The booming non-fungible token market is showing no signs of slowing as investors pour money into digital collectibles, but the tax rules for NFTs are far from clear.
NFTs are basically digital assets, the data of which is stored on a blockchain, similar to cryptocurrencies like Bitcoin and Ethereum. It can digitally represent a work of art, a photo, a tweet, or even just some other code. The technology hit the headlines in March when artist Mike Winkelmann, aka Beeple, sold an NFT of his work “Everydays – The First 5,000 Days” at Christie’s auction for $ 69 million and the first tweet from Twitter CEO Jack Dorsey was sold for $ 2.9 million. In June, World Wide Web inventor Tim Berners-Lee sold the original source code for the web for $ 5.4 million.
While Congress this week debates a provision to increase cryptocurrency tax reporting to pay for the bipartisan infrastructure plan, there is still relatively little regulation for the growing NFT market. But that could change.
“NFTs are kind of a bonanza for the IRS because they really create multiple taxable events for the parties involved,” said Shaun Hunley, tax advisor at Thomson Reuters Tax & Accounting. “First you have to look at it from the perspective of the creator of the NFT or the artist. Usually it’s an artist, but it can also be a writer. For example, NFTs can contain a tweet. It’s wild for people to buy a tweet. I think that’s why NFTs have gotten a lot of attention because many of us think it’s absurd. You are paying all that money for an extra copy of something. It can be a tweet or a work of art, but you need to look at it from the artist’s perspective first. If the artist sells the NFT, this is usually done through an auction. “
Internal Revenue Service headquarters in Washington, DC
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Sites like SuperRare and Nifty Gateway specialize in selling NFTs, while traditional auction houses like Sotheby’s and Christie’s have also taken action.
“If the creator sells it through one of these auction sites, that will be normal income for that creator,” Hunley said. “That will be business revenue. Right now the peak rate is 37%, so right there, especially if they’re selling for millions of dollars, that’s a lot for the IRS. It’s a normal income, and moreover, it will be subject to self-employment tax for being in that trade or business, a creator of NFTs, or an artist. In addition, if many of these artists sell the NFT they can actually retain the copyright to the NFT, and because they retain the copyright, they may actually receive royalties in the future when people watch the NFT. That is another layer of income that is taxed by the Creator. “
The person buying the NFT is also likely to face tax issues even if they lose the digital keys or wallet to actually view or access the NFT they spent a fortune on, or if the exchange, from who bought them goes down or simply disappears with their digital assets.
“The person who buys the NFT usually buys it with cryptocurrency,” Hunley said. For example, Sotheby’s requires you to buy it with either Bitcoin or Ethereum and you must use one of five approved virtual wallets. You have to stick to what you want to do, but you are using a cryptocurrency to buy the NFT so the mere purchase becomes a taxable event since the IRS has said cryptocurrency is owned and because it is owned every time you trade it in for something else you have a chargeable event. I don’t think a lot of investors will realize that, and it will surprise people. “
The sale of the purchased NFT also has tax implications. “Maybe they’ll hold the NFT for a year or so and then sell it, so this will actually be a capital asset in their hands,” Hunley said. “I think many practitioners agree that it is considered a collector’s item, and collectibles are taxed at 28% for high earners. Most of the people who buy these things are high income earners, so they pay 28% of the profits when they sell the NFT. So this is another tax event. It’s like it never ends. The IRS will love this. Of course they have to push it through. “
The IRS has not yet issued any guidance on NFTs. So if an investor loses access to the digital tokens, they cannot claim any investment or gambling loss. The NFT area is so new that there is no case law for practitioners to rely on.
“There is no case law on this and there is absolutely no guidance from the IRS, not even informal guidance,” Hunley said. “Sometimes they post FAQs about certain things. I haven’t seen that with an NFT. The IRS is a little slow when it comes to technology and new things that pop up. It will take you several years to find out. That’s what happened to crypto. It was about five years before they took up a position. I think this will be similar, but they’re okay with this because they just rely on the idea that you’re just using general tax principles for these kinds of things, and that’s how you will do it. Here we approach the matter from a tax law perspective. We’re just saying that you are using general tax principles and that is what we are pursuing. But you never know The IRS could come out and say something completely different and change everything, so we have to see. “
The IRS Criminal Investigation Division, on the other hand, is busy tracking cryptocurrency tax evasion cases and working with other tax authorities in four other countries – Canada, the UK, Australia, and the Netherlands – through a group called J5 for tax cases involving cryptocurrency (see story) . If NFTs are used by criminals for money laundering and tax evasion, a similar approach could follow.
“They are currently very much focused on enforcing crypto, both from a criminal law perspective and from a civil law avoidance perspective,” said Hunley. “They’ve done a lot with cryptocurrency enforcement so they may not have time to look at NFTs right now, but I think they will when these get more popular, and I think they will get more popular. You will start looking at that. “