NFT Tax Guide

What Are NFTs?

Non-fungible tokens (NFTs) are a cryptographic asset used to digitize intellectual property such as artwork, images, videos, music, or text. They are authenticated and exchanged using blockchain technology. They are a fairly new type of asset, and the Internal Revenue Service (IRS) has yet to provide any official guidance about the tax treatment of NFTs that differentiates it from other digital assets.

Artists use NFTs to digitize their original works, selling the equivalent of an autographed copy of a particular piece. The artist still maintains rights to the work, and they can still produce and sell other copies or versions. However, the digital code assigned to the unique NFT acts as a sign of authenticity for the purchaser.

NFT Tax Issues

The IRS has issued specific guidance on the tax treatment of cryptocurrencies in recent years, in Notice 2014-21 and Revenue Ruling 2019-24, and it has included NFTs in discussions of digital assets. However, it has yet to address the tax treatment of NFTs specifically, and NFTs have some key differences from cryptocurrencies.

The key difference: Unlike cryptocurrencies such as Bitcoin and Ethereum, which are fungible, NFTs are not interchangeable with each other. They cannot be directly exchanged for other currencies, goods, or services.

As such, the rules that are applied to cryptocurrencies may not necessarily apply to NFTs. Taxpayers who have invested in NFTs should seek the help of an experienced Certified Public Accountant (CPA) to decipher the complex tax code and ensure that they are following the general tax principles that exist at present.

Because NFTs are each unique and distinguishable from others, they have qualities similar to physical collectibles. The taxation of NFTs will fall somewhere between cryptocurrencies, which are taxed as property and have a long-term capital gains rate of 0% to 20% depending on income, and collectibles, which have a higher maximum capital gains rate of 28%.

NFT Life Cycle and Possible Tax Treatment

The tax treatment of an NFT differs at each stage of its life cycle, from creation to purchase to sale, and should the NFT become worthless. There are important tax distinctions at each stage.

NFT Creation

Similar to an artist autographing their artwork, when a person “tokenizes” or “mints” a piece of work into an NFT, it does not create a taxable event. The NFT makes the work more valuable, but the IRS does not impute income at this point. However, when the work is sold to a buyer, the premium paid for the NFT is also included in the purchase price and taxed to the seller.

NFT Purchase

When an NFT is sold, it is taxed to the seller. However, the buyer may also have to pay taxes at the point of purchase. Taxes are not due on the NFT directly; they might be owed if the buyer purchases the NFT using cryptocurrency. Most NFTs are purchased with Ethereum, a cryptocurrency.

Why do they owe taxes? Because cryptocurrency is not the same as fiat currency—dollars, for example. Buying with cryptocurrency is more like selling a stock to get the money to buy a painting. When an NFT is purchased with a cryptocurrency, the gain or loss on the cryptocurrency that was used must be calculated and taxed.

Depending on the length of time that the taxpayer held the cryptocurrency—and whether it has increased in value—it could be taxed as a short-term or long-term capital gain. Short-term capital gains result from holding the cryptocurrency for less than a year; they are taxed at the taxpayer’s ordinary income rate. On the other hand, if the taxpayer has held the cryptocurrency for longer than a year, the long-term capital gains rate of 0% to 20% (depending on the taxpayer’s income) would apply. Most taxpayers are subject to a 15% long-term capital gains rate.

If a person were to purchase Ethereum with the intent to use it to buy an NFT, it would be wise to hold on to the cryptocurrency for more than a year. Ordinary income tax rates are as high as 37% in 2022, depending on your income and tax bracket.

After the original creator sells the NFT, it may still generate taxable income for the creator in addition to the new owner. Depending on the intellectual property licensing terms, the creator and the new owner may receive royalty payments when others view the NFT. It is also possible that the creator could receive some portion of the purchase price on any subsequent sale of the NFT.

Additionally, NFTs have features of intangible assets. An NFT created by or for the taxpayer does not have to be amortized. However, a purchased NFT may be subject to the tax provisions in Section 197 relating to the amortization of intangible assets. If the NFT is not excluded as self-created and is held by the taxpayer to generate income in a trade or business, they may have to amortize their adjusted basis in the NFT and take straight-line amortization deductions over 15 years.

