Non-fungible Token (the “NFT”) is very popular as an investment tool of the new era. It has expanded the world of designers and artists, as well as paving the way for the investment sector in this field. One of the most critical questions that come to mind while generating income from NFT investments is the taxation of such earnings, which is becoming more important day by day.
We have previously examined crypto taxation and evaluated the case studies within the scope of different jurisdictions. You may reach the relevant article here. This article will discuss the NFT taxes in the United States.
First, it is essential to examine what NFTs are and how they are classified in the United States. NFT is a unit of data stored in a digital ledger that confirms that a digital asset is unique, unduplicable, and interchangeable. Since they are unique, they give their owners digital ownership that can be proven. This ensures the protection of the owner's rights and technical security.
Due to the expeditious rise of the NFT market in 2021, taxation has been discussed by many public authorities. When it comes to tax, everyone's eyes are turned in the same direction: Internal Revenue Service (the “IRS”). The IRS has also stated that NFTs carry some risks as they can be used for money laundering purposes. The IRS also announced the warning dated 28 April 2022 and prepared by J5 (The Joint Chiefs of Global Tax Enforcement) on its website.
When examining taxation of the NFTs, it is also necessary to distinguish between taxable and non-taxable events to reach a final balance.
- Non-taxable events
Buying, donating, and transferring NFTs to different wallets are not considered taxable since the taxable event does not occur when the person does not have any income yet. So, unless the person sells the NFTs and gains income, actions such as creating, trading, and holding NFTs will not accrue any tax liability.
- Taxable events
Fungible cryptocurrencies have been classified as property by the IRS. Tax regulations still treat the NFTs as personal property even though they are not fungible. Even though the IRS has not yet published specific guidance about the NFTs, it is clear that transactions in cryptocurrency will result in taxable events. Moreover, since non-fungible tokens fall within the IRS's definition of virtual currencies, they will be subject to taxation, according to the IRS Notice 2014-2021.
Selling and trading NFTs with cryptocurrencies are considered taxable events. It is essential to distinguish the purpose of transactions related to NFTs as it changes the taxation type and rate. Creators, traders, and hobbyists differ in terms of taxation since the kind of income changes accordingly.
Creators are those who bring art into the digital world. The creators of the NFTs are the ones who create the NFTs, whether directly in the digital world.
Minting an NFT is not taxable as creating the NFT is not taxable alone. However, a taxable event occurs when there is an income generated from selling the NFT. If the creator acts for business purposes, s/he might need to pay self-employment tax.
Sometimes, depending on the type of smart contract that embeds the NFT, the creator of the NFT gets royalty if it is sold. Although it is still unclear due to lack of the IRS’ guidance, the creator might be liable for ordinary income tax for royalty since such transactions increase their income. It is essential to know that the creator might be responsible for both income and self-employment tax, depending on the circumstances.
If traders purchase an NFT with cryptocurrency, they might be liable for capital gain tax because of their increased value. Selling an NFT or trading it on the marketplaces such as OpenSea might cause liability for capital gain tax on the amount of increased value.
- Tax Rates
Collectibles are considered a type of capital asset with some rules. It is not clear what type of NFTs are considered collectibles. If an NFT is held as a collectible, the tax rate will be a maximum of 28%. Therefore, it is essential to evaluate whether your NFT is a collectible since the result changes your tax rate.
According to the IRC Section 408(m)(2), collectibles are;
- Any work of art,
- Any rug or antique,
- Any metal or gem (with limited exceptions),
- Any stamp or coin (with limited exceptions),
- Any alcoholic beverage, or
- Any other tangible personal property that the IRS regards as a "collectible" under IRC Section 408(m).
Today, the IRS has no other tangible properties listed as collectibles. This raises questions about whether the other items on the list, such as artwork, must also be tangible. At the end of the day, there are no clear guidelines. NFTs that do not fall into one of the categories above are not likely to be collectibles based on the tax regulations.
- Capital Gain Tax
Long Term: Long-term tax likely occurs if someone holds the NFT for 12 months and sells it later.
Short Term: Selling the NFT within 12 months of acquisition causes short-term capital gains. Currently, it is up to 37% of the profits. In that case, this tax rate applies independently from its likelihood of being collectibles.
