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How Are NFTs Taxed?

Updated: Nov 4, 2023

It’s a beautiful thing when art and technology mix to let the creator and the appreciator make money. Non-fungible tokens (NFTs) represent the best in these two seemingly diverse sectors.

It’s a heavenly match — too bad there’s a serpent in the garden. If you create, buy, swap or sell NFTs, you may need to pay federal and state tax on profits you earned. Even though federal tax guidelines on decentralized finance (DeFi), cryptocurrencies and NFTs aren’t firm in early 2022, it doesn’t mean you don’t have to pay if you made money. Read on to learn more about NFT taxation.


What Is an NFT?

If you paint a picture or write a song, you establish a new, unique creation that didn’t exist before. It’s like a snowflake or a newborn — completely original and not interchangeable. You could keep it, give it away, sell it, lose it or be a victim of its theft. Unlike the actual painting, an NFT represents a digital version of ownership, which, with blockchain technology, cannot be stolen or taken from you. The Ethereum network secures NFT ownership by preventing modification to the record of ownership stored on the blockchain's ledger.


The NFT you create can have only one owner, and if you make a profit transferring ownership, the U.S. government will tax you as it does for other money you make like wages, rental income, dividends or stock profits.


How Does the U.S. Tax Income?

The U.S. government, through the IRS, imposes tax on money you make. For your 2021 personal taxes as reported on Form 1040, different income tax rates apply based on the way the money is generated and your total taxable income for the year:


  • Earned by working: progressive rates from 10% to 37%

  • Earned from long-term stock market and other asset sale profits (capital gains): rates from 0% to 20%

  • Earned from short-term stock market and other asset sale profits: progressive rates from 10% to 37%

  • Earned from sales of collectibles: 28%

  • Death benefit from life insurance: no tax

  • Given to you: no tax


How Are NFTs Taxed?

In February 2022, NFTs can be classified in two ways, but the IRS has not specified if NFTs should be considered asset sales subject to capital gains rates of up to 20% of collectibles subject to the flat 28% collectible rate.


That determination could make a big difference to how much you owe in tax.

For example, if you have a taxable profit of $10,000 from selling an NFT, you’d owe $2,800 in taxes if it is classified as a collectible. Depending on your adjusted gross income (AGI) that year, if NFTs are considered assets, you could owe as little as $0, $1,500 or $2,000 in taxes on that same sale.


That’s a sobering disparity in the amount of tax you’d have to pay.


What Do U.S. Tax Codes Say About Taxation of Digital Assets?

In simplified terms, IRS Notice 2014-21 says that a digital asset:


  • Is property, not money

  • Causes a taxable gain when you sell, swap or convert it for a profit

  • Is considered U.S. and not foreign

  • Must be quantified in U.S. dollars on the date you sell it

  • Is classed as income rather than as an asset when you create it and as an asset when you sell it


Most tax preparers consider NFTs to be digital assets. However, IRS Notice 2014-21 does not specifically classify NFTs as digital assets, and some recent guidance hints at the potential to classify these profits as collectibles subject to the 28% tax rate.


Section 408(m)(2)(A) from the Internal Revenue Code defines “any work of art” as a collectible, which would be taxed at the flat 28% rate. I.R.C. § 408(m)(2)(D) says the same about “any stamp or coin,” and I.R.C. § 408(m)(2)(F) classifies as a collectible “any other tangible personal property specified by the Secretary for purposes of this subsection.”

Even though Section 408 calls a work of art a collectible, it also referenced a “coin” as being a collectible, and IRS guidance on cryptocurrency coins deems them as assets. If the IRS does eventually categorize NFTs as digital assets, it’s likely that IRS Notice 2014-21 rules that tax long-term profits as capital gains would apply.


