the blockchain that can be bought or sold. It differs from Bitcoin for example because any Bitcoin is interchangeable with any other Bitcoin. In this sense Bitcoin is fungible. Ownership of an NFT provides a “proof of ownership” of a unique digital asset. The owner of an NFT can point to the blockchain to say they are the owner of this asset. This asset is normally digital files such as photos, videos, and audio. Detractors of NFTs say that anyone can copy the digital file, or “right-click” and save, but proponents say that when they buy an NFT they are buying the only verifiable version of that piece as minted by the artist. For many, the jury is still out on the utility of NFTs, but one thing is certain: they will be taxed.
The best defense to arm oneself against the omnipresent tax collector is knowledge, so in that vein let us dive into how NFTs are taxed. The IRS has not published specific guidance relating to NFTs, however they have made it clear that transacting in cryptocurrencies will result in taxable events. In IRS Notice 2014-2021, it states “the sale or exchange of convertible virtual currency, or the use of convertible virtual currency to pay for goods or services in a real-world economy transaction, has tax consequences that may result in a tax liability”. As non-fungible tokens fall under the definition given by the IRS of a virtual currency – that is, “it is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value”, it follows that NFTs will be subject to taxation.
The main question to consider with these taxable events is whether you are a professional NFT creator (in which case gains are treated as income and subject to Income Tax) or an NFT investor or hobbyist creator (in which case gains are treated as capital gains and subject to Capital Gains Tax).
Purchasing an NFT with cryptocurrency
This is the same whether you are an NFT professional creator or you are an investor or hobbyist creator, purchasing an NFT with cryptocurrency means you are liable to pay capital gains tax on any gains made on that purchase.
For example, Bob used 5 ETH to purchase a Crypto Punk when ETH was trading for $400 (total of $2000), but had originally acquired the ETH when it was trading for $200 (total of $1000), he would then owe capital gains tax on the ETH’s increase in value of $2000 - 1000 = $1,000.
Trading an NFT for another NFT
This will differ depending on whether you are an NFT professional creator or you are an investor or hobbyist creator. If the NFT that was traded for another NFT was minted by a professional creator, then gains would be taxed in Income Tax. Gains would be taxed in Capital Gains Tax if the NFT that was traded for another was initially bought.
Disposing of an NFT for a cryptocurrency
This will differ depending on whether you are an NFT professional creator or you are an investor or hobbyist creator.
For example, if Greg purchased a Cool Cats NFT for 1 ETH when ETH was at $2,000 but later sold it for 5 ETH when ETH was at $3,000 (total of $15,000), he would then owe Capital Gains Tax on the difference $15,000 - $2,000 = $13,000.
If however Greg was a professional NFT creator and had created a single NFT with a cost basis of $400 and later sold it for 1 ETH when ETH was trading at $4000, then the difference $4000 - $400 = $3,600 would be classified as Ordinary Income and be subject to Income Tax.
Earning royalties from an NFT
This would only apply for NFT professional creators.
If Greg’s NFT that he had created and sold had had written into the contract that any additional resales would earn him 10% royalties, then if that NFT he had sold for 1 ETH was later resold for 2 ETH when ETH was trading at $4,000, then Greg would earn (($4,000 * 2)*0.1) = $800 in royalties which would be classified as Income.
Minting an NFT
Minting an NFT is not a taxable event, however taxes will be paid on any gains made for the gas fees incurred in minting.
For example, Alice, who is a professional NFT creator who regularly mints NFTs, spends 0.1 ETH in gas fees to mint her own NFT. She originally purchased this 0.1 ETH for $50. At the time she minted the NFT, 0.1 ETH was worth $200. The act of minting an NFT would generate $150 ($200 - $50) ordinary income for Alice as the ETH she had bought would be disposed of, for a gain of $150, in gas fees. The cost basis of the NFT minted is $200.
If Alice only minted NFT as a hobby and not as her profession then the $150 gain would be taxed as Capital Gains Tax however.
The IRS has not yet issued formal guidance on the tax treatment of NFTs, as such this is still somewhat of a grey area when it comes to classifying NFTs. The main question to be considered is whether NFTs are to be considered “collectibles” or not.
If NFTs are to be considered “collectibles” they would receive a similar tax treatment to stamps, antiques or trading cards and be taxed at the higher rate of 28% which is the collectibles tax rate.
If however NFTs were to receive the same tax treatment as cryptocurrency, they would be taxed as property with a long-term capital gains rate of up to 20% based on income. Those who argue for this position state that NFTs are “intangible” digital assets and the tax code only applies the collectibles tax rate to “tangible” assets. As stated previously though, this is still a legal grey area and as such arguments on neither side are final as yet.
Lastly, the difference of whether or not NFTs are classified as “collectibles” only comes into question when assets are held for over one year. All NFTs sold after being held for less than one year will be subject to short-term capital gains tax rates regardless of whether they’re viewed as collectibles or as property.
Professionals should use Schedule C or the applicable business tax form (Form 1065, Form 1120, or Form 1120-S) to report income and business expenses related to their NFTs such as internet usage.
Hobbyist creators and investors should use IRS Form 8949 and Schedule D to report gains or losses made on minting and trading NFTs. Be sure to enter code “C” in column (f) as this indicates that you sold an NFT which is treated as a collectible.
To summarize, if you are considering investing in NFTs or have already invested it is worth spending some time learning about how NFTs are taxed. It is not an insurmountable task to get on top of your NFT taxes but they are also not entirely simple. Take the time to do your own due diligence and keep transaction records of all your NFT transactions and you will be well on your way to being on top of your tax situation! If in doubt, it is also worth seeking the advice of a tax professional which, thankfully, can also be found on Fiverr.