Cryptocurrency: Taxing NFTs

NFTs (Non-Fungible Tokens) have been around since 2014 (around the time the IRS started taxing cryptocurrency), but people only really started to notice them after the shocking sale of “Everydays: The First 5000 Days” on March 11, 2021 to Vignesh Sundaresan.

“Everydays” made history as the first NFT sold at a major auction house. This collection of 5,000 digital artworks garnered a whopping $69.35 million. It was the first NFT artwork to be sold at Christie’s or any such prestigious place – giving formal recognition to the value of digital ownership.

What was actually sold was not a physical painting, but the digital rights to a collection of computer-drawn images.

Value Is in the Eye of the Beholder

Vice News recently produced a documentary entitled “How NFTs Are Invading the Art World” in which they asked Sundaresan why he purchased a jpeg for such an outrageous amount of money. The crypto billionaire responded: “I knew that it [an esteemed auction house selling a digital photo] was an important moment in art history…and I think that NFTs will become much more valuable now.”

By 2021, the NFT market had transacted nearly $44 billion dollars, demonstrating that if people agree that something is worth money, it is automatically rewarded with value. This outrageous amount of money naturally attracted attention, not just from the general public but also from prospective NFT investors and creators. The IRS’s long nose has been officially sniffing around cryptocurrency since 2014, so it is not surprising that it discovered the NFT market years before Vignesh Sundaresan made his jaw-opening purchase.

What Exactly Are NFTs?

What a Non-Fungible Token is, lies in the essence of the name. So before we delve into the confusing tax regulations surrounding NFTs, let’s try to understand what they are.

Fungibility: To comprehend what “non-fungible” means, it first helps to know what something “fungible” is. “Fungible” assets are assets that are interchangeable. Take a ten dollar bill for instance. It can be exchanged for another ten dollar bill and still be the same thing. Similar logic applies to all cryptocurrencies: 1 BTC is the same as another 1 BTC; 1 ETH equals another 1 ETH.

Non-fungibility: “Non-fungible” items, on the other hand, cannot be exchanged for something else of equal value because they are completely unique in their identity – like a fingerprint. An NFT is a drawing, picture, GIF, song, video game avatar, digital accessory, etc. that has been uploaded onto the blockchain (a process called “minting”).

The blockchain is the decentralized, distributed ledger that makes peer-to-peer transactions transparent and irrefutable. It is the same network that maintains the security of cryptocurrencies, and preserves the integrity of the digital certificate of NFT ownership. An NFT, once minted, becomes a one-of-a-kind. It will never have an equal, like the original Mona Lisa – it will be as “authentic”, although certainly not as masterful.

NFTs Are Also Property

Your digital ownership of cryptocurrency and NFTs (which are purchased with cryptocurrency) are treated as property and upon sale, will be taxed at the appropriate capital gains tax rate.

Note that some NFTs (most commonly digital artworks) may fall into the “collectibles” category and be subject to higher long-term capital gains tax rates (up to 28% instead of 20%). Knowing which NFTs should be classified as collectibles can get very confusing, because technically each one is completely unique, and the IRS has yet to issue NFT specific tax guidelines. It is best to consult with a tax attorney about this before filing your tax return.

Is Buying an NFT with Crypto the Same as Buying Art with Cash?

NFTs that were purchased with cryptocurrency aren’t the digital equivalent of buying art with cash. Instead, the IRS implements a two-part transaction:

  1. The liquidation of cryptocurrency: When you buy an NFT, you “dispose” of your cryptocurrency. The proceeds of that sale of crypto will be subject to capital gains tax.
  2. The purchase of the NFT: You purchase your NFT with Ether (the second-biggest cryptocurrency by market cap after Bitcoin). The fair market value of the Ether (ETH) at purchase becomes the basis of your NFT.

Here’s an example:

Sheila bought 2 ETH for $5,000. After 366 days (when Sheila knows she’ll only have to pay at the long-term capital gains tax rate), her 2 ETH are worth $15,000. She wants to buy an NFT with those 2 ETH. Sheila’s annual income is $70,000, so her gain from the “sale” of her cryptocurrency is taxed at the 15% long-term capital gains tax rate (a $1,500 tax).

Sheila buys the NFT with her 2 ETH (which are regarded by the IRS as $15,000 being invested because that is their value at the date of purchase). Sheila will have to pay taxes on the proceeds of her NFT when she sells it. This will be a separate tax event.

Good Recordkeeping is Crucial!

The importance of writing down every detail of any transaction you make on the blockchain (be it NFTs or cryptocurrency) cannot be stressed enough. Luckily, these days crypto and NFT exchange platforms keep records of your transactions for you. However, we recommend you write this information down so that when tax season comes around, you’re not also burdened with the headache of going through all these records (especially if you’re a big crypto/NFT investor/trader). We provide an example of a good crypto investing chart in our cryptocurrency capital gains blog.

