Interested in NFTs? What You Need to Know Before You Invest

Interested in NFTs? What You Need to Know About How They Are Taxed Before You Invest

Non-fungible tokens (NFTs) are unique digital assets authenticated by a blockchain public ledger and have become a popular way to invest in artwork, real estate, music, sports cards, and even Tweets. Each token is distinctive and one of a kind, which differentiates it from Bitcoin and other types of cryptocurrency.

Recently, IRS Commissioner Charles Rettig stated that the Service is going to focus on uncollected taxes from cryptocurrency sales. The Individual tax Form 1040 for the 2020 tax year even includes a question at the top of the first page asking whether taxpayers have invested in cryptocurrencies.

Before investing in any type of cryptocurrency, it is important to be organized and to keep track of your cost basis. There are several key aspects regarding the taxation of NFTs.

Capital Gains Treatment

In Notice 2014-21, the IRS took the position that virtual currencies are “property” for tax purposes. NFTs are considered digital assets and would be treated as property like virtual currencies. Therefore, there is no taxable event when an NFT is purchased with cash and it would only be subject to taxation when sold, similar to a stock investment. Transactions in NFTs will give rise to capital gain or loss when they are sold for cash, exchanged for another NFT or cryptocurrency or when they are used as currency in a barter transaction to purchase another asset, like another NFT or cryptocurrency.

Example:

• An individual invests $10,000 in an NFT in April 2021 using a Binance coin purchased for $100 a few years earlier.
• In December 2021, the investor sells the NFT for $25,000.

For tax purposes, the investor is treated as if they sold the Binance coin and used the proceeds to purchase the NFT. Thus, the investor will recognize $9,900 ($10,000 – $100) of long-term capital gain on the deemed sale of the Binance coin, and they will acquire a cost basis of $10,000 in the NFT. In December 2021, the investor will recognize a short-term capital gain of $15,000 ($25,000 – $10-,000) on the sale of the NFT because they held it for less than 1 year.

Tax Rates

Long-term capital gain tax rates currently are either 0%, 15% or 20% depending on the taxpayer’s income. Short-term capital gains are taxed at the taxpayer’s ordinary income tax rate, which can be as high as 37% currently. The Net Investment Income Tax (NIIT) of 3.8% may also apply depending on the taxpayer’s Adjusted Gross Income (AGI).

NFTs are also considered collectibles under IRC section 408(m)(2). Because of this, NFTs are subject to tax at a maximum long-term capital gain rate of 28%. Collectibles generally include:

• Any work of art
• Any rug or antique
• Any metal or gem
• Any stamp or coin
• Any other tangible personal property specified by the Secretary

The above tax rates are subject to change as the President’s infrastructure plan makes its way through Congress. Because tax rates are generally expected to increase, investors with appreciated assets should consider whether to trigger capital gain now at current tax rates rather than wait until any future tax increases take effect.

State Income & Sales Tax

Taxpayers should also monitor guidance coming from states on the taxation of NFTs. Many states view the sale of an NFTs as a sale of an intangible asset. Each state also may have its own unique rules on the sourcing of the sale of intangible assets. Generally, states tend to follow the federal tax treatment of virtual currencies, with the exception that many states do not have a separate beneficial tax rate for long-term capital gain. Unlike sales of physical artwork and collectibles, NFTs are not yet subject to sales tax, but this may change in the future.

Author: Bryan Nachwalter, CPA | [email protected]