By Anthony Diosdi
The popularity of Non Fungible Tokes (“NFTs”) has become popular in the past year. Just over a year ago, the New York Times published an article entitled “Why Did Someone Pay $560,000 for a Picture of My Column” and sold the article as an NFL. So what is an NFT?
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 an investor purchases a minted NFT, the investor is acquiring a hacker-resistant, public proof of ownership of the digital asset. Now since we know a little about NFTs, it’s time for us to discuss how they are taxed. There are a number of different ways NFTs can be taxed. We will discuss the ways an NFT can be taxed in more detail below.
Overview of the Tax Consequences for the Creator of an NFT or a Business that Sells NFTs
For the creator, the minting of an NFT is not a taxable event. Instead, the creator of an NFT is taxed at the time he or she sells an NFT. When the creator receives payment from the sale of an NFT that is part of the creator’s trade or business, the gain from the sale of the NFT will be taxed as ordinary income rates. For federal income tax purposes, ordinary income is taxed at rates up to 37 percent. However, a creator of an NFT or a business that sells NFTs may be able to deduct the tax consequences associated with the sale of the NFT. For example, let’s assume Bob creates an NFT. Let’s also assume that Bob sold the NFT for one Ether (“ETH”). If today’s exchange rate for one ETH is $1,976.59, Bob will recognize $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 income tax consequences associated with the sale of the NFT.
Overview of the Tax Consequences to the Holders of NFTs Who Hold These Assets for Personal Use
NFTs held for personal users are treated as capital assets. Long-term capital assets are those that are held for more than one year. Currently, for federal income tax purposes, long term capital gains tax rate is 0%, 15%, or 20%, depending on the individual’s income for that tax year. If the NFT is held for less than one year, the income from the NFT is taxed as ordinary income. Individuals that hold NFTs for personal use may also be subject to a Net Investment Income Tax (“NIIT”) in the amount of 3.8 percent.
In case of a loss, individuals that acquire NFTs for personal use, may be allowed to utilize losses to the extent of gains from sales up to $3,000 ($1,500 in the case of a married individual filing a separate return) annually against ordinary income such as wages. Any losses exceeding $3,000 can be claimed in future tax years. An NFT trader may also claim capital loss deductions under Internal Revenue Code Sections 1211 and 1212. When an NFT investor offsets capital gains with losses in an NFT, the investor is permitted to offset long-term capital losses (long-term capital gains are derived from assets that are held for more than one year before they are disposed of) against long-term capital gains. Investors are allowed to offset short-term capital losses against short-term against short-term capital gains (a short-term capital loss is a loss incurred after selling an asset less than a year after it was acquired).
Because an NFT is treated as a capital asset for personal users, it is important for an individual user to track his or her basis in any NFT acquired. For example, let’s assume that on April 1, 2022, Linda acquired an NFT worth $3,953. Let’s assume that Linda used two ETH worth $3,953.18 ($1,976.59 x 2 = $3,953) to acquire the NFT she purchased a number of years ago. At that time, the two ETHs were valued at $400. Cryptocurrency is treated as property for federal income tax purposes and therefore subject to capital gains. Since Linda held the 2 ETH for more than one year, she would be taxed at favorable long term capital gain on $3,553.18 ($3,953 – $400 = $3,553.18). 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 = $6,446.82). The gain is short term because Linda held the NFT for less than 12 months before she sold it. This means that Linda will be taxed at ordinary income tax rates on the gain on the NFT. Linda may also be subject to NIIT.
The Unpleasant Tax Surprise of an NFT Being Classified as a Collectible
Many individuals that hold NFTs for personal reasons are unaware that their investments can be taxed as collectible assets (collectibles). Collectibles can be taxed at a maximum rate of 28 percent. Collectible gains are also potentially subject to NIIF tax. The tax consequences of treating an NFT as a collectible is significantly higher than if it were taxed under the long-term capital gains rules.
Under Internal Revenue Code Section 408(m)(2), a collectible are defined 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; or
6. Any other tangible personal property specified by the Department of Treasury.
While it is clear that gold and silver coins are collectibles, what about NFTs? Are they also considered collectibles? Because certain NFTs are unique, in some cases, an NFT may be considered a collectible. In these cases, individuals selling an NFT may be unaware that gains from the sale of the NFT may be subject to a higher tax rate. Whether or not NFTs can be taxed as a collectible should be determined on a case-by-case basis.
Conclusion
Overall, NFTs are still an emerging asset class with a largely undefined tax framework. While the Internal Revenue Service (“IRS”) has issued guidance as to the tax consequences involving cryptocurrency, it has yet to issue guidance regarding the tax consequences of NFTs. Anyone holding an NFT or considering selling an NFT should seek guidance from an experienced tax attorney.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on international and domestic tax planning. He advises multinational companies, closely held businesses, and individuals on a host of complicated tax matters. Anthony has authored numerous articles on international and domestic tax planning.
Anthony Diosdi is a frequent speaker at international tax seminars. Anthony Diosdi is admitted to the California and Florida bars.
Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: 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.