NFTs and Taxes: Everything You Need to Know
NFTs, or non-fungible tokens, are unique digital assets that can represent anything from art and music to sports memorabilia and virtual land. They exploded in popularity in 2022, with some NFTs selling for millions of dollars.
An NFT is a unique digital asset that is verified on a blockchain. It can, indeed, represent anything, from art to music to virtual real estate. The ownership of an NFT is stored on the blockchain, making it virtually impossible to counterfeit or duplicate. Because each NFT is unique, they are often sold at high prices. But what are the tax implications of buying, selling, or creating NFTs?
In this post, we will explain everything you need to know about NFT taxes in 2023.
How are NFTs taxed by the IRS?
The IRS has not issued any specific changes on the treatment of NFTs yet, but it has stated that NFTs are considered “digital assets”, similar to cryptocurrencies like Bitcoin or Ethereum. This means that NFTs are subject to capital gains and income tax, depending on how you acquire and dispose of them.
But please note: The IRS is in the process of classifying some NFTs as collectibles. They recently issued guidance seeking public comments on the matter. The implications of this move are explained later in this article.
Capital gains tax applies when you sell or trade an NFT for more than you paid for it. The amount of tax you pay depends on how long you hold the NFT and your personal income tax bracket. If you hold the NFT for less than a year, you pay the short-term capital gains rate, which can range from 10% to 37%. If you held the NFT for more than a year, you pay the long-term capital gains rate, which can be 0%, 15%, or 20%.
Income tax applies when you receive an NFT as payment for your work or service, such as creating or minting an NFT. The amount of tax you pay depends on your ordinary income tax rate, which can vary from 10% to 37%. You need to report your income from NFTs whether you are paid in dollars, ether, bitcoin, or any other cryptocurrency.
Thus, based on the above, you should know how to treat your NFTs (as income or capital gains) depending on how you got yours. All this information should be accompanied by supporting documents because the IRS will not just tax you without the full knowledge of how you got your NFTs in the first place. Failure to provide such paperwork or proof could result in tax problems for you. These include IRS Notices or an audit.
What are some taxable events for NFTs?
Here are some common scenarios that trigger taxes for NFTs:
Buying an NFT with cryptocurrency: This is considered a two-part transaction by the IRS. First, you sell your cryptocurrency for its fair market value at the time of the transaction, which may result in a capital gain or loss. Second, you buy the NFT with the proceeds from the sale of your cryptocurrency, which establishes your cost basis for the NFT.
Selling an NFT for fiat or cryptocurrency: This is considered a sale of property by the IRS. You need to calculate your capital gain or loss by subtracting your cost basis from your selling price. You also need to report the sale on Form 8949 and Schedule D of your tax return.
Trading an NFT for another NFT: This is considered a like-kind exchange by the IRS. You need to calculate your capital gain or loss by subtracting your cost basis of the NFT you gave up from the fair market value of the NFT you received. You also need to report the exchange on Form 8824 and Schedule D of your tax return.
Creating or minting an NFT: This is considered a creation of property by the IRS. You need to report your income from selling or receiving an NFT as ordinary income on Schedule C of your tax return. You also need to pay self-employment tax on your net profit from your NFT business.
What are some non-taxable events for NFTs?
Here are some scenarios that do not trigger taxes for NFTs:
Buying an NFT with fiat currency: This is considered a purchase of property by the IRS. You do not need to report anything on your tax return until you sell or trade the NFT.
Transferring an NFT between different wallets: This is considered a transfer of property by the IRS. You do not need to report anything on your tax return as long as you retain ownership and control of the NFT.
Donating an NFT: This is considered a charitable contribution by the IRS. You may be able to deduct the fair market value of the NFT at the time of donation if you itemize your deductions and donate to a qualified organization. You also need to file Form 8283 if the value of your donation exceeds $500.
How can you reduce your NFT tax liability?
NFTs are subject to capital gains and income tax, depending on how you acquire or sell them.
More so, the IRS recently issued guidance, seeking the public’s comments on their intended move of taxing NFTs as collectibles. This will result in them attracting a higher long-term capital gains tax, making it crucial for NFT holders to implement strategies to save their money on NFT taxes. The long-term capital gains rate for collectibles is as high as 28%, while assets like stocks and cryptocurrency typically carry a maximum federal rate of 20%.
Nevertheless, here are some possible ways to reduce your NFT tax liability are:
- Holding your NFTs for more than a year to qualify for lower long-term capital gains rates.
- Donating your NFTs to a qualified charity and claiming a deduction for the fair market value.
- Harvesting your losses by selling your NFTs that have decreased in value and offsetting your gains.
- Creating a business entity such as an LLC or a corporation and deducting your NFT-related expenses.
You should always think about consulting a tax professional for more specific advice on your situation. This is because as soon as you include other types of income sources or investments, your return gets complicated. It will be different from someone only dealing with employment income from a single employer. Usually, complicated returns attract more scrutiny from the IRS, which leads to many notices and audits.
Conclusion
NFTs are a fascinating new technology with many potential uses. However, it’s important to understand the tax implications of buying, selling, or creating NFTs. If you’re unsure how to proceed, it’s always a good idea to consult a tax professional. They can help you navigate the complex world of NFTs and ensure that you’re in compliance with all applicable tax laws.
If you need a tax pro’s help with your taxes – be it filing tax returns, back taxes, representation, or you are facing an audit – contact me. Do not waste time. You can get hold of my team at +1 202-618-1297 to book a quick tax chat with me.
Frequently Asked Questions
- What are NFTs used for?
NFTs, or non-fungible tokens, can be used to represent unique digital assets such as artwork, music, virtual real estate, and more. They allow creators and collectors to prove ownership and authenticity of these digital assets in a secure and decentralized manner.
- How does an NFT make money?
NFTs can make money through the buying and selling of the tokens themselves. As NFTs gain popularity and value, they can be sold for a profit just like any other investment. Additionally, creators can earn money by selling their digital assets as NFTs and receiving a percentage of the sales.
- What are some examples of NFTs?
Examples of NFTs include digital art, music, virtual real estate, in-game items, and more. Some notable examples include the $69 million sale of Beeple’s “The First 5000 Days” digital artwork and the sale of a virtual house in the game Axie Infinity for $1.5 million.
- What is the purpose of tax?
The purpose of tax is to provide funding for government programs and services. Taxes are used to finance infrastructure, education, healthcare, social welfare programs, national defense, and other essential services.
- What is the definition of taxation?
Taxation is the practice of imposing a financial charge, or tax, on individuals and businesses by the government. Taxes are usually based on income, property, goods, and services, and are used to generate revenue for public expenditures.
- What is the meaning of taxes in economics?
In economics, taxes serve several purposes. They can be used to raise revenue for government spending, influence consumer behavior, promote economic growth, and redistribute wealth. Taxes can also be used as a tool for regulating businesses and markets.
