In recent years, blockchain technology revolutionized how many of us think about currency, but secretly alongside this, there has also been a rise in digital files being sold as what is called NFTs – or Non Fungible Tokens.
What NFTs have done is completely transformed the way that original creations are being sold by celebrities, artists, musicians, and sports stars.
But with the rise of these types of digital transactions for (sometimes) eye-watering amounts of money, it’s no surprise that there are tax implications involved. As much as we don’t want to break the bad news, if you’re wondering if NFT’s are taxed — they are indeed taxed by the IRS.
What exactly are NFTs?
While we cannot be sure exactly what applications they will have in the future, it is safe to say that NFTs are here to stay. If you were one of the early adopters—in which case this part of the article won’t be so important—or are considering dipping your toe into the world of NFT, read on to find out what implications you will need to be aware of.
Let’s begin with what an NFT actually is, in the simplest possible terms.
The “Non-fungible” part implies that your “token” is unique and cannot be replaced by something else. That is unlike cryptocurrency, for example, which is fungible – in that you can replace one bitcoin for another and it is the exact same thing.
It could be worth considering this in terms of Ethereum coins—or ETH—instead, because NFTs are currently all added to the Ethereum blockchain, but other cryptocurrencies are starting to join in.
At the moment, NFTs usually come in the form of digital art, music, video, or even text such as a tweet!
As major brands begin scrambling to figure out the best possible application of an NFT in real life—such as Nike—you will be currently stuck with buying surreal images of cats, GIFs of Dogecoin, or png images of rocks… literally rocks.
Why are NFTs taxable?
While there is currently no formal position taken by the IRS with regards to NFTs, depending on the acquisition, creation, or selling of one, they can be considered as either a part of your inventory or a capital asset.
In the same way that cryptocurrency as a fungible asset is taxable, so is an NFT. This is simply because the profits generated from the NFTs sale are considered income and therefore liable to your tax rate of 10% to 37%.
So regardless of whether you are trading one NFT for another, selling one for crypto, or purchasing an NFT with cryptocurrency, you will need to report it and pay the relevant taxes.
The differences in liability will depend on what your status is in the transaction.
When creating (or minting) NFTs, you may be required to pay a standard income tax and self-employment tax of 15.3% upon their sale. You will need to have the intellectual property rights to the media in order to legally turn it into an NFT in the first place.
If you are looking to retain the copyright to the media that has been used to create the NFT, it will be considered as royalty by the IRS because you are effectively selling copies of your copyrighted work.
This then creates a potential triple taxable event if you want to create and sell an NFT, that is:
- Income tax on the sale,
- Self-employment tax, and
- Potential income tax from royalty generation
Trading and investing in NFTs
If you are not minting NFTs and interested only in purchasing and trading them, the IRS will treat them differently.
When you purchase an NFT using a cryptocurrency like Bitcoin or Ethereum, it is considered as a disposal of assets because cryptocurrencies are treated as property by the IRS. In other words, you are incurring a capital gain or loss depending on whether your crypto coin (let’s use Ethereum ETH as an example) has appreciated or depreciated.
So if you buy an NFT artwork using appreciated ETH, you are incurring a capital gain. This gain is subject to either a long or short-term capital gains tax rate depending on how long you have held the ETH for.
If you purchase the NFT artwork using depreciated ETH, you are incurring a capital loss. This can be used to offset other capital gains in order to lower your tax liability.
If you are trading NFTs, you will also trigger a taxable event, but one that is dependent on the net increase in value of the NFT in relation to that which you traded it with (at the time of the transaction). So if you trade one NFT valued at $1000 for another and within a few months it increases in value by $500, you will have incurred a taxable capital gain of $500.
The same principle applies to selling an NFT for cryptocurrency. So the profit that you make in selling your NFT for ETH over the value at purchase will incur a taxable capital gain. Equally, if you make a loss, it will incur a taxable capital loss.
Know what you are getting into with NFTs
NFTs are still in the early stages of growth and the current tax obligations are likely to be formalized in the near future as we see a continued increase in adoption of them and cryptocurrency in different forms.
With the current legislation, it is important to always stay on the side of caution and account for a worst-case scenario to avoid any surprises at the end of the tax year. Considering most NFT platforms do not currently issue Form 1090’s for transactions, you should stringently keep track of all values, before and after transactions, to be on the safe side.
Alternatively, you can always contact our team and we will ensure that your NFT and crypto books are being kept correctly.