NFTs have been around since the early days of crypto but have become more mainstream starting in 2020. While many people have heard of NFTs, very few can describe them. I will discuss what an NFT is and how the IRS views them for tax purposes.
When most people think of NFTs, they think of virtual art. Common NFTs that have gone mainstream, aka the blue-chip NFTs, are Bored Ape Yacht Club (BAYC), Crypto Punks (Punk), and Smol Brains. However, NFTs are so much more than virtual art. NFTs refer to anything digital that can be tied to the blockchain.
A high-level view of the blockchain is a database of electronic information that is highly secured and is used to verify ownership of anything on it. An NFT needs to be tied to the blockchain since it is the blockchain technology that provides 100% proof of ownership and as the old saying goes, possession is 9/10ths of the law. In this case, owning property on the blockchain is easy to determine who the rightful owner is since the blockchain is secured by thousands of people verifying the data. There are also multiple layers to the blockchain currently in layers 1 and 2. Layer 2 is relatively new and was built on top of layer one to allow for decentralization, transparency, and security while reducing the carbon footprint (the gas fees used per transaction).
Now that you understand better what an NFT is, you may be wondering how to acquire one. Currently, most NFT’s are purchased through an online marketplace such as OpenSeas, LooksRare, and Trove. These online marketplaces sell NFTs using Ether as the currency needed to purchase them. Another common crypto used to buy NFT’s is Solana, which is a layer 2 project that can mint these NFT’s at cheaper gas fees. Ether is a cryptocurrency (crypto) that can be purchased from online central exchanges and is considered one of the major crypto coins along with bitcoin. To put the process in a simple format, you use the currency to purchase crypto on a central exchange and use crypto to buy NFT’s on an online marketplace.
Now let’s discuss the tax ramifications for each of these steps. In IRS Notice 2014-21, the IRS defines crypto as property and not a currency. Therefore, general tax principles applicable to property transactions apply. The IRS has also determined the character of gains associated with crypto is all dependent upon how the taxpayer uses it. Crypto is deemed a capital asset for investment purposes and capital gain rules would apply when the crypto is sold or exchanged. I mention exchanged here since crypto does not qualify for 1031 Like-Kind exchanges as of January 1, 2018, when the Tax Cuts and Jobs Act went into effect. The IRS upheld their ruling in Legal memo 202124008 that crypto no longer applies to Section 1031.
Before we can get to how the NFT itself is taxed, let’s walk through the taxable events that take place beforehand. Using a central exchange, Ether (ETH) is purchased. We will say ETH is valued at $3,000. We buy 3 ETH for $9,020. There is an exchange fee of $20 and we have purchased 3 ETH. The exchange fee is capitalized into the cost and our 3 ETH has a cost basis of $9,020.
With 3 ETH in our wallet, we go to OpenSea, an online marketplace for NFTs, and search for an NFT to buy. We will assume the price of ETH has not changed and we find an NFT for 2 ETH and purchase it, again incurring $20 in gas fees. We are left with slightly under 1 ETH in our Wallet and 1 NFT worth 2 ETH. The taxable event that took place here would be a capital loss of $13.34. Each ETH is worth approximately 3,006.67, therefore 2 ETH in our wallet has a cost basis of $6,013.34. Considering our cost basis of our ETH minus the value of purchase would trigger that $13.34 loss. The additional gas fee paid would be capitalized to the NFT and we would be left with roughly $2,980 worth of ETH or .99 ETH in our wallet. Since the exchange took place with a capital asset held under 1 year, it would trigger a short-term loss. Had the ETH been held for longer than a year before the purchase of the NFT a long-term loss would have happened. Since ETH is traded on a marketplace, there is the possibility of the value of ETH increasing or decreasing by the time you purchase the NFT which would trigger a larger capital gain or loss. In our example, had ETH decreased by $100 by the time we purchased the NFT, the loss would have been $213.34. In addition, since it is a capital asset, it is also subject to the additional 3.8% tax Net Investment Income Tax.
Assuming the first example where the price of ETH did not change, we now own an NFT with a cost basis of $6,020 ($6,000 for 2 Eth and $20 for gas fees). What can be done now? That all depends on the NFT purchased and whether there is utility. Utility means the NFT is more than just a jpeg picture. It means that it can be used to play a game, visit a real-life event, stake to earn rewards, etc. Both layer one and layer two NFT’s can have utility and each project can have its different utility.
Here we will assume we purchased a layer one NFT. If we are lucky to have purchased a blue-chip layer one NFT such as BAYC or Punk, we may see the value rise dramatically. The current floor price of BAYC or Punk is 78 ETH and 62 ETH, respectively. If we had a Punk and sold it for a 60 ETH gain (assuming zero tax basis), we would realize a capital gain of $180,000 (60 * $3,000). If the Punk was held under 1 year it would be a short-term gain and if more than 1 year it would be a long-term gain. The IRS has already concluded that NFT’s are capital assets, but what they have not yet determined is if they are considered collectibles. Per the IRS, collectibles are any work of art, rug or antique, metal or gem, stamp or coin, alcoholic beverage, or any other tangible personal property specified by the Treasury. While the IRS has not determined the status of NFTs, it can be assumed that the IRS would rule that they are collectibles since people consider NFTs art. If the IRS determines that an NFT is a collectible that increases the long-term capital gain rate from 20% to 28%, which is a significant tax increase. We would go from a long-term capital gain on our punk of $42,840 (180,000 * 23.8% (20% + 3.8)) to 57,240 (180,000*31.8%). In this example, being classed as collectible increases our taxes by $14,400.
As you can see investing in crypto can be highly confusing with lots of tax ramifications and pitfalls. It is important to keep track of all your purchases and consult with a tax professional. We will update this further as the IRS releases regulations around NFTs. Remember we are still early!!!