Non-fungible tokens (NFTs) are collectible digital assets created in limited quantities to maintain scarcity.
The interest in NFTs has been re-ignited by the recent upsurge in cryptocurrency markets. For example, Michael Joseph Winkelmann, a digital artist known professionally as Beeple, recently sold his one-of-a-kind digital collage named “Everdays: The First 5,000 Days” for $69 million. The New York Times sold this column as an NFT for $560,000 in March 2021. Thousands of other creators have made their NFTs available for sale in marketplaces like SuperRare and Nifty Gateway.
Taxation in general
The IRS has not issued any NFT specific tax guidance yet. However, NFTs are likely treated as “collectibles” under tax code Section 408(m)(2). Although not specifically defined, according to the Section 408(m)(2)(A) “any work of art” is considered a collectible.
The taxation of NFTs depends on how you interact with them. There are two ways you can be involved with NFTs: You can create and sell NFTs in a marketplace, or you can buy and sell NFTs as an investor.
NFT creators are subject to ordinary income taxes and self-employment taxes
Creators are the artists who create NFTs and offer them for sale in marketplaces like SuperRare and Nifty Gateway. Creators encounter a taxable event when they sell NFTs. Say Adam created an NFT art and sold it for 2 ether (ETH) valued at $2,000. He would report $2,000 as ordinary income. This income will also be subject to self-employment taxes. If he is in the trade or business of creating NFTs, he can also deduct ordinary and necessary business expenses to offset income.
NFT investors are subject to capital gains tax
Investors are individuals who buy and sell NFTs for speculative purposes. Generally, most people fall into this category.
For NFT investors, taxes are similar to those for cryptocurrency trading. NFTs are often purchased using cryptocurrencies like ether. Purchasing an NFT using Ethereum triggers a taxable event because you are disposing of a cryptocurrency, which is treated as a property per IRS Notice 2014-21.
Say, David purchased an NFT valued at $2,000 (1 ETH) in January 2021. To make the purchase, he used 1 ETH purchased at $200 several years ago. When he purchases the NFT in January, he would incur a long-term capital gain of $1,800 ($2,000 - $200). This is considered long-term because the holding period of the ETH is more than 12 months. Long-term capital gains are taxed at either 0%, 15%, or 20% tax rates. The cost basis of the NFT purchased would be $2,000.
If David sold this NFT in March 2021 for $10,000, he would have a short-term capital gain of $8,000 ($10,000 - $2,000). In this case, the gain is short-term because he only held on to the NFT for less than 12 months before selling. Short-term gains are taxed at your ordinary income tax rates.
High-net-worth individuals are subject to a higher tax rate on NFTs
Since NFTs are likely considered “collectibles” as explained earlier, it exposes high income earners (single filers with over $441,450 of taxable income and married filers with over $496,000 of taxable income) to a 28% tax rate on collectible gains vs. the highest 20% tax rate on regular cryptocurrency and stock long-term capital gains. High income earners will also have to pay the 3.8% net investment income tax in addition to the highest 28% tax rate on collectibles.
How to report NFTs on taxes
For 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). Under Section 162, creators can deduct any ordinary and necessary business expenses from the income recognized. Common expenses include auction fees, transaction fees, subscription fees, or any other expenses incurred in connection to NFT sales income.
Investors can use Form 8949 (Sales and Other Dispositions of Capital Assets) and Schedule D (Capital Gains and Losses) to report dispositions of cryptocurrency to purchase NFTs and the subsequent sale of NFTs. Make sure to enter code “C” on Form 8949 column (f) to indicate a sale of collectible.
There is no robust information reporting mechanism in place in the cryptocurrency space. In other words, participants do not generally get 1099 forms with cost basis information from NFT platforms. Therefore, it is extremely important to keep detailed records of cost basis and market value information of the cryptocurrency used to purchase NFTs and the NFTs themselves. This information is required to correctly calculate your capital gains and related taxes.
Trading NFTs generally requires receiving, sending, or selling a cryptocurrency. Therefore, if your client dealt with NFTs during 2020, make sure to check “Yes” on the virtual currency question on the front of Form 1040—“At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Shehan Chandrasekera is head of tax strategy at CoinTracker. Shehan is one of the handful of CPAs in the country who is an operator and conceptual subject matter expert on cryptocurrency taxes. Prior to CoinTracker, Shehan co-founded and worked for several regional and national public accounting firms for several years.
Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.