In today’s digital economy, the concept of virtual currencies, such as Bitcoin and Ether, have remained a mystery to many. Throw in non-fungible tokens (NFTs) and the confusion grows. This appears to be true with the Internal Revenue Service (IRS) as well.
The IRS has only ever issued two items on Cryptocurrency. In March 2014, the IRS issued Notice 2014-21, stating that cryptocurrency was to be treated as property rather than currency for U.S. federal income tax purposes. This gave some clarity on the tax implications of cryptocurrency transactions, but also left many unanswered questions. Five years later on Oct. 9, 2019, the IRS issued guidance on cryptocurrency transactions when it released Revenue Ruling 2019-24. This Revenue Ruling discusses the tax implications of two previously unsettled areas of tax law: “hard forks” and “air drops.”
In 2020 the IRS added a question to the top for the Federal Form 1040 Individual Income Tax return asking, “Did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” All that is required is a simple “yes” or “no” without opportunity for further detail. This left many wondering how well the IRS understands these transactions. Additionally, what about NFTs and other digital assets that do not fall under the virtual currency umbrella?
Recently, it appears the IRS is catching up. On Oct. 19, 2022, the IRS updated draft instructions for the 2022 tax year to replace the term “virtual currency” with “digital assets.” The Treasury Department’s tax division published a document classifying NFTs as digital assets, alongside virtual currencies, and released the following statement: “Digital assets are any digital representations of value that are recorded on a cryptographically secured distributed ledger or any similar technology. For example, digital assets include non-fungible tokens (NFTs) and virtual currencies, such as cryptocurrencies and stablecoins. If a particular asset has the characteristics of a digital asset, it will be treated as a digital asset for federal income tax purposes.”
With this change, perhaps the IRS has now set its sights on this new source of tax revenue. So, what does this mean for those involved with NFTs?
Background on NFTs
Non-fungible tokens (NFTs) are just that – non-fungible. This means they are unique and cannot replace something else. Virtual currency, such as Bitcoin, is not unique in that you can replace one Bitcoin with another and still have the same item after the trade, even if at a different value. Most NFTs are digital assets that represent a real-world asset, such as art, music or a video. This is what we traditionally relate to NFTs.
However, the global digital environment is rapidly expanding to use NFTs in business as well, such as in real estate. NFTs can be used to represent the ownership of real-world property, either in its entirety or through fractional ownership. We will see more and more NFTs held as collateral and in lease arrangements. “Smart Contracts” are also on the rise. These uses are gaining popularity because of the blockchain technology behind them. The blockchain online-ledger keeps track of who is holding and trading the NFTs and is a way to store data without having to trust any one company or entity to keep things secure and accurate.
Buyers of NFTs generally tend to live in the digital space and prefer the ability to buy and sell these unique tokens online, with the security of the built-in authentication serving as proof of ownership. It is an area that few understand and are hesitant to enter.
Tax Implications of NFTs
With the minimal guidance provided by the IRS thus far, it has left tax advisors with the only option of extrapolating existing tax code for proper tax treatment of NFTs. Because an NFT generally represents some other “real-world” asset, is it important to look at the underlying asset and how it would be taxed if “physical” and not “virtual.” The IRS does not and will not in the immediate future transact in any other currency than the U.S. dollar. Therefore, all transactions must come back to the U.S. dollar equivalent in some way for income tax purposes.
When determining the tax treatment of NFTs, there are several questions that must be asked:
- What is the taxpayer’s role with the NFT?
- To what extent does the taxpayer interact with the NFT?
- What are the underlying assets?
- What currency was used to create or buy the NFT?
- What is the holding period?
All of these questions determine when and how (at what tax rate) the taxpayer will be taxed on their NFT transaction.
Creation of NFTs
Creators are taxed at the time they mint or sell the NFT. “Minting” an NFT is simply and uniquely publishing a token on the blockchain to make it purchasable. Minting an NFT made from scratch requires access to a crypto blockchain and an NFT marketplace. The minter must first create a digital wallet to purchase a small amount of cryptocurrency to cover the cost of minting the NFT. That digital wallet is then linked to an online marketplace (such as Rarible, OpenSea or Zora).
This is where the taxation of product creation is a bit different from the traditional sense. If you are an artist using traditional canvas and paint mediums, you use your U.S. dollar currency to purchase the supplies. That becomes the cost basis for your project. When you sell the artwork, you can then deduct that initial cost against your proceeds to derive your gain.
Because the minting of NFTs is done using a digital wallet, taxation may occur during the actual minting process, not just upon the sale of the digital token.
For example, assume John desires to mint an NFT. He sets up his digital wallet and purchases 0.5 Ether (ETH) for $500. Then at the time he actually mints his NFT, the 0.5 ETH is now worth $1,500. Even though John has not sold his NFT, he will have to recognize a gain the on minting transaction of $1,000.
