NFT Tax Overview: Considerations for Creators and Investors

Non-fungible Tokens (NFTs) have exploded in popularity over the last several years, and as investors begin to consider their 2021 tax filings, uncertainty exists with respect to how the Internal Revenue Service (IRS) wants taxpayers to report these transactions. To date, there is limited guidance on the federal taxation of cryptocurrency. In Notice 2014-21, the IRS set out its position that virtual currency is considered property for tax purposes. Since then, an FAQ and additional non-authoritative guidance issued by the IRS have failed to address the taxation of NFTs, leaving taxpayers to speculate on the proper treatment.

NFTs are units of data stored on a blockchain that can be transferred or sold. Although most laypeople think of NFTs as artwork, they have a number of applications in music, gaming and now the virtual world or “metaverse.” Unlike cryptocurrency, each NFT represents a specific asset — digital or physical — that is not mutually interchangeable with any other NFT. This means that NFTs are not “fungible” like cryptocurrencies, even though it may seem as though they are traded or exchanged in the same manner. This distinction has led to additional uncertainty for taxpayers.

   

Minting NFTs

Creating or “minting” an NFT usually involves some expense, but can be done with relative ease on a platform like OpenSea or Rarible. Generally, the creation of an NFT is not a taxable event, but the creator should expect an ordinary income event upon disposal. In addition, certain NFTs provide ongoing royalty-type income to the creators through a smart contract that establishes a transaction fee when it is later exchanged in a secondary market. However, the type of taxpayer minting the NFT can still impact the effective rate on sale:

 

Determining whether an activity is a trade or business or a hobby is a facts and circumstances exercise and should be examined with the help of an experienced tax advisor.

 

Investing in NFTs

Despite the lack of IRS guidance, the broader tax community seems to have acknowledged that the most commonly traded NFTs — digital artwork like CryptoPunks — are collectibles, meaning they carry a 28% capital gains rate pursuant to IRC Section 1(h)(4) (versus a 20% rate for other capital assets). This position would appear to be conservative, as any non-creator of an NFT is typically buying the asset in an investment or “capital” capacity that otherwise could take advantage of the lower rate. These investors should keep in mind that when they transfer a cryptocurrency, for example Ethereum (ETH), to acquire the NFT, they will need to recognize any gain or loss on the ETH at such time, and the current value will also set their cost basis in the NFT.

   

NFTs as Securities or Commodities

Among the current ambiguities that cross tax and financial regulation is whether NFTs could be considered “securities” or “commodities” for tax or regulatory purposes. For tax purposes, special rules under IRC Section 475 require dealers in securities (and permit traders in securities) to account for gains or losses on securities on a mark-to-market basis.

Dealers and traders in commodities are likewise permitted to apply a mark-to-market method of accounting. Although it seems clear the more commonly traded collectible-type NFTs would not be securities or commodities as those terms are currently defined under Section 475, without more concrete guidance taxpayers should examine their positions carefully. 

   

NFTs now represent a broad class of investments, from collectibles to more financial-type assets. As the applications advance, the existing consensus on the tax treatment of NFTs may change. Moreover, recently proposed legislation makes clear that Congress is focused on modernizing existing tax rules to address cryptocurrency (and NFTs), which could include an expansion of the rules under Section 475 to apply to items such as NFTs.

 

NFT Ventures 

As an example, individuals pooling money in a single crypto wallet to buy and sell NFTs may be carrying on a tax partnership without realizing it. Consulting with a tax advisor on this issue can prevent delinquent and amended filings and help the investors understand their future tax liabilities, possibly leading them to restructure into a more favorable tax profile.

   

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