Article – US Taxation of NFTs

by Lance Morris
Mar 26, 2023

Whilst it was only a short while ago that many of us learned what an NFT is, they are now a clearly defined part of the investing and collectors landscape.

For those unfamiliar with the term, an NFT is a Non-Fungible Token. Not that this means a great deal of course, so I’ll go a little further. A Non-Fungible Token is essentially the digital ownership of an asset, whether it be a photo, video or any other type of digital media.

For example, when an image becomes viral online and is shared/edited many thousands of times, the NFT holder is the owner of the original image. A bit like that the Mona Lisa can be seen anywhere online, but the original sits with the Louvre in Paris. You could almost say that the Louvre owns the NFT for the Mona Lisa.

An NFT doesn’t represent intellectual property rights, but only ownership of the digital asset. Anyone can create an NFT, though it wouldn’t necessarily have any value.

The market for NFTs first made traction in 2020, and subsequently boomed shortly after, with vast trading now occurring online. Whether they make for a wise investment however is something which can be measured in tax terms.

The sudden, almost instant rise of NFTs caught the IRS off guard, as did the overnight popularity of cryptocurrencies. Although, given that the popularity of NFTs occurred during the height of the pandemic, the IRS could be forgiven for being a little slow off the mark.

But, since 2020, many investors, collectors and hobbyists alike who hold, sell, and buy NFTs have been left with little guidance as to the correct tax treatment. This has left some individuals treating NFT gains as ordinary income (higher tax rate) as a conservative approach, whilst others have not reported this income at all.

Fortunately, the IRS have now (almost) arrived at a conclusion on how to treat NFTs for tax purposes, which will be the same approach as other collectibles (such as art, antiques, stamps, coins etc.). The IRS’ statement is below:

A nonfungible token (NFT) is a unique digital identifier that is recorded using distributed ledger technology and may be used to certify authenticity and ownership of an associated right or asset. Distributed ledger technology, such as blockchain technology, uses independent digital systems to record, share and synchronize transactions, the details of which are recorded simultaneously on multiple nodes in a network. A token is an entry of data encoded on a distributed ledger. A distributed ledger can be used to identify ownership of both NFTs and fungible tokens, such as cryptocurrency, as described in Rev. Rul. 2019-24.

Section 408(m)(2) of the tax code provides for a specific list of items that constitute collectibles for certain purposes. Acquisition of a collectible by an individual retirement account (IRA) or individually-directed account of a qualified plan is treated as a distribution from the account equal to the cost to the account of the collectible. Generally, collectibles also do not have as advantageous capital-gains tax treatment as other capital assets.

Until additional guidance is issued, the IRS intends to determine when an NFT is treated as a collectible by using a “look-through analysis.” Under the look-through analysis, an NFT is treated as a collectible if the NFT’s associated right or asset falls under the definition of collectible in the tax code. For example, a gem is a collectible under section 408(m); therefore, an NFT that certifies ownership of a gem is a collectible.

Whilst it is helpful to have guidance from the IRS on the treatment of NFTs, this doesn’t spell great news for those who hold NFTs.

Capital gains on the sale of collectibles (held for greater than 1 year) are taxed at a higher rate than ordinary other investments, specifically a 28% tax rate. This is far higher than the ordinary long-term capital gains tax rate of 15-20%. Indeed, the 28% tax rate may well be in excess of the ordinary tax bracket for many taxpayers.

Whilst the guidance is currently only at a preliminary stage (and open to public submissions), it would appear likely that this punitive tax rate will apply for NFT trades.

In short, for those who sell an NFT for greater than the purchase price, then the 28% rate will apply above on the gains.

In some cases, if your US tax bracket is lower than 28%, it may be beneficial to sell an NFT in under one year after purchasing. This means that the sale will be treated as a short-term capital gain, and therefore you will pay your ordinary income tax rate, as opposed to the 28% long-term tax rate.

It is important that for anyone who purchases NFTs, to keep good records of the cost of purchase, and any other associated expenses. This information will, upon the sale of the NFT, be crucial in determining your basis (line in the sand for capital gain/loss) and ensuring you’re not taxed on the entire sale price.

For US citizens who reside in New Zealand or any other country without a comprehensive capital gains tax system, you should expect that there will be no foreign tax credit (for local tax paid) to offset the US liability on any NFT gains.

If you’re considering your investment options, it is important to seek advice before you begin investing. Avoiding tax traps is easy, but only with the right advice.

For any questions, please feel free to contact US Global Tax on 093732949.