You may not have any personal interest in non-fungible tokens (NFTs). But as a tax professional, it’s important to know if and how NFTs are taxable.
NFT sales totaled $24.9 billion in 2021, a remarkable 26,138% increase from $94.9 million in 2020, according to DappRadar data reported by Reuters. More recent DappRadar data shows that 2022 NFT sales remain in the billions, despite lower year-over-year trading volume.
Now, the tax and accounting industry is playing catch-up.
So, what are NFTs? Do you pay taxes on NFTs? If there’s an NFT tax, then what’s the NFT tax rate? Here’s a breakdown of what you need to know to help clients properly report their NFT activity.
What are NFTs and how do they work?
NFTs are digital assets with unique identification codes. These codes give NFTs important economic properties: exclusivity and scarcity. Before NFTs, all digital assets were inherently fungible—that is, interchangeable. If you and your coworker both downloaded the same e-book, you could trade your files without gaining or losing value. If one of you were to upload the e-book to an illegal pirating site, its scarcity would effectively become zero. Visitors could make interchangeable copies ad infinitum.
Money is another classic example of a fungible item. If you and your coworker both have a $10 bill, you can trade them and be left holding the same value.
But let’s say you both had the same Mike Trout baseball card. Yours is covered in coffee stains; your coworker’s is pristine. These items are non-fungible. Your coworker would be a fool to trade with you. She’d be left holding significantly lower value!
NFT technology makes it possible to create non-fungible assets in the digital space for the very first time. For example, the author of that e-book might sell a limited number of files as “first edition” NFTs. If you purchase one of these NFTs, it is no longer interchangeable with your coworker’s file, even though the words inside are the same. After all, yours is a first edition. It’s worth more!
NFTs also solve a second problem: proof of ownership. If possession is nine tenths of the law, it gets tricky when your asset is a pattern of 1s and 0s that anyone can copy. That’s why NFTs log transfers of ownership on a public blockchain.
Blockchain technology creates an online public ledger of transaction records. In the same way they track cryptocurrency trading, blockchain-based networks document NFT transactions in public view.
By leveraging the publicly distributed, immutable nature of blockchains, all NFTs can be stored in a transparent way, allowing anyone to check the authenticity of any NFT at any time.CoinDesk, February 2021
NFTs are bought and sold across various online marketplaces, many of which exclusively use cryptocurrency. Ethereum’s blockchain is the primary home for NFT transactions at this time, although smaller competitors are also in the game.
The bottom line? Digital assets can now be made scarce, non-interchangeable, and exclusively owned. That means they can start to behave like other capital assets. No wonder the IRS has taken notice!
What are some examples of NFTs?
NFTs were originally invented to protect digital art. Many people still associate NFTs with art, but they have far wider applications. Any digital asset can be made into an NFT: artwork, music, videos, concert tickets, in-game items, and more. That Mike Trout baseball card? You can now buy it as an NFT!
Are NFTs taxable?
Yes. NFT transactions, like cryptocurrency transactions, should be treated as property for federal tax purposes. Both follow the same capital gains tax rate.
In October 2022, the Internal Revenue Service (IRS) adjusted its annual tax instructions to account for NFTs. An updated draft of the Form 1040 for 2022 replaced “virtual currency” with “digital assets” and explicitly recognized NFTs. This clarifies the taxability of NFTs for the time being, but instructions are likely to change in the future. The role of blockchain technology in the modern economy is still evolving and new regulations are inevitable.
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What is the tax rate for NFTs?
As mentioned above, NFTs should follow the same capital gains tax rate as any other capital asset. Assets held for less than 12 months are subject to the short-term capital gains tax rate (10-37%). If the asset is held longer than 12 months, then the long-term capital gains tax rate (0-20%) applies.
What constitutes a taxable event for NFTs?
NFTs follow the same logic as other capital assets.
- Buying or selling an NFT triggers a gain or loss and should be reported on the investor’s tax return. Advise your clients to document the value of the NFT at the time of the transaction, along with any transaction fees.
- If one NFT is exchanged for another, both parties are expected to report the gain or loss from the transaction.
- Creating an NFT is not considered a taxable event, as long as the NFT is not sold or exchanged.
- Receiving an NFT as a gift is not a taxable event for the recipient. If the recipient chooses to sell the NFT at a later date, then that transaction is taxable.
What about a state NFT tax rate?
So far, only two states have issued information regarding NFT tax implications:
- The Pennsylvania Department of Revenue has confirmed that NFTs are taxable, but hasn’t provided any further guidance.
- The Washington Department of Revenue published an interim statement providing legal definitions and examples of NFT taxation. Based on the information provided, NFTs could either be interpreted as a digital good or a digital service. The state plans to announce more comprehensive guidance in the future.
It seems likely that more states will eventually provide tax guidance on NFTs due to the overall growth of the NFT market. You can stay informed on NFT tax rate developments by following the latest communications from your state’s department of revenue.
The future of NFT taxation
The tax treatment of NFTs is still a relatively new area. More clarity may be coming down the road. For now, you can treat them like any other capital asset. Recommend to NFT investors that they carefully document all transactions. We suggest signing up for alerts on the IRS “Stay Informed” page and creating news alerts so that you can keep your clients informed of any IRS and state updates.
Feeling a more prepared for NFT taxes? Knowing how to pay taxes on NFTs could be another differentiator for firms looking to expand their expertise and enhance their value proposition for clients. NFTs look like they’re here to stay for the foreseeable future.
Disclaimer: The information contained within this document is provided for informational purposes only and is not intended to and must not be taken as a substitute for obtaining accounting, tax, legal, or other professional advice from a tax professional (e.g., an Enrolled Agent, CPA, attorney, etc.). No warranty or representation, express or implied, is made by SurePrep LLC, nor does SurePrep LLC accept any liability with respect to the information and data set forth herein. Distribution hereof does not constitute legal, tax, accounting, investment, or other professional advice. You should consult a professional advisor prior to acting on the information set forth herein.