The tax rate that John applies against this $1,000 gain will depend on two factors – how long he held the original Ether, and his overall involvement in minting the NFT. If John is a “hobbyist” creator and may only mint one or two NFTs in his lifetime, the minting may not be deemed a “trade or business” and would be subjected to capital gains tax. The capital gains rate will be dependent on how long John held his Ether before using it in the minting of the NFT. If less than 365 days, the gain will be short-term and subject to regular ordinary tax rates, which are currently as high as 37 percent. If held more than 365 days, the gain will be deemed long-term and subject to the preferential capital gain rates of either 0 percent, 15 percent or 20 percent, dependent upon his overall income tax bracket. The additional 3.8 percent net investment tax may also apply depending on John’s adjusted gross income. This gain would be reported on Schedule D of his personal income tax return.
If John is a “professional creator” and in the trade or business of minting NFTs, meaning that he will create future NFTs and this is his “line of work,” the gain will be deemed ordinary business income and subject to his regular ordinary tax rate. John would report this gain through his business entity. If he has set up a separate entity, it would be reported on the entity income tax return, and either be taxed at the entity level or flow through to his personal return. If no separate entity is established, he would report this income on Schedule C of his personal return and may be subject to self-employment taxes.
Regardless of how the gain on the minting of the NFT is taxed, John will now have a basis in the NFT of $1,500.
Sale of NFTs
The sale of an NFT will always be a taxable event. The taxation of the sale will again depend on the same factors above – holding period and trade or business intent.
In our example, assume John is once again a hobbyist creator and sells his NFT after holding it for less than 12 months for 10 ETH, which at the time of sale was the equivalent of $30,000. John retains his basis of the $1,500 he generated when he minted the NFT. Therefore, he will now report an overall gain of $28,500 on his tax return. As a hobbyist, it will be deemed investment income and taxed as a capital gain. However, since he held it less than 12 months it will be reported as a short-term capital gain and subjected to ordinary income tax rates. If he held it longer than 12 months, it would be taxed at the preferential long-term capital gain rates. The gain would be reported on Schedule D of his personal income tax return.
If John were a professional creator, he would report an ordinary business income of $28,500. However, he could also deduct from that any related business expenses he incurred as part of his “trade or business.” The income would again be reported based on the entity type he has created for his business, or on his personal return on Schedule C. A professional creator may want to carefully consider entity selection and the tax impact of each before beginning the NFT creation process.
Royalties
As with any other tangible or intangible asset, earning royalties from an NFT you own is a taxable event. Royalties are deemed ordinary income, regardless of whether the NFT is held for business or investment purposes. If the royalties are paid in cryptocurrency, the income recognized will be based on the value of the crypto at the time of receipt of the royalty payment.
The IRS has not issued any guidance about NFT royalty income. However, it is likely treated as business income if you are actively involved in minting NFTs. Alternatively, a one-off sale that generates royalties could likely be reported as passive income on Form 1040 Schedule E.
For example, assume John receives 1 ETH in royalties, and at the time of receipt, 1 ETH is worth $4,000. John the “hobbyist creator” will report $4,000 of royalty income on his personal return on Schedule E. John the “professional creator” will report the royalty income as business income, potentially subject to self-employment taxes.
NFTs as Investments
The majority of individuals involved with NFTs will be investors that buy and sell NFTs for speculative purposes. They are not the creator. For NFT investors, taxes work similarly to the way they work for crypto trading.
Purchasing an NFT maybe a taxable event if cryptocurrency is used in the purchase. Similar to minting, the change in value of the crypto used is taxable at the time of use.
For example, assume Mary purchases an NFT on Jan. 1, 2022, using 1 ETH, valued at $1,000 on that date. Mary acquired that 1 ETH several years ago for $200. When she purchases the NFT, she will incur a long-term capital gain of $800 because she held the ETH for more than 12 months before disposing of it to purchase the NFT. The long-term capital gain rate will gain depend on Mary’s personal tax bracket and will be reported on Schedule D of her income tax return. If Mary had held that 1 ETH less than 12 months, the gain would be short-term and subject to Mary’s ordinary tax rate.
Since Mary has reported this gain, she has stepped up the basis in her NFT to the $1,000. When selling the NFT, Mary will be taxed on the sale, regardless of the currency received. If Mary were to sell this NFT in April 2022 for $10,000, she would have a short-term capital gain of $9,000. If sold after January 2023 for $10,000, it would be long-term capital gain of $9,000.