Taxable NFT Events

The taxation of NFTs depends on whether you were the Creator or an Investor.

An “Investor” is a person who buys and sells NFTs that they did not create. If you’re an Investor, most of your NFT transactions will be taxable as capital gains/losses.

  • Buying an NFT with cryptocurrency: Remember that two-part transaction we talked about? Well, unfortunately cryptocurrency is taxed any time it is used to make a purchase, whether you are paying for digital assets or real-world, physical objects and services. So if you acquire an NFT with crypto, that will trigger a taxable event.
  • Selling an NFT for fiat currency: The instant you buy an NFT with crypto or fiat currency you’ve made an investment. When you liquidate that investment for cash, you’ll be subject to capital gains tax on your profits.
  • Selling an NFT for cryptocurrency: Let’s say you bought an NFT for 2 ETH back in September of 2018 when those ETH were worth $400. In January of 2021, you decide to sell your NFT for 2 ETH. Those 2 ETH are now worth $2,000, so you realize a capital gain of $1,600. Since it has been more than 366 days since you purchased your 2 ETH, you’ll be subject to long-term capital gains taxes on that sale.
  • Trading NFTs: There are some NFT platforms that allow you to swap one NFT for another. This is kind of like trading cards. When you exchange your “digital card” for another “digital card” you’re disposing of an asset, and you’ll be subject to capital gains tax on the profit from the exchange. So if you traded your $3,900 NFT for a $4,000 NFT, you’ll owe capital gains tax on your $100 gain. If you traded your $4,000 NFT for a $3,900 NFT you can use your $100 loss to offset other capital gains.

A “Creator” is the person who minted the NFT then sold it. If you’re a Creator, many of your NFT transactions may be regarded as self-employment income.

  • Selling an NFT: The proceeds from an NFT you minted are considered income. By creating an asset that you can sell for a profit to increase your livelihood, you’re essentially creating inventory, so any money you make when you sell that inventory will be taxed as self-employment income. Unfortunately, you will have to pay self-employment taxes as well.
  • Earning NFT Royalties: When you sell an NFT you created, you can choose to continue to receive a certain percentage of the profits from each re-sale of that digital asset. This way, if the value of the NFT you minted increases in value, you profit from someone else selling it, even though you don’t own that NFT anymore. The IRS has not issued any specific guidelines regarding NFT royalty income – at this point, if you’re actively minting NFTs the safest action is to treat your profits as self-employment income. It’s best to consult with a tax attorney about NFT royalties to prevent misunderstandings and possible tax penalties in the future.

Non-Taxable NFT Events

There is no distinction between NFT Creators and Investors for non-taxable NFT transactions:

  • Buying an NFT with fiat currency: Some cryptocurrency exchange platforms such as Coinbase and Rarible allow for the direct purchase of NFTs with credit cards (and not just with Ether). This transaction is non-taxable because it is just like making an initial investment in property. However, when you sell your NFTs, your gains/losses will be subject to capital gains tax.
  • Transferring NFTs between wallets: The IRS regards this the same way it regards a five dollar bill being moved from your old wallet to a new one. No gain and no loss were realized. The NFT, like the five dollar bill, was simply moved to another digital location, so no taxable event occurred.
  • Gifting an NFT: As of 2022, gifts of up to $16,000 (according to the fair market value of the NFT at the time) are non-taxable. If you gift NFTs valued at more than that amount, you’ll need to file a gift tax return unless the recipient is your spouse. You should speak to a tax attorney about structuring large gifts in a way that can avoid gift tax implications.
  • Donating an NFT to nonprofits or charities: A donation to a 501(c)(3) tax-exempt charitable organization is non-taxable and can be used to offset your capital gains for that year. Make sure that you donate your NFT directly to the organization and not through a third party – if you auction an NFT for charity without first transferring that NFT to the 501(c)(3), you’ll owe capital gains taxes on the proceeds of the auction, despite the fact that the money is ultimately given to the charity.
  • Minting an NFT: When you upload an image onto the blockchain (thereby creating your NFT, or “minting”), the money you spend in “gas fees” such as listing or auctioning can be added to your cost basis (and gas fees involved in destroying your NFT can be used to offset other gains). So if you purchased an NFT for the amount of Ether equivalent to $15,000 and you paid $50 in fees to mint it, your cost basis is $15,050. For more on cost basis, refer to our cryptocurrency capital gains tax blog.

NFT Tax Attorneys

Buying and selling NFTs can be exciting and financially rewarding, but the last thing you need is to wake up one morning facing an unexpected tax bill. Contact us to learn more about how we can help you manage your NFTs and minimize your tax liability