- Income Tax
Hobbyists, one-time traders, or persons that do not have business purposes should pay income tax over the sales considered ordinary income and are currently taxed between 10%-37% at the federal level.
Play to Earn
With the rise of Web3, the industry provides its users to earn profits through Play-to-Earn (the "P2E") structured games where users trade their tokenized in-game assets. With such mechanisms, the beneficiaries would likely be liable for capital gains as they earn income by selling their in-game assets, which would cause a trade between cryptos. However, it is critical to evaluate the mechanisms of such games since their structure may differ for taxation purposes. For games such as Axie Infinity, where the players can buy and sell their NFTs in the marketplace, it is likely that their earnings might be subject to capital gain tax.
Airdropped NFTs are also considered ordinary income at the time they are acquired. The fair market value of NFTs should be considered to calculate the net income.
Gas fees are added to the transaction costs, like commission fees. Although the IRS has not provided any guidelines about crypto gas fees, it is assumed that it is likely that they will be accounted of a cost according to Publication 551.
Getting NFTs as a gift does not cause tax liability unless the value is under $16,000. In that case, the beneficiary may be liable for gift tax. It is important to note that selling the crypto with a profit also results in a capital gain tax payment.
It is still unclear if investors have the sales tax liability for selling their NFTs. As known, sales tax differs at state levels, so it is vital to communicate with local tax authorities. However, some states, such as Washington and Puerto Rico, allegedly lean toward regulating the taxation of NFTs as a sales tax. Many experts believe that NFT sales have already created a tax liability in states that tax digital goods.
- Tax Reduction
Reducing taxes will be helpful for your activities related to NFTs. Holding the NFTs for the long term -more than 12 months- is a way of reducing taxes since it imposes a lower tax rate. Another way is disposing of the NFTs when the annual income is low since the yearly income determines the tax bracket. Buying the NFT with fiat currency is also advantageous in reducing the tax since the coins' price matters while calculating the capital gains. Investments made with fiat currency do not result in capital gains since this method does not reflect a property sale. There is always a way to reduce taxes by claiming capital losses on tax returns if NFTs are sold at a loss.
- Reporting Taxes
Investors (who are not a company) should report their taxes with Form 1040, which is for individual income tax returns, and Schedule D for capital gains and losses. Capital gains and losses from capital assets should be reported through Form 8949. Creators acting for business purposes should report the income via Schedule C for profit and loss of business and Schedule SE for self-employment tax. It is essential to know that form changes as the types of businesses differ (such as C corporations, S Corporations, and partnerships). As collectibles are taxed independent of the rest of your capital assets, you may be able to report your capital gains and losses more accurately by filling out a separate Form 8949.
It is still unclear what the tax liability and the rates are since IRS has not officially issued a guidance on this issue. However, transactions related to NFTs, including profits, are considered taxable events and cause tax liability, depending on the type of transaction. It is crucial to follow any guidance that the IRS might adopt, and industry players should stay on alert.
This article examined the NFTs and taxwise liabilities arising from the NFT transactions. Cryptocurrencies are still in the grey area regarding legal, administrative, and taxation aspects. For detailed information and processes, please review the explanations and necessary documents of the IRS and consult your tax advisor.
As Vircon Legal, we will continue to inform you regarding NFT-related news and taxation.
1-https://www.irs.gov/pub/irs-utl/j5-media-release-4-28-2022.pdf (Accessed on: 21.05.2022).
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12- https://www.bankrate.com/investing/nft-tax-guide-top-tips-for-non-fungible-token-creators-and-investors/#:~:text=Investors%20and%20creators%20don't%20owe%20tax%20until%20an%20NFT%20sells&text=That%20income%20will%20be%20recognized,an%20NFT%20for%20a%20profit. (Accessed on: 21.05.2022).
13- https://coinledger.io/blog/how-are-nfts-taxed#do-you-pay-sales-tax-when-you-buy-nfts- (Accessed on: 21.05.2022).
14- https://www.coinbase.com/learn/your-crypto/understanding-nft-taxes (Accessed on: 21.05.2022).