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NFTs Draw Scrutiny from IRS

08.19.21 | BERDON VISION

The popularity of non-fungible tokens (NFTs) is skyrocketing, with artwork, music, and sports memorabilia being the tip of the digital assets iceberg. NFT sales exceeded $2.5 billion in the first half of 2021, up from $13.7 million in the first half of 2020.1 With high-profile sales drawing considerable media attention, it should come as no surprise that NFTs are drawing the attention of the IRS.2

What is an NFT?

Before addressing the heightened scrutiny NFTs are under, it is important to understand the basics. An NFT is a digital certificate that entitles the holder to certain rights associated with an asset. Merriam-Webster defines NFTs as “a unique digital identifier that cannot be copied, substituted, or subdivided, that is recorded in a blockchain, and that is used to certify authenticity and ownership (as of a specific digital asset and specific rights relating to it).”3 While NFTs are often associated with digital assets, they can also represent rights to physical assets or even experiences. Their use dates back to 2014, but they have only recently begun gaining market acceptance.

NFTs appeal to collectors because they document exclusive ownership rights: an NFT can only have one owner at a time. In addition, unlike the physical collector’s items that entail risks such as forgery or dubious ownership history, NFT’s are inherently verifiable and transferable due to their existence on a blockchain. That’s why even Major League Baseball is using them for physical assets.4

Beware of Rapidly Evolving Tax Treatment

The IRS has issued limited guidance on the taxation of cryptocurrencies and is yet to issue any specific guidance on NFTs. However, it is likely that, like cryptocurrencies, the taxation of NFTs will be governed by general tax principles. Riskier still, the IRS may deem NFTs to be treated as “collectibles,” which is defined by the Internal Revenue Code as “any work of art.” If this is the case, the tax impact will depend on your NFT activities—are you creating and selling, or are you buying and selling?

NFT Features Can Create Tax Complexities

If you are an artist who creates and sells NFTs, or if you regularly buy and sell them as a business (aka, a dealer), you will recognize income at the time of sale that will be subject to ordinary income tax rates and potentially self-employment taxes. If your business is creating NFTs, you can deduct ordinary and necessary business expenses from that income.

An interesting and compelling feature of NFTs is that they can include “smart contracts” that are embedded in the blockchain technology that enable the owner to collect payments from viewers of the NFT and even share a portion of those payments with the artist/creator. Additionally, the creator can collect a percentage every time the NFT is sold or transferred. These fees are considered taxable income to the owner and the creator.

However, these unique features can create complex tax issues. NFTs are considered intangible property, and when selling intangible property, U.S. tax rules require you to distinguish if the transfer constitutes a sale or license.

  • Transfer is a sale: the taxable income is limited to the seller’s gain in the property by offsetting the sales price by its basis, or cost. If the seller owned the property for more than one year, the gain would be taxed at lower capital gains tax rates.
  • Transfer is treated as a license or a right to use the property: the transferor will recognize royalty income and will not be able to directly offset the income with its basis in the property. Instead, the basis will be amortized and deducted over future years. In addition, royalty income is taxed at higher ordinary income tax rates.

NFT Buying and Selling

The tax consequences of a non-creator or non-dealer selling an NFT are the same as selling any capital asset: gains are taxed at the capital gains tax rate. Income realized will depend on whether the gain is classified as short- or long-term, and losses from these transactions can be used to offset capital gains. However, if NFTs are classified as collectibles, the tax rate will be 28%, which is 40% higher than the tax rate on regular crypto and stock long-term capital gains.

As a general rule, recognition of capital gains and losses should be recorded if:

  • You purchase an NFT with a fungible crypto asset, such as bitcoin or Etherium
  • You sell an NFT for another NFT
  • You sell an NFT for a fungible crypto asset

When an NFT is purchased using U.S. dollars or other fiat money, the taxable event only occurs when the NFT is sold. But, if the NFT is purchased using cryptocurrency, there is an additional taxable event based on the difference in value of the cryptocurrency at the time of purchase.

IRS Audit Risks & Implications

The proliferation in NFT transactions has caught the IRS’ attention, and the potential for audits grows as the regulatory environment, including recent attention in Congress, expands. Typically, these audits will be conducted with the assistance of a cryptocurrency specialist. Beyond the usual Information Document Requests, the IRS will likely seek a mass of information that includes, but is not limited to:

  • Lists of cryptocurrency transactions involving cash and the cryptocurrency involved
  • Lists of all currencies received via:
    • hard forks, software updates by a blockchain or cryptocurrency’s network nodes that are incompatible with existing blockchain protocol. This causes a split (or fork) into two separate networks that run parallel
    • faucets, apps or websites that distribute small amounts, like water drops, of cryptocurrencies as a reward for completing a simple task
    • tipping, cryptocurrency gifts of appreciation as in the case of a waitperson in a restaurant
  • A detailed explanation of the method used to compute basis.

With NFTs now in the spotlight, you should fully document and support all transactions in case the IRS comes calling. To its credit, the IRS has begun providing guidance, and more is expected in the future.5,6 Given the risk of evolving tax regulations, it is best to work with financial and investment advisors that are experienced with crypto transactions before moving forward.

Questions? Contact your Berdon Advisor.

1 https://www.reuters.com/technology/nft-sales-volume-surges-25-bln-2021-first-half-2021-07-05/
2 https://www.bloomberg.com/news/articles/2021-08-02/nfts-could-go-even-more-mainstream-with-shopify-s-latest-move
3 https://www.merriam-webster.com/dictionary/NFT
4 https://www.forbes.com/sites/kenrapoza/2021/07/12/mlb-goes-all-in-on-nfts-with-lou-gehrig-now-la-dodgers-art-why-is-this-still-a-thing
5 https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions
6 https://www.irs.gov/businesses/small-businesses-self-employed/virtual-currencies