It would be safe to say that non-fungible tokens (NFTs) will be the next big thing. Yet just because they're new doesn't mean the IRS won't be paying attention to them.

The last thing you want at the end of the year is to be surprised by a tax bill. This comprehensive guide explains how NFTs will affect you come tax season.

example of various NFTs

What is an NFT?

NFTs are non-fungible tokens, or digital certificates of ownership rights built on the blockchain, typically Ethereum. The NFT is a one-of-a-kind token that cannot be duplicated and is unlike fungible cryptocurrency coins like Bitcoin or Litecoin. Bitcoins, for example, maybe swapped for another bitcoin, each with the same value, but because NFTs are unique, they cannot be exchanged.

A non-fungible thing is one whose units can't be exchanged with another, and whose value is not necessarily the same. Gemstones, for instance, are non-fungible because each type is unique. In general, if you exchange one diamond for another, you are unlikely to retain the same value since each diamond varies as far as size, cut, purity, etc.

In the case of artists, musicians, and anyone creating one-of-a-kind content, converting your digital masterpiece into an NFT is a way to ensure authenticity and document ownership. Many investors believe they can make a lot of money by buying and selling digital assets.

Although all the buzz and excitement surrounds NFTs, one important factor can be easily overlooked: taxes. Artists and investors who create and sell NFTs as well as those who buy and trade NFTs for profit must understand NFT taxes in order to avoid getting caught with a nasty tax surprise.

Are non-fungible tokens taxed?

Yes, NFTs (non-fungible tokens) are generally subject to the same tax laws as fungible cryptocurrencies.

Artists who receive income from selling NFTs need to report the proceeds on their tax returns. NFTs will be treated as property, and any profits earned through sales and trades will be subject to capital gains tax.

Taxable NFT activities include:

  • The sale of an NFT in exchange for cryptocurrency
  • Purchasing an NFT with cryptocurrency
  • Trading an NFT for another NFT

info icon Helpful Resource: How is Cryptocurrency Taxed?

Tax Considerations for NFT Creators

Creating an NFT does not usually trigger a taxable event. If an artist converts a piece of art into an NFT, the process itself generates wealth, since the NFT may be more valuable than the original. In general, however, such imputed income is not generally taxed by the IRS, just as when an artist makes a copy of their work more valuable by autographing it.

It is fairly straightforward for those creating NFTs to pay taxes. However, if you ignore the tax implications that come with digital art, it's not uncommon to receive an unwelcome tax bill when you file your taxes.

Selling an NFT You Created for Cryptocurrency

In itself, creating an NFT is not taxable. Selling the NFT on a marketplace, however, is taxable. You will have to pay taxes on the profits from the sale of an NFT.

Profits are considered income and are taxed at your ordinary-income tax rate, which varies between 10% and 37%. The tax treatment is comparable to that of getting paid in crypto, mining crypto, or staking crypto.

In addition, this income is subject to self-employment taxes at a rate of 15.3%.

Tax Considerations for NFT Investors

Investors and traders of NFTs must consider a few possible taxable scenarios.

Purchasing an NFT With Cryptocurrency

Purchasing an NFT with a cryptocurrency constitutes disposal of the cryptocurrency and incurs a capital gain or loss. A person who buys an NFT with appreciated Ethereum would incur a capital gain and would be liable for taxes on this gain. If you held Ethereum before using it to purchase NFT, you would either be subject to long-term capital gains tax or short-term capital gains tax.

info icon Helpful Resource: Long Term Vs. Short Term Capital Gains Tax Guide

In contrast, if you purchased the NFT using depreciated Ethereum, you would incur a capital loss and could use this loss to offset other capital gains, lowering your tax liability.

Trading One NFT for Another

A taxable event is also triggered by trading one NFT for another NFT. For example, if you bought an NFT for $5,000 in ETH and then traded it for another NFT worth $6,500 in ETH, you would have a taxable gain of $1,500.

Selling NFTs For Cryptocurrency

A capital gain or loss is incurred whenever you sell an NFT. As an example, if you buy an NFT for $20,000 of ETH and then sell it for $25,000 of ETH, you would incur a taxable capital gain of $5,000.

