If you’ve seen recent headlines associated with Bitcoin, Ethereum, and several of the other altcoins in this space, you probably realize that cryptocurrency is the next big thing and you should be aware of cryptocurrency tax considerations as well. You should also know that nonfungible tokens (or NFTs) are taxed by the IRS. Possibly, you’re one of the early adopters who’ve already been purchasing NFTs and understand how important they’ll be in several elements of the online world.
However, after purchasing NFTs and possibly trading them, you may not have considered the tax ramifications associated with using NFT in the economy.
The Difference Between NFTs and Crypto
One of the most significant differences between NFTs and cryptocurrencies is fungibility. NFTs are nonfungible, making each token unique. Cryptocurrencies are created with fungibility. This characteristic makes them interchangeable with other units of the same kind, such as Bitcoin, Ethereum, Cardano and Polkadot. As for the question, “Do I have to pay taxes on cryptocurrency?”, the answer is that you may have to pay cryptocurrency tax and NFT taxes on both of these digital units when you make specific transactions.
Do I Have To Pay NFT Taxes?
Getting involved with NFTs and crypto may have you wondering, “Do I have to pay taxes on NFTs?” Before answering this question regarding NFT tax, it can be helpful to understand the differences between NFTs and cryptos. An NFT is a unique, non-interchangeable digital token holding pieces of data. While it commonly reflects some type of art, it can represent video, music, text and more. NFTs are not cryptocurrencies, but they both exist on the blockchain.
Examining NFT Taxes When They're Being Created
Getting involved with NFTs can be done in two separate ways. Purchasing NFTs you like that have already been created is the first way to obtain them. The second way to get an NFT in the economy is to make (or mint) one. Having the intellectual property rights to the music, meme, tweet, picture or video game collectible gives you the legal right to turn it into an NFT.
After going through the process to mint your NFT, it’s considered a self-created intangible, and you have no “basis,” except for possibly your expenses related to minting it. However, the IRS has a rule that may enable artists to deduct expenses before the artwork is sold. Following their guidelines may give you a zero basis in the NFT valuation if you deduct expenses in the tax year before a year in which you sell the NFT. In this case, and depending on the tax rules you apply, your profit could be 100 percent of the proceeds, based on your sale. Selling it for $10,000 would mean you may have a $10,000 taxable profit.
What the IRS Says
Digging deeper into guidance from the IRS regarding NFT taxes becomes even more complex. Generally, they are likely to be considered your inventory by the IRS if you create one as opposed to a capital asset. Whether you are minting NFTs to sell or just for fun, when you do sell one, you may be subject to an ordinary income tax and self-employment tax.
In addition, you can retain the copyright to the media used to create the NFT. One of the top players in the NFT marketplace is doing that right now. NBA Top Shot will sell you an NFT while they hold the copyright to the highlight video. Retaining copyright and selling copies is considered royalty by the IRS, which must be reported on a Schedule E annually and attached to your Form 1040. The bottom line is that if you create an NFT and sell it, you may be looking at paying NFT taxes on three taxable events. These taxes may include an income tax on the sale itself, self-employment tax and possibly income tax due to the generation of royalties.
How Are You Taxed When You’re Only Purchasing NFTs?
If you’re not interested in minting NFTs and only want to purchase them to hold or trade, it’s essential to know that the IRS treats them differently than trading capital assets such as real estate or stocks. Purchasing NFTs is completed by using cryptocurrency. Executing this conversion may be seen as a taxable event by the IRS as it treats cryptocurrency as property.
Converting your crypto to purchase the NFT may require you to pay cryptocurrency tax on any gains you make. In addition, the profit could be taxed as ordinary income, depending on the amount of time it was held. Being liable for an additional 3.8 percent Investment Income Tax may also be possible if your income is high enough. You may also have to pay capital gains tax if you ever sell the NFT. However, NFTs are considered collectibles, which may make you liable to pay a 28 percent tax rate on any gain you make from the sale.
Example of Cryptocurrency Tax and NFT Valuation
Looking at an example may help clarify the taxable events you could be liable for when you purchase an NFT with cryptocurrency. Using Ethereum you purchased for $1000 to purchase an NFT with a value of $5000 means you may be paying $4000 in capital gains tax or ordinary income tax, depending on how long you held ETH. Selling it later in five years when it’s valued at $10,000 could have generated a $5000 capital gain and may be subject to a flat 28 percent tax as it is considered a collectible. Paying this tax obligation is significantly larger than you would if it was based on 0, 15 or 20 percent capital gains rates.
Since cryptocurrency and NFTs are often seen as the next big thing, you may want to join the party. Taking into account that you probably have to pay taxes on NFTs is the start, but tax preparation can be complicated and it will likely be beneficial to get professional help. Doing so can ensure the NFT valuation is correct as well as the taxes being paid. Taking this action can be highly cost-effective and keep you from making costly errors.
Fusion CPA can help you make sense of NFT taxes
This blog article is not intended to be the rendering of legal, accounting, tax advice or other professional services. Articles are based on current or proposed tax rules at the time they are written and older posts are not updated for tax rule changes. We expressly disclaim all liability in regard to actions taken or not taken based on the contents of this blog as well as the use or interpretation of this information. Information provided on this website is not all-inclusive and such information should not be relied upon as being all-inclusive.