Accounting Method for Cryptocurrency
When using cryptocurrency in NFT transactions, the accounting method used to value the crypto is important. The general, default method would be first-in-first-out (FIFO). This means that you use or sell the first crypto you acquired, and at that cost basis. So, for example, if Bill buys 1 ETH each on January 2021, September 2021, and May 2022 for $1,000, $3,000, and $2,000 respectively, and then uses 1 ETH to mint his NFT, he will use the cost basis of $1,000 in his gain calculation, as that was the “first-in.”
The IRS does recognize two other methods. Last-in first-out (LIFO) and highest-in first-out (HIFO). In the above example under LIFO, Bill’s basis would be the 1 ETH that he bought in May 2022 for $2,000. Under the HIFO method, it would be the highest basis amount, or the $3,000 he bought in September 2021.
If Bill were to mint his NFT in December 2022 and use the 1 ETH, which in December 2022 is now worth $2,500, his gain would vary dependent on the accounting method he chooses. Under FIFO and LIFO he would report a gain of $1,500 and $500 respectively. However, under HIFO, the basis would be higher than the current value and Bill would recognize a loss of $500.
According to IRS guidance, you can use a specific identification method like LIFO or HIFO if you have records containing the following information: 1) the date and time each unit was acquired; 2) the basis and the fair market value of each unit at the time it was acquired; 3) the date and time each unit was sold, exchanged, or otherwise disposed of; and 4) the fair market value of each unit when sold, exchanged or disposed of, and the amount of money or the value of property received for each unit.
Using HIFO or LIFO instead of FIFO may help save on current taxes. However, FIFO is used by most investors since it is considered the most conservative accounting method. HIFO and LIFO should only be used if detailed records of crypto transactions are kept
Collectibles
In some instances, the NFT created or acquired and sold may be deemed a “collectible.” In this case the preferential 0 percent, 15 percent and 20 percent capital gains rates may not apply. The gain on the sale of collectibles is subject to a 28 percent capital gains rate, regardless of the tax bracket of the taxpayer.
As previously discussed, the taxation of the NFT in dependent on the underlying asset. The IRS defines collectibles as “(A) any work of art, (B) any rug or antique, (C) any metal or gem, (D) any stamp or coin, (E) any alcoholic beverage, or (F) any other tangible personal property specified by the Secretary for purposes of this subsection.”
Because many NFTs are digital “art,” they may fall under this definition. While further clarification from the IRS is required before any definitive determination can be made as to when or if an NFT is a collectible, many conservative taxpayers are advised to report NFT gain as collectible gain when the NFT involves an image that can reasonably be considered “art.”
Sales Tax
Many states currently have laws in place to apply sales and use tax to digital goods. U.S. sales tax laws have yet to provide specific guidance on NFTs. For those that create and sell NFTs for investment purposes, sales tax may not apply under casual sale laws. However, for those that are professional creators, the collection of sales tax may be required.
Washington and Pennsylvania have become the first states to issue sales tax guidance specifically around NFTs. On July 1, 2022, Washington released detailed guidance around the state’s treatment of NFTs. The guidance explains the taxability of NFTs and common issues in applying sales tax.
The most concerning issue is determining in which state the sale should be sourced for sales tax purposes. Earlier on May 22, 2022, Pennsylvania released guidance for all retailers within the state. Under the section for Computer Hardware, Digital Products and Streaming Services, the state newly identified NFTs as being taxable. However, unlike in Washington, there was no specific guidance or explanation accompanying the decision as to how the state expects a taxpayer to apply tax to sales of NFTs.
Foreign Reporting
Under the Foreign Bank Account Report (FBAR) regulations, foreign financial assets are required to be reported by all U.S. taxpayers if the account balance exceeds $10,000 in any account at any time during the tax year. Currently, the FBAR regulations do not define a foreign account holding virtual currency as a type of reportable account. However, in December 2020, the Financial Crimes Enforcement Network (FinCEN), which oversees FBAR reporting, issued Notice 2020-2 announcing a proposed rule that would amend the regulations regarding reports of foreign financial accounts to include virtual currency as a type of reportable account. In June 2022, FinCEN announced that it will soon propose new regulations affecting cryptocurrency holdings at foreign exchanges.
NFTs are defined as property by the IRS. So, should they be reported as specified foreign financial assets on Form 8938? Form 8938 is required to be filed by all U.S. taxpayers as part of the individual income tax filings for: 1) any financial account maintained by a foreign financial institution; 2) other foreign financial assets held for investment that are not in an account maintained by a U.S. or foreign financial institution; or 3) any financial instrument or contract that has as an issuer or counterparty that is other than a U.S. person. While there is currently no specific guidance, it may be better to be “safe than sorry” and report any NFTs held in foreign accounts on Form 8938. Failure to report foreign financial assets can result in significant penalties.
For more information on cryptocurrency and NFT taxation, please reach out to Nicole Suk, or your Windham Brannon advisor.