The most important take-away is that profits you make from NFT sales will be subject to some rate of tax that you cannot evade. In time, which it has an ample amount of, the IRS will usually be able to learn about money you earned and contact you years later to require payment of taxes due. Although the statute of limitations for audits is three years, if tax fraud is suspected, that protection is suspended. Many taxpayers don’t find out about unpaid taxes due until years later when they try to get a mortgage or pay college tuition for their kids, which can derail a mortgage or loan application even if the IRS doesn’t get involved.


If you don’t have the money to pay your taxes, the IRS works with taxpayers via payment plans, Form 1127 (an extension-to-pay request resulting from hardship), abatement of penalties and sometimes tax reductions.


Which Tax Forms Will I Need?

Creating NFTs: The administrative process to create an NFT is easy — although anyone who is or loves an artist knows how arduous the creation process is — and hopefully, after you make one, you can sell it for a profit. Unlike tax rules for NFT sales, tax rules on creator profits are clear. You have no tax reporting actions when you create an NFT, but if you create art as a business, it’s worth capturing the expenses you incur in that effort. You would report those expenses on Schedule C on your personal 1040, on Form 1065 for your LLC or on Form 1120 for your corporation. You need not have revenue to be able to report those expenses in the year you incurred them, and you hold onto a net loss to use in future years, called carrying over a loss.


Selling NFTs as the creator: If you create an NFT and sell it, you add that revenue to your Schedule C in a personal return or in the appropriate revenue section in a business return. Selling an NFT as a creator works the same as if you knitted a scarf and sold it on Etsy.


Selling NFTs as a secondary buyer: When you sell an NFT you bought from the creator or within an NFT marketplace like OpenSea, Nifty Gateway, LooksRare, Rarify or many other NFT markets, you pay taxes on profit you make, either as a collectible sale or as an asset sale once the IRS makes its classification formal. For your 2021 taxes, your tax professional will help you decide how that profit should be entered.

In early 2022, OpenSea and most other NFT marketplaces don’t generate tax forms for you to use in preparing taxes. However, no form doesn’t mean you don’t owe; if you sold NFTs, you have to report that sale, and, if after expenses you earned a profit, you still have to pay tax on that profit.


For NFT sales, your tax software or your tax professional may ask for Form 1099-B that your brokerage or trading platform would issue to you. Centralized crypto brokerages like Coinbase Global Inc. (NASDAQ: COIN) issue these forms to their account holders, but few of these brokerages offer NFT marketplaces. When Coinbase goes from waiting list to NFT trading, you’ll receive an appropriate form for your taxes, most likely a 1099-B.

If you receive no form, list the NFT you sold, the dates you bought and sold it, the price you earned when you sold it, the price you paid for it, the expense associated with the sale and the net loss. From that information, the tax preparer would be able to complete the necessary sections in the tax form.


Stop Crying or I’ll Give You Something to Cry About

Remember that gray area when you went from little kid to teenager, and it took your parents a while to figure out new rules? Crypto and NFTs are also in their adolescence, and it seems like the powers-that-be are still wishing that digital assets hadn’t grown up so fast. Nostalgia aside, the IRS taxes profits from digital assets and collectibles, so if your Social Security number is associated with crypto or NFT sales, eventually you will need to account for those activities to the IRS even if it hasn’t clearly defined how. Check back with Benzinga to stay current with the IRS regulations that impact you.


Originally published by Benzinga on 2-14-2023


Kathryn Hauer, a Certified Financial Planner ™, adjunct professor, and financial literacy educator has written numerous articles and several books including the “11-Step, DIY, Comprehensive Financial Plan Workbook” and “Financial Advice for Blue Collar America.” The owner of Wilson David Investment Advisors, she works to help clients and readers understand and act on complex financial information to keep them and their money safe. She functions as a strong advocate and guiding light for her clients as they move through murky and unfamiliar financial and career worlds. Read more at her website.


Disclaimer

This article represents my interpretation of cryptocurrency tax regulations based on IRS guidance published to date, which may continue to evolve and change. None of the information in this article should be considered as advice or an individualized recommendation. Please consult a tax professional regarding your own tax circumstances.

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