Last year, digital artist Bipple sold his NFT-based work, Everydays: the First 500 Days, at Christie’s for an incredible $69,346,250. This was the first time a major auction house had sold an NFT; NFT is still unknown to many, but it has become a multi-billion dollar market. However, before you can start creating, selling, or buying Non-fungible tokens (NFTs), you need to know what they are and how they are taxed.
What are Non-fungible tokens (NFTs)?
Non-fungible tokens (NFTs) are unique digital assets created in limited quantities. They are bought and sold as physical collectibles. They can range from artwork, memes, sporting goods, music, games, and even tweets. Unlike crypto-currencies, they are unique and cannot be traded.
The main appeal of this type of digital investment is the ability to guarantee authenticity, record ownership, and track transactions. Artists can also receive royalties for subsequent sales, and there are several marketplaces where NFTs can be bought and sold, including OpenSea and Mintable, backed by billionaire Mark Cuban.
NFTs and Taxes
The IRS has not yet taken an official position on the taxation of NFTs, although it is possible that some NFTs are considered collectibles and may be subject to higher tax rates. However, given that they are used in most NFT transactions, they are more likely to be subject to the same tax regime as crypto-currencies. If you use cryptocurrencies to buy NFTs, both the seller and the buyer are involved in a taxable transaction. Depending on whether you are a creator, trader, or investor, there are different tax consequences to consider.
Creator
If you create NFT, you will only be taxed when you sell your creation. Profits made after the sale are taxed at normal income tax rates and are subject to self-employment tax. Any crypto-currency fees paid on subsequent sales will also be taxed upon receipt.
Buyers/Investors
If you purchase NFT with cryptocurrencies, you must pay taxes on any short-term or long-term capital gains or losses. For example, if you use Ethereum (ETH) to purchase a piece of digital art worth US$10,000 that you bought two years ago for US$1,000, the long-term capital gain would be US$9,000 (US$10,000 – US$1,000). However, NFTs classified as collectibles may be subject to a long-term capital gain rate of 28% for higher income earners.
In the same situation, you will have to pay a higher tax rate on short-term capital gains if the ETH was purchased less than 12 months after the date of purchase. Depending on the federal tax rate, this rate can be as high as 37%.
On the other hand, if you buy ETH for $15,000, you will incur a loss of $5,000 ($15,000 – $10,000). Potential gains or losses can also occur when an ETH is exchanged for another ETH or sold in its entirety.
Note that most exchanges do not provide documentation, so you must keep detailed records of your transactions to determine costs and market value.
Tax-Free NFT Transactions
There are a few instances where the acquisition of NFTs does not fall within the scope of a taxable event. These are as follows.
- Purchases are made with U.S. currency or credit cards and not with crypto-currencies.
- The purchase of new crypto-currencies to acquire NFTs rather than withdrawing them from an existing account.
However, you must determine whether there is a gain or loss (of capital) when you sell or trade NFTs.
Don’t forget about state taxes and fines.
In addition to the federal taxes, buyers and sellers of NFTs may pay income, sales, and/or use taxes. It is important to find out what rules apply to capital transactions in your state. Depending on where you live, capital gains may be taxed as normal income.
It is also important to contact a tax consultant service about quarterly tax payments; if you make a significant profit on the sale of an NFT, but do not make enough payments during the year, you may be subject to an underpayment penalty. Quarterly payments help avoid penalties.
