The Evolution of the Taxation and Reporting of Non-Fungible Tokes

Digital currency is money. There are a number of different digital currencies. They include bitcoin, ethereum, and dogecoin. Digital currencies are also called cryptocurrency. This is because cryptocurrency can be held in an online account, a USB drive, or in a digital wallet app. The value of these currencies varies depending on online exchanges such as Coinbase. Because cryptocurrencies are digital, it is extremely difficult to counterfeit. Cryptocurrency currency is also very difficult to hack because every digital transaction is recorded across a huge decentralized network of ledgers.The good news for people that hold cryptocurrency is that digital currency has been steadily rising over the past several years. There are other online assets besides digital currency. There are video gains, digital artwork, logos, animation, and video clips. Although copyright law protects these assets, it can be pretty easy to pirate digital assets without legal repercussions.

The concept of an NFT is to marry the world of digital assets with the security of cryptocurrency. An NFT is a digital asset with a certification of authenticity which is protected by copyright law. When one purchases an NFT, that individual is acquiring a hacker-resistant, public proof of ownership of the digital asset. Now since we know a little more about NFTs, it’s time for us to discuss how they are taxed. How an NFT is taxed depends on two factors. First, whether or not an individual created and sold the NFT. Second, whether or not an individual bought and sold the NFT as an investment.

Overview of the Tax Liability for a Creator of an NFT

A creator of an NFT is taxed at the time he or she sells an NFT. For example, let’s assume Bob creates an NFT. Let’s also assume that Bob sold the NFT for one Ether (ETH). Let’s also assume that today’s exchange rate for one ETH is $1,976.59. In this case, Bob will report $1,976.59 of ordinary income associated with the sale of the NFT. However, Bob may be able to deduct any business related expenses associated with the creation and sale of the NFT to reduce the tax consequences of the sale.

Overview of the Tax Liability for NFT Investors

Some investors are betting big on the NFT art. Others are acquiring NFTs just for publicity or bragging rights. Whatever the reason for investing in an NFT, the tax consequences associated with buying and selling an NFT is similar to trading digital currencies. Like cryptocurrency, the buying and selling of an NFT creates a taxable profit to the investor. Investors are subject to short or long term capital gains taxes, plus 3.8 percent Medicare Tax, plus applicable state and local taxes.

For example, let’s assume that on April 1, 2021, Linda acquired an NFT worth $3,953.18 (2 ETH). Let’s also assume Linda used 2 ETH to buy the NFT. However, Linda acquired the two ETH used to purchase the NFT a number of years ago. At that time, the 2 ETHs were worth $400. When Linda purchases the NFT, she would incur long-term capital gains on $3,553.18 ($3,953.- $400 = $3,953). Since Linda held the 2 ETH for more than one year, she would be taxed at favorable long-term capital gain rates. Linda’s cost basis in the NFT would be $3,553.18.

If Linda were to sell this NFT in September 2021 for $10,000, she would have a short-term capital gain of $6,446.82 ($10,000 – $3,953.18). The gain is short-term because Linda held the NFT for less than 12 months before she decided to sell it. Short-term gains are subject to favorable rates. This means, Linda will be taxed at ordinary income tax rates on the gain in the NFT. Linda will also be subject to Medicare Tax, and applicable state and local taxes.

The Consequence of an NFT Being Classified as a “Collectible”

An NFT may potentially be taxed as collectible. Internal Revenue Code Section 408(m)(2) defines a collectible as: 1) any work of art; 2) any rug or antique; 3) any metal or gem; 4) any stamp or coin; 5) any alcoholic beverage; 6) any other tangible personal property specified by the Treasury. While it is clear that NFTs may be considered works of art. But it is unclear whether or not an NFT can be considered a collectible. Whether or not an NFT can be considered a collectible for tax purposes can make a big difference to the investor’s tax bill. This is because the maximum long term capital gains rate on gains from the sale of most assets is 20 percent. On the other hand, the maximum rate on gains from the sale of collectibles is 28 percent. An NFT has important implications for retirement plans. Under Section 408(m)(1) of the Internal Revenue Code, “the acquisition by an individual retirement account (“IRA”) of a collectible shall be treated as a distribution from the IRA equal to the cost of the IRA of the collectible.” Section 408(m)(1) also provides “that the acquisition by an individual directed account under a qualified plan under Section 401(a) of a collectible shall be treated as a distribution from the account equal to the cost to the account of the collectible.”