High-Net-Worth Individuals are Subject to a Higher Tax Rate on NFTs

Single filers with over $441,450 of taxable income and married filers with over $496,000 of taxable income are considered high net worth individuals.

Due to the fact that NFTs are likely considered "collectibles", they are subject to a 28% tax rate on collectible gains for high net worth individuals, compared to the highest 20% tax rate on regular cryptocurrency and stock long-term capital gains. In addition to the highest 28% tax rate on collectibles, high-income earners must also pay a 3.8% net investment income tax.

various images of NFTs

How are NFTs taxed?

It's important to note that the IRS has not taken an official stance on the tax treatment of NFTs as of yet. An NFT could be taxed the same way as cryptocurrency, which would be taxed as property with a long-term capital gains rate of 0 - 20%. A different solution would be to treat NFTs as stamps, antiques, or trading cards and tax them at the collectibles tax rate, which is significantly higher at 28%.

It only becomes relevant when assets have been held for more than one year. Therefore, any NFTs sold after less than one year will be subject to short-term capital gains tax rates, regardless of whether they're considered property or collectibles.

‍When Do I Owe Taxes On An NFT?

Any gains from transacting in virtual currencies will be subject to taxation by the IRS. Tax Notice 2014-21 defines virtual currencies as digital representations of value that can be used as a medium of exchange, a unit of account, and/or a store of value-and both conventional crypto tokens and non-fungible tokens fall under that definition.

The unique nature of non-fungible tokens makes identifying units that have been sold much easier, just like you would with a bond's CUSIP or stock's certificate number. A NFT might be subject to regular income, capital gains, or tax-exempt taxation, depending on what it is and what its use case is.

Take, for instance, the case of purchasing an NFT that represents a piece of art. Tokens are merely digital representations of physical assets, which means their taxation will parallel that of art rather than cryptocurrencies. Deductions, such as depreciation, may be available to offset gains.

How to Report NFTs on Taxes

In the case of creators, NFT-related income is reported on Schedule C (Profit or Loss From Business) or on the applicable business tax return (Form 1120, 1120S, or Form 1065). Section 162 of the Internal Revenue Code allows creators to deduct ordinary and necessary business expenses from the income recognized. Auction fees, transaction fees, subscription fees, and other expenses connected to NFT sales income are examples of common expenses.

Investors will report dispositions of cryptocurrency to purchase NFTs and the subsequent sale of NFTs using Form 8949 (Disposition of Capital Assets) and Schedule D (Capital Gains and Losses). For Form 8949 column (f), enter the code "C" to indicate that a collectible was sold.

Cryptocurrency reporting mechanisms are lacking. Participants do not generally receive 1099 forms with cost basis information from NFT platforms. Thus, keeping detailed records of the cryptocurrency used to purchase NFTs and the NFTs themselves is essential. You will need this information to calculate capital gains and related taxes.

NFT trading generally involves receiving, sending, or selling a cryptocurrency. Therefore, you should check “YES” on the virtual currency question on the front of Form 1040 if you have dealt with NFTs —“At any point in 2020 did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”

What do I report if I bought an NFT in the last tax year?

Capital gains taxes are due if you used a cryptocurrency that increased in value between the time you acquired it and the time you exchanged it for an NFT.

What do I report if I sold an NFT in the last tax year?

An NFT that you sell or otherwise dispose of will be subject to capital gains taxes if the value of the NFT increases between the time of acquisition and the time of sale or disposal.

Filing Your Taxes with NFTs

The IRS has not issued a formal statement regarding NFT tax treatment. However, you can still plan ahead and anticipate what you'll have to pay.

Blockchain technology is capable of so much more than cryptocurrency. As non-fungible tokens gain popularity, blockchain technology is being used to represent everything from digital artwork to physical real estate. Of course, these transactions have tax consequences for investors and traders.

There are so many exciting things emerging every day with NFT technology that it's easy to get lost in the latest NFT project or start a new NFT business without considering the tax bill.

Keep yourself informed and proactive as the IRS continues to issue new guidance, and keep in touch with your accountant.

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