13/08/2021 NFTs: Why The Next Big Thing In The Digital Economy Is A Cash Cow For The IRS

Sales and trading in nonfungible tokens (or NFTs) have gone from increasing to skyrocketing. They’re new. Their values can be volatile. But for those with U.S. tax obligations they can also be a goldmine for the IRS. Why? Because unlike most other forms of income and assets, NFTs can create multiple taxation events for both those who are creating them and those who are trading them. In a recent interview for Forbes.com Shaun Hunley, a Georgia-based tax attorney and tax consultant for Thomson Reuters, stressed the importance of understanding all of the different ways creating and/or trading in NFTs can result in federal income tax.

NFT Creators

NFTs are considered “self-created intangibles” like many other performances or works of art. What this means is that the creator has no “basis” in what is being sold other than possibly the expenses related to creating it. The IRS, however, has an exception that allows artists to deduct expenses as they go rather than when the artwork is sold. If an NFT creator has deducted their expenses in a tax year prior to the year in which the NFT is sold, the creator has zero basis in the NFT. That means the profit or gain is 100% of the proceeds realized on the sale. Someone who creates an NFT and sells it for $1M has $1M of taxable profit.

Although actual guidance from the IRS is woefully lacking, general tax principles indicate that NFTs are likely to be considered their creator’s inventory (as opposed to capital assets) by the IRS. Whether someone is in the business of creating NFTs or is an artist or celebrity who is simply adding NFTs to their income stream, the sale of an NFT is not only going to be taxed as ordinary income (as opposed to the more favorable capital gains) it is also going to be subject to self-employment taxes. And the tax fun doesn’t end there. While the original NFT is a unique token on the blockchain the artist or creator may retain the copyright to whatever was used to create the NFT itself. For example, NBA Top Shot (one of the hottest NFT markets right now) allows an individual to purchase a unique URL that links to a site where a specific NBA highlight is located. The individual is not purchasing the copyright to the highlight video, the NBA retains that. The individual is purchasing a limited use license (that does not include making and distributing copies of the video). An artist or performing artist may decide to sell multiple NFTs based on the same original artwork or performance, similar to limited edition signed reprints or limited released copies of a live performance. When copyright is retained and copies are being sold the income is considered royalties which must be reported annually on Schedule E and attached to the individual’s Form 1040. Bottom line? NFT creators could be looking at three taxable events when they sell a self-created NFT: income tax on the sale itself, self-employment tax on the sale, and income tax generated by royalties.

NFT Traders and Investors

But what if you’re not a creator? What if you are simply buying NFTs to hold or to trade? Unfortunately trading NFTs is not as simple as trading other capital assets (like stocks or real estate). Currently NFTs must be purchased with cryptocurrency (specifically ethereum). Because the IRS still treats cryptocurrency as property rather than currency, simply purchasing an NFT creates a taxable event: the conversion of cryptocurrency for purchase of the NFT. Depending on the taxpayer’s basis in the cryptocurrency exchanged (what was paid for the crypto) the purchaser could realize a taxable gain or loss on the conversion. Additionally, gains could be taxed as ordinary income (rather than at long-term capital gains rates) if the holding period for the crypto isn’t long enough to qualify for the more preferential tax treatment. Gain on conversion of crypto may be subject to the additional 3.8% Net Investment Income Tax (NIIT) if the taxpayer’s income is high enough. The taxpayer will also be subject to capital gains tax on the sale of the NFT should they ever decide to sell it. But unlike cryptocurrency, NFTs are considered collectibles which are subject to a 28% tax on gains on their sale (plus NIIT if it applies).

Consider a taxpayer who used ethereum purchased for $10,000 to buy an NFT valued at $100,000. The taxpayer has a $90,000 gain on the conversion of the ethereum. Depending on the holding period for the ethereum the taxpayer is either going to pay ordinary income tax or capital gains tax on that $90,000. Five years later the NFT is worth $500,000. The taxpayer decides to sell it. The sale of the asset (the NFT) generates a $400,000 capital gain (because of the five-year holding period) but, because NFTs are considered collectibles, the $400,000 is subject to a flat 28% tax as opposed to the lower (and income-based) capital gains rates (0%, 15%, or 20%). Finally, unless there are offsetting losses somewhere else on the tax return, a transaction this large will almost always result in NIIT as well.

Compliance and Enforcement

Right now the IRS is highly focused on cryptocurrency transactions and, according to Hunley, it may take them another few years to catch up with taxation enforcement of NFT creation and trading. NFT trading, while growing, is still low volume when compared with cryptocurrency transactions. In other words, IRS enforcement of taxation of cryptocurrency transactions casts a much wider (and more lucrative) net in the short term. Nevertheless, Hunley feels that the IRS may apply the lessons they are learning in cryptocurrency taxation and enforcement to NFTs and other emerging digital economy technologies moving forward.

Tax practitioners who specialize in the digital economy have been calling for more guidance for both cryptocurrency and NFTs. The IRS has been slow to respond. Right now Hunley suggests practitioners in the area rely on general tax principles and best practices such as documenting the guidance relied on when deciding how to report the transaction on a client’s tax return. Hunley notes that “valuation especially can be sticky.” Taxpayers who are investing in NFTs should track all of their cryptocurrency transactions, keep a record of the purchase price of their NFTs, and keep a record of the sale price or fair market value of the NFTs for reporting purposes. Like any other asset NFTs may decline in value and a trader may realize a loss. Losses realized on the decline in value of personal assets, however, are not deductible on a tax return. When asked about “a blockchain ending apocalyptic event that renders all NFTs worthless” Hunley indicated that, while such an event was extremely unlikely, if it did occur the associated losses would most likely result in non-deductible personal losses (similar to casualty losses in non-disaster areas) than deductible capital losses (which are limited, but are at least available). Again, however, absent specific guidance from the IRS on such issues, most practitioners must rely on their knowledge of basic tax principles and do their best to apply them to the client’s specific facts and circumstances.

Taxpayers who trade in cryptocurrency and/or NFTs also need to be aware of the potential for creating reporting requirements for foreign accounts and possibly foreign-sourced income. The penalties for even accidentally overlooking foreign reporting requirements are steep, and those for willful non-reporting are worse. And, as with cryptocurrency, the IRS is prioritizing enforcement around foreign account and income reporting.

Finally, securitization of cryptocurrency is already happening and the possibility for securitization of NFTs held for investment is always a possibility although according to Hunley probably not in the immediate future. Hunley reminds readers that the best way to avoid surprises is to tell your tax professional about your cryptocurrency and your NFTs each year and to be honest when answering their questions. Remember, however, that communications for return preparation purposes are not privileged so if you haven’t been doing contemporaneous reporting it may be better to consult an attorney before working with your tax professional to correct prior year reporting and non-compliance.



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