NFT Sale

The sale of an NFT produces different tax consequences, depending on whether the seller held the NFT as a capital asset or noncapital asset. As discussed in the previous section, an NFT that was created by a taxpayer is a noncapital asset. NFTs held by taxpayers other than the original creator are likely capital assets. Gains and losses on the sale of an NFT held by the creator would generate ordinary gains or losses. Gains and losses on the sale of an NFT held by subsequent owners would generate capital gains and losses.

If NFTs are used in a trade or business for more than one year, it would generally fall under Section 1231 business asset provisions. If a taxpayer sells a Section 1231 asset used in a trade or business, the net Section 1231 gains are classified as long-term capital gains. Net Section 1231 losses are classified as ordinary losses. In the case of Section 1231 gains, Section 1245 recapture rules relating to amortization of intangibles may also apply.

Capital Gain or Collectible? There is an additional tax aspect that needs to be considered by sellers of NFTs that have risen in value. Works of art are considered collectibles and are taxed at the higher-than-capital-gains 28% rate. It would be wise to get advice from a tax professional on whether you will be subject to the capital gains rate or the collectibles rate if you profit on the sale of an NFT that you purchased. If the NFT was purchased for business use, it may qualify for capital gains treatment.

Worthless NFTs and Loss Treatment

If an NFT becomes worthless, its tax treatment depends on its use. If the owner purchased the NFT as an item for personal use, similar to artwork hanging in the taxpayer’s house, then a loss deduction is disallowed. However, if the NFT was held for business use prior to becoming worthless, the taxpayer may be able to take a deduction for the worthless asset under Section 197.

Examples of Potential NFT Tax Treatments

Let’s spell out how these tax rules could work in two contrasting NFT buying and selling situations.

Gains on Purchase and Sale of NFTs

Susan, a single taxpayer who makes $250,000 per year and is in the 35% tax bracket, purchased $5,000 of Ethereum. Two years later, she uses the Ethereum to purchase an NFT valued at $8,000. The transaction results in a $3,000 long-term capital gain from the disposition of her cryptocurrency, taxed at 15%. If Susan had held the Ethereum for less than one year, it would have been taxed at her ordinary income tax rate of 35%.

If Susan sells the NFT after six months for $10,000, her $2,000 gain is considered to be a short-term capital gain, taxed at her 35% marginal tax rate. Had she held the NFT for more than one year, the $2,000 gain would have been considered a long-term capital gain. Her income falls within the 15% long-term capital gains bracket. However, if the NFT qualifies as a collectible, she will be subject to the higher 28% collectible capital gains rate.

Losses on Purchase and Sale of NFTs

Mike, a single taxpayer who makes $125,000 per year and is in the 24% tax bracket, purchased $12,000 of Ethereum. One year later, he uses the Ethereum to purchase an NFT valued at $8,000. The transaction results in a $4,000 capital loss. If he has no other capital asset sales to offset the loss, he will only be able to deduct $3,000 to offset his income in the first year. The remaining $1,000 capital loss will carry forward to future tax years.

If Mike sells his NFT in two years for $7,000, he has a $1,000 capital loss. Mike had no other capital asset transactions. If Mike is considered to be an investor, his $1,000 loss can be deducted against his income. Note that if the loss had been greater than $3,000, only $3,000 can be taken in the first year and any additional loss must be carried forward to future tax years. On the other hand, if Mike was not considered to be an investor, his loss would be a personal loss and capital loss treatment is disallowed.

The Bottom Line

NFTs are a new type of asset. Current tax law does not have provisions specifically related to the tax treatment of NFTs, so all tax treatments outlined in this article are speculative based on existing tax law. If you are investing in NFTs, be sure to keep good records of your transactions. Seek the help of a tax professional who can guide you through current tax law that may be applied to NFT transactions. As the IRS releases additional guidance, the taxation of NFTs will become more clear. With proper documentation of your purchases and sales, you may avoid penalties.