Loyola University Chicago School of Law, JD 2023
The popularity of NFTs has been rapidly increasing over the past year, but regulations and guidance relating to the tax consequences of buying and selling NFTs has been slow to keep up. Despite also living on the blockchain, NFTs and cryptocurrencies are not created equally in the eyes of the IRS. The IRS has addressed the rising popularity of cryptocurrencies and published guidance for crypto-investors but has not yet published any specific guidance for NFTs. This leaves many investors in a position of uncertainty regarding the tax consequences of their investments.
What are NFTs?
Non-fungible tokens (NFTs) are currently one of the most popular digital assets. Each asset is a unique digital code representing a specific item of text, image, video, or music, and can sometimes include additional information about the content as well as embedded rights. NFTs are typically purchased and sold using the specific type of cryptocurrency or digital token used or accepted on the particular blockchain that hosts the data comprising the NFT. The increasing popularity of NFTs is reflected through the dramatic prices customers are willing to pay for these collectible items. In the third quarter of 2021, NFT sales reached $6 billion, up from $22 million in 2020. In March 2021, Christie’s became the first major auction house to sell a fully digital, NFT-based piece of artwork, fetching a sales price of just over $69 million.
What happens when NFTs are sold or exchanged?
Unlike conventional assets, the tax consequences of NFT sales or exchanges are unclear. The IRS has addressed cryptocurrency, digital tokens, and other cryptocurrency-related digital assets, but none of these pronouncements have addressed NFTs. The guidance issued by the IRS that many NFT investors look to consists of Notice 2014-21 (2014-16 I.R.B. 938) and the 2019 Frequently Asked Questions (FAQs) relating to convertible cryptocurrency taxation, which apply the same general tax principles from property transactions to convertible cryptocurrency transactions. Although these relate to convertible cryptocurrencies, and therefore do no address non-convertible cryptocurrencies such as NFTs, it is expected that many other cryptocurrencies and tokens will likewise be subject to the property framework for tax purposes.
Due to the lack of clear guidance from the IRS about how NFTs will be taxed, the tax consequences of a sale or exchange of an NFT depends on a number of factors, such as whether the seller created the NFT; whether the seller is a dealer, trader, investor, collector, or personal user; how long the seller has held the NFT; whether the NFT has appreciated in the seller’s hands; what type of property is used to purchase the NFT; and, if the buyer used appreciated property to buy the NFT, how long the buyer held the property. For example, if you are an artist who creates and sells NFTs, or if you are a dealer whose business is buying and selling NFTs, you will realize income at the time of the sale and will likely be able to deduct ordinary and necessary business expenses from that income. However, if you are a non-creator or non-dealer, selling or exchanging an NFT will result in the same tax consequences as selling a capital asset – which then requires determining whether any resulting gain will be classified as a short- or long-term capital gain. If the gain is a short-term gain (meaning the asset was held for less than twelve months before the sale or exchange), the transaction could be subject to the maximum thirty-seven percent marginal rate if the taxpayer is in the highest tax bracket. If the gain is a long-term gain (meaning the asset was held for more than twelve months before the sale or exchange), the transaction would be subject to a maximum twenty percent capital gains tax rate, plus an additional 3.8 percent Net Investment Income (NII) Tax for high-income taxpayers.
Beyond the property framework, there is also a possibility that NFTs will be classified as collectibles, resulting in a twenty-eight percent tax rate, plus the additional 3.8 percent NII Tax. The Internal Revenue Code defines “collectible” as including any work of art, any rug or antique, any metal or gem, any stamp or coin, or any alcoholic beverage (IRC § 408(m)). Due to the unique nature of many NFTs, similar to works of arts or other traditionally “collectible” item, it is likely that NFTs will be treated as collectibles, at least for NFTs qualifying as works of art, rather than for NFTs that reflect ownership or provide for experiences.
In addition to the potential federal tax consequences outline above, buyers and sellers of NFTs should be aware of any potential state taxation on NFT transactions, including state income tax, sales tax, and use tax.
How can buyers and sellers calculate gain or loss on NFT transactions?
NFT marketplaces currently do not provide buyers and sellers with any tax documents or transaction history reports. As a result, buyers and sellers should keep detailed records of any transactions involving NFTs and take care to correctly calculate their basis in the asset. Taxpayers should also carefully ascertain the market value in order to correctly calculate gains or losses using the tax treatment for property transactions as a general guide.
Due to the complexity and novelty of the NFT space, buyers and sellers should seek the advice of legal counsel when preparing their tax returns to ensure accurate reporting and avoid any omissions or errors.