Whether or not NFTs can be taxed as a collectible will need to be determined on a case-by-case basis. In this context, the IRS provided its first guidance on the tax treatment of NFTs in Notice 2023-27. In Notice 2023-27, the IRS provided for an intent to issue guidance on whether NFTs should be classified as collectibles, but also stated that pending that future guidance, the IRS intends to apply what it calls for a “look-through analysis.” This analysis involves a determination of “whether an NFT constitutes a Section 408(m) collectible by analyzing whether the NFT’s associated right or asset is a Section 408(m) collectible.” For example, the Notice states that an NFT that certifies ownership of a gem is a collectible because the gem itself is a collectible under Section 408(m)(2)(c). However, an NFT that “provides a right to use or develop a ‘plot of land’ in a virtual environment is not a collectible because that right itself is not a collectible under Section 408(m).

IRS Proposed Regulations that Impact NFTs

In the Infrastructure Investment and Jobs Act of 2021, the Internal Revenue Service (“IRS”) issued proposed regulations that impact NFTs. See Pub. L. No. 117-50 Section 80603. Under these proposed regulations, NFTs are included in the definition of “digital assets.” Section 80603(b)(1)(B) of the Infrastructure Act defines a digital asset as “any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar..” The proposed regulations define a digital asset as “a digital representation of value that is recorded on a cryptographically secured distributed ledger or similar technology.” See Prop. Treas. Reg. Section 1.6045-1(a)(19)(i). Whether or not an NFT can be classified as a digital asset is debatable. As the American Bar Association’s (“ABA”) Section of Taxation stated in its comment to proposed regulations, it is difficult to see how NFTs qualify as “digital representation of value,” a key requirement for an asset to be classified as a digital asset. See American Bar Association Section of Taxation, Comments on REG-122793-19, December 20, 2023. The ABA went on to say “the majority of NFTs or tokens representing ownership of real-world assets do not function principally as ‘digital representation of value’ and are not commonly used in ordinary course transactions, and therefore are not analogous to traditional financial assets.”

The definition of broker is also expanded in the proposed regulations. This expanded definition of the term “broker” could result in NFT digital trading platforms being required to report transactions to the IRS. The Infrastructure Investment and Jobs Act expanded the definition of the term “broker” to inflect all digital assets. Section 6045 requires a person doing business as a broker to “file information returns, and furnish payee statements…for each customer for whom the broker has sold stocks, certain commodities, options, regulated futures contracts, securities futures contracts, forward contracts or debt instruments, in exchange for cash, showing each customer’s name and address, details regarding gross proceeds, and adjusted basis of certain categories of assets sold, and other information.” See Prop. Treas. Reg. Section 1-6045.

Section 80603(a) of the Infrastructure Act defines a broker as “any person who, for consideration, is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.” See Pub. L. No. 117-58, Section 80603. The regulations under Section 6045 define the term broker as “any person…U.S. or foreign, that, in the ordinary course of a trade or business during the calendar year, stands ready to effect sales to be made by others.” See Treas. Reg. Section 1.6045-1(a)(1). The proposed regulations has an extensive definition for the term “digital asset middleman” to include “any person who provides a facilitative service…with respect to a sale of digital assets wherein the nature of the service arrangement is such that the person ordinarily would know or be in a position to know the identity of the party that makes the sale and the nature of the transaction potentially giving rise to gross proceeds from the sale.” See Prop. Treas. Reg. Section 1.6045.

Section 6045 and its associated regulations and Section 80603(a) of the Infrastructure Act provide an extremely broad definition to the term “broker” for purposes of transactions involving an NFT. Anyone falling under the definition of a broker will be required to report an NFT transaction to the IRS on a Form 1099-DA. The IRS recently unveiled a draft Form 1099-DA on its website. The Form 1099-DA is the first tax form created specifically for reporting digital assets.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.