The Complexities of NFT Taxation for Investors
Written by Matthew Boucher August 8, 2022
The following article is an opinion piece by the author and is not intended nor should it be considered to be tax advice.
Crypto currencies have been all over the news in the last few years and an unprecedented number of newly minted digital investors jumped into the market in search of the eye popping returns they have seen posted by social media influencers. Unfortunately, many of those new investors found those amazing returns can also come with the potential for brutal losses. The tax implications of major crypto currencies, like Bitcoin and Ethereum, have been well documented, and the IRS has even issued guidance on tax treatment for recognizing gains and losses, but the IRS has yet to release direct guidance on the taxation of NFTs. This article will focus on often misunderstood Non-Fungible Tokens (NFTs) and some of the potential tax pitfalls associated with them.
What is an NFT?
When you hear people talk about digital assets, NFTs are often lumped in with crypto currencies, but comparing NFTs to crypto currencies is like comparing apples to pancakes. Sure, they’re both food, but that’s where the similarities end. In the case of crypto currencies and NFTs they’re both digital assets built on a blockchain, but that’s again where the similarities end. So, what is an NFT? The simplest explanation is that they are a piece of digital artwork. When you think of NFTs, you may immediately think of the “Bored Ape” series of digital art pieces, but they can also be videos, music and even in-game items, like a special fancy hat for your avatar. You may ask, “What makes them different than music I’ve purchased online for years?” The answer to that question is the blockchain. This is where people confuse crypto currencies with NFTs, both of them are built on a blockchain architecture that ensures they can’t be counterfeited. We’re not going to go into the details of how a blockchain works here, but the fact that it ensures the provenance of an asset is what makes NFTs valuable. The creator of the NFT can limit the supply to only a few authentic pieces and then once they are “minted” they can’t be altered or reproduced. Every time the asset is traded or sold, it will be recorded on the blockchain. The creator of the NFT can even build in with a smart contract that pays them a royalty every time the asset is sold. With limited supply and guaranteed authenticity, we have a digital asset that starts to resemble invest grade pieces of art.
How are Gains taxed?
Now that we understand what an NFT is, we can apply tax theory to understand how NFTs are going to be taxed. There’s some difference of opinion on how exactly NFTs should be taxed, and this debate is being driven by the fact that the IRS has not yet released any guidance on the taxation of NFTs, as well as the fact that many tax preparers don’t fully understand emerging digital assets. Since NFTs are essentially pieces of unique art, they probably won’t qualify for normal capital gain treatment1. Instead, they will likely be subject to the tax rate on collectibles. This is a less favorable treatment since the long term gain rate on capital assets caps out at 20% while the long term gain rate for collectibles is 28%2. While this creates an unfavorable gain rate on NFTs, it is not the biggest pitfall of NFT investing.
How are Losses taxed?
As I said previously, the IRS has not yet released any guidance on NFTs which causes some of the murkiness around their taxation. If we continue with the logic that the IRS will ultimately classify NFTs as art, the losses associated with them become a bit more tricky. The first step in this process will be determining if the purchase of the asset was strictly for investment purposes with the anticipation of appreciation or if it was purchased for personal use and enjoyment. This can be a tricky determination for an NFT. You will need to determine for yourself which classification applies to the NFT in question, but we can look again at the taxation of tangible art pieces for some guidance. If an artwork was purchased and left in secure storage that protected it from degradation due to sunlight or other environmental effects it is normally a good indicator that it was purchased strictly for investment purposes3. If the artwork is displayed and the owner receives the enjoyment of seeing the artwork, that normally signifies that it is for personal enjoyment and would be classified as a personal use asset.
If the NFT is determined to be for investment purposes, the total losses for the year would need to be separated and follow the netting rules for each category2. This assumes that the purchase of the NFT was strictly for investment purposes. The taxpayer may be able to offset gains from other investments with the losses from the sale of the NFT.
If the NFT is determined to be a personal use asset, the losses will not be deductible against any other income or gain realized by the taxpayer2. That creates a significant risk if an NFT is purchased and then displayed.
With the recent meltdown in the crypto and NFT markets, there are likely millions of taxpayers who will be wondering how they should report their losses on their tax forms. Without additional guidance from the IRS on how they will interpret NFTs, taxpayers should consider seeking the advice of professional tax preparers with experience in digital assets.
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Footnotes:
1IRC Section 408(m)
2Publication 544 (2021), Sales and Other Dispositions of Assets
3IRS, Audit Technique Guide: Artists: Art Galleries (January 2012)