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A Guide to NFTs and Tax Law

On Behalf of | Feb 17, 2022 | NFTs

NFTs are one of the most popular types of cryptocurrency. As expected, the U.S. government has set its sights on a share of the profits from NFT sales. The market for nonfungible tokens has increased to $44 billion. Many creators of NFTs are not aware of the tax rates they may need to pay when they sell an NFT. When a sale places a person in the highest tax bracket, or they are already in the highest tax bracket. The IRS has stated that they are preparing to crack down on people trying to avoid paying income tax on NFT profits.

The Tax Rules Regarding NFTs are Not Clear

The taxation on the purchase or sale of an NFT varies depending on how the taxpayer uses the NFT. Existing IRS guidance can be used as a framework to understand how NFTs should be taxed. The IRS should prepare more detailed guidance as the NFT market grows. Many of the tax rules related to tokens are not crystal clear, making many NFT collectors and investors concerned that they may face penalties. You may think that since the IRS is not clear on its rules, you will not be held accountable for not reporting gains or losses correctly. Unfortunately, that is not the case. If you have questions about NFTs and tax law, one of the best things you can do is discuss your case with an attorney.

How Does the IRS Tax NFTs?

In most cases, non-fungible tokens are subject to the same tax laws as any other type of fungible cryptocurrency. The IRS treats NFTs as intangible property for federal income tax purposes. For example, if you are an artist who sold an NFT and earned money, you would need to report the proceeds from the sale as income on your tax return. Likewise, if you invest in an NFT, any profits you earn through sales or trades of the NFTs will be taxed as property.

NFTs are typically bought and purchased with cryptocurrencies. The IRS usually treats an exchange of a crypto asset for another crypto asset as a taxable transaction. Regardless of the use of the NFT, if you purchase an NFT with cryptocurrency, it could trigger a gain or a loss for the buyer and the seller. If the buyer has built-in gains or losses on the cryptocurrency, he or she may need to report the gain or loss. They will also be subject to capital gains tax. The most common types of activities that trigger the need to pay taxes related to NFT activities include the following:

  • Selling an NFT for cryptocurrency
  • Purchasing an NFT with a fungible cryptocurrency
  • Trading an NFT for another NFT

Tax Considerations for NFT Creators

Self-created intangible assets are considered non-capital assets under Section 1221 of the tax code. Artists who create NFTs for a living will typically recognize ordinary income. They will need to pay self-employment taxes when they sell NFTs. There are some differences between creating and selling NFTs for a living and creating and selling physical artwork.

Depending on whether the creator transfers “substantially all” or “limited” rights in their NFT, the tax consequences may be different. If the NFT creator transfers substantially all of the rights, it would constitute a sale. The creator would recognize ordinary business income equal to the excess of the sales price of the NFT that is required to be capitalized.

If there is a limited transfer of rights, the sale will be treated as a license for the purposes of federal tax purposes. In this case, the creator of the NFT would recognize royalty income which will be taxed at the ordinary tax rate. Even so, the creator could keep amortizing all of the capitalized costs for the term of the license. In both cases, the creator can and should deduct any qualifying expenses related to the creation of the NFT.

Dealers who purchase and sell NFTs during the ordinary course of business will have ordinary income since NFTs are considered inventory. Dealers of NFTs are allowed to deduct business expenses in connection with the sale of NFTs, including the costs the dealer pays to acquire the NFTs.

What if I Sell an NFT to Promote Another Product I am Selling?

What if the taxpayer does not hold an NFT for sale to another customer? Instead, they sell an NFT to promote a product they are selling. In these cases, the taxpayer may be able to qualify for long-term capital gains treatment when selling the NFT if they held it for over a year and the sale results in an overall gain for the year. If the sale of the NFT combined with the sale of other taxpayer’s assets results in a loss, the loss would be treated as an ordinary loss that can offset the taxpayers other ordinary income.

Tax Considerations for NFT Investors

If you are holding an NFT for investment purposes, you will probably qualify for capital gains treatment for the sale of your NFTs. Short-term capital gains are taxed at your highest margin tax rate. The tax rate may be as high as 37%. If a taxpayer holds an NFT for over a year, any gain will be subject to the preferential long-term capital rate. Many tax experts expect the IRS to treat NFTs as collectibles such as antiques, art, stamps, etc. These collectibles are taxed at a higher rate of 28%.

Contact an NFT Tax Attorney Today

Whether you are investing in NFTs or creating them, knowing the tax implications is essential. The more NFT transactions you engage in, the more complicated the process of calculating your NFT taxes. Most NFT platforms do not issue 1099 forms that show cost basis information. It is in your best interest to keep detailed records of the cryptocurrency you use to purchase NFTs and the actual NFTs. If you have questions about paying taxes on your NFT purchases or sales, speaking to an experienced attorney is crucial. Contact the experienced NFT attorneys atAU LLC as soon as possible.