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How Are NFTs Taxed?

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.”