2021 was the year NFTs exploded, with a staggering 21,000% increase from 2020. Unsurprisingly, just as the public became more interested in NFTs, so did the IRS. NFT creators and investors are looking for guidance from tax professionals, but with no explicit guidelines from the IRS, it’s up to tax experts to interpret and apply existing tax laws to NFTs.
To help you make the best decisions for your clients, we’re covering what every tax preparer should know about NFTs and taxes.
What are NFTs?
Non-fungible tokens (NFTs) can be any type of digital item such as a piece of art, a song, a news column, a trading card, or other collectible. Their ownership is verified and tracked using the blockchain, and they are usually bought and sold using cryptocurrency such as Ether.
How are NFTs taxed?
Since the IRS hasn’t issued guidance specific to NFTs, they are a point of confusion for many crypto traders and tax professionals alike. While NFTs aren’t technically cryptocurrency, they are blockchain-backed digital assets and face similar tax laws.
Like cryptocurrency, NFTs are usually taxed property and are subject to capital gains taxes. In some cases, NFTs may be subject to special tax rates for collectibles. And in the case of creators, profits from NFTs should be treated as income.
Creators of NFTs should regard any proceeds from the sale of their NFTs as regular income. Since NFTs are usually purchased with cryptocurrency, creators will need to keep records of the fair value in U.S. dollars of that currency on the day of sale.
If your client creates NFTs as a business, they can deduct the expense of creating and minting their NFTs from their taxable income. Income from their business will also be subject to self-employment taxes. If creating NFTs is simply a hobby, however, your client won’t face self-employment taxes, but they also won’t be able to deduct the associated expenses.
Investors & Collectors
Under usual circumstances, purchasing a tangible piece of art would not make the buyer liable for capital gains taxes. It’s only when that art is sold for a gain that the collector incurs tax liability. But because NFTs are almost always purchased with cryptocurrency, the tax implications are more complicated.
When an NFT is bought with Ethereum or another cryptocurrency (as they almost always are), this is a taxable transaction for the buyer. The IRS regards this as converting the cryptocurrency to “real,” government-backed currency like the U.S. dollar, and then using those dollars to purchase the NFT. If the currency grew in value from the time the buyer first acquired it to the time they “sold” it to buy the NFT, the purchase would result in capital gains.
Similarly, if the cryptocurrency had gone down in value, the purchase of the NFT would result in a capital loss. Selling an NFT for cryptocurrency also results in a capital gain or loss.
Again, it’s important for clients to keep records of the fair value of the cryptocurrency at the time of sale. Their net capital gains will be subject to either the short or long-term capital gains tax or the higher capital gains tax on collectibles (see below).
Are NFTs taxed as collectibles?
The IRS regards “any work of art” as a collectible, making these assets subject to a higher maximum tax rate of 28% instead of the usual capital gains tax rate. The list of items considered collectibles also includes a catch-all provision for “any other tangible personal property that the IRS determines is a ‘collectible’ under IRC Section 408(m).”
This has created a gray area for investors and tax professionals trying to interpret how the tax law relates to NFTs. Some NFTs are art pieces, but since they are not “tangible,” it’s unclear whether they should be considered collectibles.
Tax experts are divided on the issue, with some interpreting the law to mean that nearly all NFTs are collectibles, while others believe that because they are not “tangible,” they are not collectibles. Many take a reasonable middle ground, regarding only NFTs that are works of art as collectibles, while treating all others as regular capital assets. Until the IRS offers more guidelines, the issue will remain unsettled.
As a tax professional, it’s up to you to use your knowledge of the tax code and own best judgment when determining how to treat your clients’ NFTs. Just make sure that you’ve thoroughly reviewed the IRS’s guidelines on collectibles and digital currencies and can justify whatever position you take. For more help, see our guides on Cryptocurrency & Taxes, Reporting Stock Investments, and Capital Gains & Losses.