NFT Investments Taxes Overview
Non-fungible tokens (NFTs) are cryptographic assets on a blockchain with unique identification codes and metadata. They are usually bought and sold online, frequently with cryptocurrency, and they are mostly encoded with the same underlying software as many cryptos. Unlike cryptocurrencies, NFTs investments cannot be traded or exchanged at equivalency. After taking the art and gaming world by storm, NFTs have now exploded into the mainstream. Indeed, celebrities and big brands became involved. Digital artists are seeing their lives change, thanks to huge sales to a new crypto-audience.
Non-fungible tokens have exploded in popularity over the last few years, and as investors begin to consider their 2021 tax fillings, there is some uncertainty on how the Internal Revenue Service (IRS) would want taxpayers to report their NFT transactions. Until now, limited information and guidelines exist on the federal taxation of cryptocurrencies. In the Notice 2014-21, the Internal Revenue Service made it clear that they considered cryptocurrency property for tax purposes. Since Notice 2014-21, the IRS has not issued further information and clarification concerning NFTs. Thus, leaving taxpayers to speculate on the proper treatment of the same.
How is NFT Different from Cryptocurrency?
NFTs use the same kind of programming language and codes as cryptocurrencies, such as Bitcoin and Ethereum. However, that is just where the similarity ends. Physical money, as well as cryptocurrencies, are "fungible". This means that people can trade or exchange them for one another. Physical money and cryptocurrencies are also equal in money, one dollar is always worth another dollar and one Ethereum is equal to another Ethereum.
NFTs however, is different. Each NFT has a digital signature that makes it impossible to exchange for or equal to one another. For instance, you cannot exchange a piece of art with another piece of art. Indeed, they don't necessarily carry the same market value.
Regardless of the lack of IRS guidance, the tax community looks to have acknowledged that the most commonly traded NFTs as collectibles. This means that NFTs carry a 28 percent capital gains rate pursuant to IRS Section 1(h)(4). This position appears to be a conservative one because any non-creator of an NFT typically buys the asset in an investment or the "capital" capacity that otherwise may take advantage of the lower rates. Investors need to understand that when they transfer a cryptocurrency like Ethereum in order to buy an NFT, they need to recognize any gain or loss on Ethereum at such time. The current value also sets their respective cost in the NFT.
Tax Implications for NFT Investments for Creators/Dealers
Self-created intangibles are usually treated as noncapital assets under Section 1221. Therefore, artists that create non-fungible tokens for a living are generally expected to recognize ordinary income and must pay self-employment taxes on the transfer of their NFTs. The tax conditions can potentially differ, depending on whether the creator transfers:
- Substantially all
- Limited rights in the NFT
For federal tax purposes, limited transfer of rights occurs as a license. In this situation, the creator recognizes royalty income. However, it would not be able to offset such income with the basis of the NFT. Having said that, the creator would continue amortizing all the capitalized costs for the term of the license. This also means that the creator can deduct qualifying expenses that are related to the creation of NFTs.
In a similar manner, the dealers involved in the buying and selling of NFTs within the ordinary course of business recognize ordinary income. Just like the NFTs creator, dealers can deduct business expenses in connection with the sale of NFTs. This includes the cost of acquiring NFTs.
NFTs as Securities or Commodities
One of the current dilemmas and questions that surround tax includes whether NFTs consist of "securities" or "commodities" for tax or regulatory purposes. For tax purposes, special rules under IRC Section 475 usually require dealers in securities to account for gains as well as losses on securities on a mark-to-market basis.
The dealers and traders in commodities can apply a mark-to-market method of accounting. Even though it may look clear, the more commonly traded collectible-type NFTs would not actually be securities or commodities because those terms are currently defined under Section 475. The term's definition doesn't include concrete guidance for taxpayers.
Generally, NFTs are currently representing a broad class of investments, from collectibles to more financial-type assets. As different terms and applications occur, the existing agreement and framework on the tax amendment of NFT may change. Additionally, the proposed legislation makes it very clear that Congress focuses on modernizing the existing tax rules in order to address cryptocurrency (and NFTs). This could potentially include an expansion of the rules under Section 475 to apply to items like NFTs.
Personal User Sales
A personal use asset is usually defined as one that is held neither for use in a trade or business nor for investment. These kinds of assets include those held by individuals for utilization in a hobby or recreational activities. A taxpayer's intent should evaluate whether an NFT is a personal use investment asset. The gains from the sale of an NFT held for personal utilization would be taxable as capital gains. In some cases, for the sale of collectibles, losses on sale would not be deductible.
Learn More About NFT Investments Taxes
Even though the Internal Revenue Service has not clearly provided definitive guidance, the existing statutory, regulatory, and case law can provide a basic framework for determining how to treat the purchase as well as the sale of an NFT for tax purposes. The taxation of NFT sales varies depending on whether the creator or another NFT holder makes the sale. Taxpayers who create, purchase, and sell NFTs should seek guidance and advice from tax professionals.