NFTs, or non-fungible tokens, have captured the investing world’s interest in recent years as high-profile sales of digital art and other digital collectibles like CryptoPunks soared in popularity and price. According to CoinGecko, a total of $26.3 billion worth of NFTs were sold in 2023, although that number dropped to $11.8 billion in 2023, which many see as a new frontier in digital investing.
With all that speculation, some traders are making a profit, while NFT creators are also generating revenue for their virtual designs. But in this rapidly emerging market, the Internal Revenue Service (IRS) has not yet provided clear guidance on a number of tax issues, creating even more uncertainty.
So what should investors and creators know when filing taxes and how do they respond? Here are six things those involved in creating and trading NFTs need to know.
1. Investors and creators do not owe taxes until an NFT is sold
If you create or trade NFTs, you don’t owe taxes until the NFT is actually sold. In the case of a creator, it is the same as anyone who creates something, such as a painting. When they sell that painting, they realize income from the production, but not before. That income is recognized as ordinary income and taxed like any other salary from work.
In the case of NFT transactions, traders are liable to pay taxes if they sell an NFT for a profit. But as long as they hold the NFT and don’t sell it, they can sit on their unrealized gains without paying taxes.
And how are these NFT transactions treated for tax purposes? In March 2023, the IRS issued a statement saying it planned to tax some NFTs as collectibles, while others could be taxed at the more preferential capital gains rates.
The IRS says tax treatment depends on the underlying asset of the NFT. If that underlying asset is currently considered a collectible (such as art), the NFT is treated as a collectible. If it is not a collectible, it is taxed at the capital gains rate.
That treatment is important because different tax rates are applied to each type of profit, says Christopher Rogers, senior tax partner at Capital Fund Law Group in New York City.
If you treat NFTs as capital gains, you will owe capital gains tax on the net gain. Rogers says that depending on the filer’s income, this tax treatment is generally more favorable to individuals than collectible treatment, where rates can be as high as 28 percent.
The great thing is that if you have realized a loss on a trade, you can offset that against any profits. In fact, you can realize a net capital loss of up to $3,000 each year and deduct that from your taxable income.
2. Even NFT buyers can create tax liabilities
If you use cryptocurrency like Ethereum to purchase NFTs, you could be creating an entirely separate liability, apart from the NFT itself. That’s because any transaction involving crypto has the potential to create a tax problem, due to the way the IRS has structured the rules around its use.
You create a tax liability when you exchange virtual currency for goods like NFTs or services that are worth more than what your cost basis is in the cryptocurrency. Imagine if you bought Ethereum for $1,000 and then spent it on NFTs worth $3,000, you have created a tax liability and will owe taxes on that transaction. (You can also suffer a loss.)
The IRS rules have made it difficult to use cryptocurrency as an actual currency, and they extend to all transactions involving cryptocurrencies, such as the purchase of NFTs.
3. You also owe taxes on NFT royalties and income
Some NFTs have embedded “smart contracts” that pay the original creator a royalty every time the NFT is sold. For example, the creator can sell to person A, who sells the NFT to person B within six months. Depending on the NFT, the creator can realize a royalty of a few percent on that second-hand sale by Person A, creating a tax. liability for the maker.
Of course, that second-hand sale could also result in a taxable gain or loss for Person A, depending on exactly the cost basis and sales price of the NFT (see point 1 above) and the value received for the cryptocurrency (see point 2 above).
Other newer types of NFTs can represent a stake in an asset and generate income over time. If you receive income from these types of NFTs, you’ll owe taxes at normal income tax rates, Rogers says. It is treated like other regular income.
4. Other IRS rules surrounding NFTs can be murky
The treatment of NFT income is consistent with long-standing IRS rules on income. But what happens when someone gets an NFT? The situation is less clear.
For example, a number of major companies have entered the NFT space, including PepsiCo. In 2023, the soft drink giant minted NFTs and gave them away for free to consumers. Did this promotion result in a tax liability for Americans who received the NFT?
Pepsi did not answer that question and specifically disclaimed any responsibility:
“Participants are responsible for paying any taxes due as a result of participating… and should consult their tax advisors to determine the tax consequences for them.”
In other circumstances, giving away something valuable can create an obligation. For example, if you win a car on a game show, you will probably owe taxes on it. But experts say the way the NFT is treated is unclear: Could it be a dividend in some circumstances and an interest payment in others?
Also unclear is the value of the NFT and what reference price could be used to create a cost basis. While that game show giveaway may have a retail price, what is the “real value” of an NFT? If an NFT entitles the owner to an actual physical asset, is the value of that asset the true value of the NFT?
Experts – and even PepsiCo – recommend that investors get tax help from a professional. Still, the IRS rules seem unclear.
5. Even if you have not received a statement, you still owe tax
If you trade NFTs and make a profit, you will owe taxes even if your NFT exchange or trading platform has not provided you with a Form 1099 detailing your profits. While 1099s are typical of more traditional financial markets and are routinely offered by stock brokers, other brokers may not yet offer them, even though the best brokers and the best cryptocurrency exchanges already do.
You can use Form 8949 to report any sales of NFTs, just as you would if you were reporting cryptocurrency trading activity.
Some cryptocurrency traders may be convinced that they don’t owe taxes on their profits, but the IRS has made it clear that they do and has uncovered mocking laws. Likewise, if you make a profit from trading NFTs, not having a 1099 doesn’t absolve you of your tax liability.
6. Beware of sales tax on NFTs
Many states may start looking closely at taxing NFTs at the point of sale, especially if recent tests in Washington state, Pennsylvania and Puerto Rico do well, opening up sales taxes on digital art.
The Washington state government has made NFTs subject to sales and other taxes in 2023, and Puerto Rico has been exploring the possibility, including creating laws that would treat NFTs as part of digital products subject to sales taxes.
While some experts say the sale of NFTs already legally creates a tax liability in states that tax digital goods, these states receive little or no revenue from them. So it’s possible that more states will soon adopt rules that provide clearer – and enforceable – guidelines for the sale of NFTs.
In short
Even though the IRS hasn’t yet made an official ruling on certain aspects of NFTs and other digital art, that doesn’t mean you’re no longer affected by having to pay taxes on the income from their sale or profits from trading them . Those involved in the NFT market should remain alert as the rules change and ensure they monitor them closely.
