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.”
Later 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 their sights on this new source of tax revenue. What does this mean for the 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. Most NFTs are digital assets that represent a real-world asset, such as art, music, or a video. 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, and “Smart Contracts” are also on the rise. These uses are gaining popularity because of the blockchain technology behind them, which keeps track of who is holding and trading the NFTs and acts as 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 like 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.”
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 extend 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 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. 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. If someone is a “professional creator” and in the trade or business of minting NFTs, the gain is considered ordinary business income and subject to tax, and reported gains would be through the business entity.
Sale of NFTs
The sale of an NFT will always be a taxable event. The taxation of the sale will again depend on the holding period and trade or business intent. Gains would be deemed investment income and taxed as a capital gain – if held less than 12 months, it is reported as short-term capital gain; if held for longer, it would be taxed at the preferential long-term capital gain rates.
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.
NFTs as Investments
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.
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. The IRS does also recognize last-in first-out (LIFO) and highest-in first-out (HIFO). 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
NFTs are defined as property by the IRS. As such, 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 US 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 at [email protected].
