The annual tax season is here again, and the rise of NFTs has spawned a new generation of investors. For today’s NFT investors, it’s important to keep the tax implications in mind. Otherwise, they could end up in a tax nightmare.
After the 2017 bull run, many cryptocurrency traders found themselves in a bind. They accumulated huge tax burdens when the market rose, but no longer had the money to pay them after the crash. Many of these traders are simply unaware of the tax implications of their trades and are not prepared accordingly.
This article will share three things every NFT investor needs to know about taxes to avoid disputes with the Internal Revenue Service (IRS).
When buying NFTs, you will most likely have to pay taxes
Disposing of your cryptocurrency is considered a taxable event, and the purchase of NFTs using Ethereum (ETH) or other cryptocurrencies falls into this category. Depending on how the price of the cryptocurrency changes since you originally received it, you will incur capital gains or losses.
Many NFT traders are saddled with huge taxes because the price of their tokens has surged since they were originally received. To avoid running into tax problems, you should calculate your potential tax bill for every transaction you make, and save the money ahead of tax season.
Taxes when selling NFTs
Selling NFTs is also considered a taxable event, whether you are selling fiat currency, cryptocurrency or exchanging it for a different NFT. NFTs are taxed in a similar way to cryptocurrencies – the taxable income from the sale of NFTs is determined by calculating the difference between the original cost basis at which the NFTs were purchased and the gross proceeds from the sale.
If the value of your NFT has declined since you originally received it, you can claim a capital loss and reduce your taxes as long as you use the NFT as an investment and not for personal use.
You can determine whether the NFT is for investment or personal use by looking at the reason for the purchase. Are you planning to make a profit, or are you planning to just enjoy the NFT for your own use, regardless of whether the asset will appreciate in value.
Capital losses on investments can offset your capital gains for the year and ordinary income of up to $3,000. Capital losses for personal use are not deductible.
Your NFTs may be considered collectibles
Part of what makes it so difficult to classify NFTs for tax purposes is that they are a new type of asset class. Unfortunately, this means that the IRS has yet to issue clear tax guidance on whether certain NFTs will be considered collectibles and taxed at a higher rate.
Certain physical assets are considered collectibles under tax law. This includes art, metals such as gold, and collectibles on stamps or baseball cards. When these assets are sold after a year, they are taxed at a top rate of 28%, while the typical long-term capital gains rate is between 0% and 20%.
It is reasonable to conclude that certain NFT artworks would be considered collectibles for tax purposes.
So what about avatar collections like the Bored Ape Yacht Club? It’s easy to see why they’re considered collectibles by the IRS, as all 10,000 unique images are part of a “collection.” However, this issue is still not fully resolved.
Without additional IRS guidance, any NFT that is not a work of art may not meet the taxable rules. For example, it is reasonable to assume that NFTs representing Uniswap v3 liquidity positions would not be considered collectibles.
Some NFT investors are taking more aggressive tax options. They argue that without guidance from the IRS, NFTs should not be considered collectibles because they are intangible. These investors are taking this approach because the tax code associated with collectibles refers to tangible property — making the situation confusing.
This seems like a difficult case to raise with the IRS. But without guidance, it’s hard to be sure, and there may be taxpayers who decide to lean toward uncertainty and take a more aggressive tax approach, knowing that guidance from the IRS on this issue could be years away.
Tax laws regarding collectibles are complex, and it is best to speak to a tax professional when assessing the collectible status of your digital assets.
Of course, this question may not be important to most NFT investors at the moment. Because NFTs are so new, most sales likely involve NFTs that have been held for less than 12 months. Whether or not they are classified as collectibles, these NFTs are taxed as short-term sales at ordinary rates.
Keeping the tax implications of NFTs in mind, you can avoid unknowingly incurring a very large tax burden in the coming year. Keep in mind that when you buy or sell NFTs, you will most likely be taxed, but it takes careful research to determine if your NFTs are taxable collectibles.
You might also be counting on the IRS to have more clarity on how to classify NFTs, and that clarity may not be coming anytime soon. In the short term, the IRS may turn its attention to NFT investors who choose not to pay taxes at all.