Why the IRS Should Love NFTs

Sales and trading of nonfungible tokens (NFTs) are soaring recently. With the emergence of major marketplace platforms such as Opensea, NFTs are no longer an obscure segment of the blockchain technology world. Even old guard auction houses such as Sotheby’s are getting in on the action. In early September, the auction house facilitated the sale of a set of “Bored Apes” NFTs that sold for more than $24.4 million.

While the emerging space of NFTs is full of excitement, risk and opportunity, there’s the boring tax side of the equation. Unlike most other forms of assets or income, creating, trading and investing in NFTs can trigger a tax event.  

Creators

NFTs are classified as “self-created intangibles” like other works of art. The IRS allows the artist to deduct the expenses of creating the NFT immediately – even if the artwork is not sold. As a result, the creator typically has zero “basis” in their work. This mean when they do sell their work, they’ll have no deductions, so a $100,000 sale means $100,000 of taxable income.

There is little formal guidance, but general principles indicate that NFTs are their creator’s inventory instead of a capital asset. This means that this income is treated as ordinary income and not capital gains – and it is subject to self-employment taxes as well.

Lastly, with certain NFTs, while the NFT itself is a unique blockchain token, the creator might retain copyright to whatever underlying artwork was used to make the NFT. Here, the creator may sell multiple NFTs based on the same original artwork as limited-edition, signed reprints. When the copyright is retained and copies are sold, the income is considered a royalty.

Traders and Investors

Trading NFTs is not as simple as trading stocks.

NFTs are purchased with cryptocurrency (most commonly Ethereum). Since the IRS treats cryptocurrency as property instead of currency, the purchase itself creates a taxable event. Swapping your Ethereum for an NFT means you’ll have to pay tax on any gain you have in your Ethereum position between its value at acquisition and the moment of using it to acquire the NFT.

Second, taxpayers will trigger a taxable event when they sell the NFT, thereby subject to capital gains taxes on the sale of the NFT at the 28 percent collectibles rate.

Conclusion

NFTs offer fantastic opportunities at tremendous risk. As a result, there will be winners and losers, but one thing is certain: the IRS should love NFTs for the taxes.


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