Blockchains are great records of digital assets because they are secure and immutable. Although cryptocurrencies have become synonymous with blockchain, the same technology can store all kinds of digital objects. The emergence of non-fungible tokens, or NFTs, marks a step in this direction and opens the door to digitizing many different assets.
Let's take a closer look at NFT (non-fungible tokens), how they differ from traditional tokens, and how they can be treated from a tax standpoint for both investors and creators.
What are non-fungible tokens?
Non-fungible tokens or NFT tokens are a special type of crypto tokens that represents a unique asset. For example, each NFT has unique properties through metadata that can be verified with ownership on the blockchain. These dynamics differ from fungible tokens such as Bitcoin in that they are not unique and interchangeable.
Conventional Tokens
Fungible
May be securities
Standardized and regulated
NFTs Non-Fungible Tokens
A diverse set of regulations
Each item is unique
Usually not securities
Technically, ERC-20 fungible tokens contain a name, balance, chip pool, and symbol. Non-fungible ERC-721 tokens contain rich metadata that can be used to provide asset details or other authenticated info. These metadata capabilities provides NFTs the ability to verify college degrees to register properties and provide special access or privileges.
There are many emerging use cases for NFT:
Artists move their creative resources to NFTs, which allows them to build a stronger community, collect royalties on secondary sales, and prevent piracy.
Infrastructure providers can use NFTs for licenses, domain names, or certificates.
Markets can help create liquidity for NFTs like OpenSea.
Physical assets, such as real estate, can optionally be stored on the blockchain with NFT.
NFTs are relatively new, and their primary use cases are subject to change as they are adopted en masse. Most people know NFTs as works of art or collections, most with little or no use in today's world. NFTs will be used for everything from movies, music royalties and special privileged fan tokens to things like championships and blockchain-verifiable biological degrees.
When do I have to pay taxes on an NFT?
The IRS has made it clear that virtual currency transactions will involve some form of income tax. According to Internal Revenue Service Notice 2014-21, virtual currencies are a secure digital representation that functions as a means of exchange, a unit of account, and/or a secure deposit and is used for both conventional and non-fungible cryptocurrencies—included in this definition.
Most conventional cryptocurrencies are considered securities because they are fungible and standardized. While the IRS may not track individual tokens, exchanges are required to report overall activity. The agency used this data to generate letters sent to cryptocurrency traders and investors, asking them to pay their fair share of taxes.
Because non-fungible tokens are unique, it's much easier to identify units that have been sold, as you would with a stock's certificate number or a bond's CUSIP. NFT taxes can be categorized as ordinary income, capital gains, or tax-exempt, depending on what NFT is and the essence of the NFT business, given its many use cases.
For example, suppose you buy an NFT, which is real estate. The token is simply a digital representation of a physical asset, which implies that the taxation of the asset will reflect that of real estate rather than the cryptocurrency. You may be entitled to property deductions, such as depreciation, to offset income.
What is the NFT tax rate?
As long as you take maximum advantage of the increased demand for cryptocurrencies, you will be subject to regular capital gains taxes. But in the case of NFTs transactions, this is not true. This is because NFT can be considered collectible and, therefore, benefit from a higher capital gains tax. However, they can be considered stocks in rare circumstances and therefore are subject to income tax rates.
NFT Taxes for the Investor
Most of the people involved in NFT are investors. These are the people involved in buying and selling NFT on the open market. For investors, taxes work the same way as cryptocurrency trading.
Purchasing NFT
When you buy NFT using cryptocurrencies, you are subject to taxes.
For example, John bought 2ETH for $500/ETH years ago ($1000 in total). In March 2021, John used the same 2 ETH to buy an NFT Bored Ape, but the ETH is now worth $1,000, so the purchase of Bored Ape is $2,000. John realized a capital gain of $1000, increasing by 2 ETH, and is subject to the NFT exchange rate.
Selling NFT
Another taxable event is the sale of your NFT for cryptocurrencies, fiat currencies, other NFTs, or even goods and services.
Take the same example. If John sells his NFT for $12,000 after six months, he will be entitled to $10,000 in short-term capital gains ($12,000-2,000). Short-term profits are taxed at the normal rate of income tax.
NFT Taxes for the Creator
The creation of NFT is not taxable. However, all crypto transactions related to NFT are considered taxable by the Internal Revenue Service (IRS).
Creators produce or create NFTs and offer them for sale in various markets, such as SuperRare and OpenSea.
The creators of NFT are of two types:
Leisure creators
Professional creators
Leisure creators create NFT for fun, while professional creators invent NFT as a full-time transaction.
Minting NFT
Gasoline costs paid for the manufacture of NFT are taxable. Let's understand this with an example.
Jane mints NFT as a hobby. She spent 0.2 ETH to mint an NFT Ape Bored. When she first bought this ETH, it was worth $200. At the time of the creation of the NFT, the same 0.2 ETH increased in value to $400. Therefore, NFT minting with this ETH will result in a capital gain of $200. ($400- $200), while the cost basis of the NFT he minted is $400.
Instead, if Jane was a professional creator, $200 would be her normal income, and the cost basis would be $400.
Selling NFTs
The sale of NFT for any crypto or even the exchange of one NFT with another NFT is taxable for the creators of NFTs.
Suppose James holds his NFT for nine months and sells it for 5 ETH, now worth $15,000. Since owning NFT for less than a year, James will now have a short-term capital gain of $14,600 ($15,000 to $400 {cost basis}). If James had NFT for more than a year, his benefit would be considered a normal (not short-term) capital gain.
If James had been a professional creator, $14,600 would have been reported as regular income. He can also offset his gains by completing Schedule C to deduct Internet, utilities, and other business expenses.
NFT Royalties
Income from recurring royalties is also subject to tax.
Suppose Julian releases a work of art in the form of NFT, with 1% royalties permanently tied. After the original, NFT was sold several times in the secondary market, and Julian received 1% of each sale as royalty. After the first secondary sale, Julian earned 0.30 ETH in royalties, so he should have declared regular income equal to the dollar value of that ETH when he received it.
NFT Airdrops
Holders of popular NFT projects, such as Cryptopunks and Bored Ape Yacht Club, will often find that coins or other NFTs with monetary value are deleted for them (free data). Interestingly, airdrops tokens are a few things the IRS has provided with explicit advice; airdrops are taxed as ordinary income. The value of this income is the US dollar value of the coins/tokens released when they reach the wallet.
Reporting NFT transactions on your taxes
Reporting of NFT transactions is different for hobby creators and investors than for professional creators and investors.
Hobby investors and investors
IRS Form 8949 and Schedule D
Mention NFT collectibles as code C in column F
Professional investors and creators
Report NFT Income and Business expenses
Form 1065, Form 1120 or Form 1120-S or Schedule C
Final thoughts on non-fungible tokens (NFTS)
Cryptocurrencies are only scratching the surface of what is possible with blockchain technology. With the advent of non-fungible tokens, blockchain technology is applied to everything from digital works to digital representations of physical buildings. Of course, these transactions have tax repercussions for traders and investors. Talk to a tax expert to fully understand your situation.
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