Tax Rules for NFTs: How Non-Fungible Tokens Are Treated by the IRS

Tax Rules for NFTs: How Non-Fungible Tokens Are Treated by the IRS

Non-fungible tokens, or NFTs, have exploded in popularity in recent years. But when it comes to taxes, there’s been a lot of confusion about how NFTs are treated by the IRS. This article will break down the key tax rules and implications for NFTs in plain English so you can understand how they’ll impact your crypto taxes.

What are NFTs?

First, a quick refresher on what NFTs are. NFTs are unique digital assets that represent ownership of something digital, like art, music, videos, tweets, etc. Unlike cryptocurrencies, NFTs are not interchangeable. Each NFT has distinctive properties and value that make it one-of-a-kind.

NFTs are bought and sold on marketplaces using cryptocurrency, most commonly Ethereum. The record of who owns an NFT is tracked on a blockchain. NFT trading exploded in 2021, with sales exceeding $30 billion.

How the IRS Plans to Tax NFTs

In March 2023, the IRS announced it intends to tax some NFTs as collectibles, like artwork or precious metals. This means NFTs could be subject to a higher capital gains tax rate of up to 28%, compared to the typical maximum rate of 20% for assets like stocks or real estate.

The IRS said it will use a “look-through” analysis to evaluate each NFT and determine whether it qualifies as a collectible. They will consider factors like the nature of the underlying asset, how it’s traded, how much control the owner has, etc.

This proposed guidance is still not finalized. The IRS is seeking public feedback in 2023 before issuing official rules. But the announcement gives us insight into how the IRS views NFTs for tax purposes.

Tax Implications of the IRS’s Approach

If finalized, the IRS’s plan to tax certain NFTs as collectibles would have several key implications:

• Higher taxes for high-income taxpayers – The collectibles tax rate of 28% applies to individuals with >$539,900 in taxable income. For these high earners, NFT profits could face substantially higher taxes.
• Limitations for IRAs/401(k)s – Individual retirement accounts and other tax-advantaged accounts face restrictions on holding collectibles. This could limit investors’ ability to hold NFTs in retirement accounts.
• Headaches for DeFi protocols – Decentralized finance apps that reward users with NFTs may need to issue 1099 tax forms if the NFTs are deemed collectibles, complicating tax reporting.
• Record-keeping challenges – Collectibles require meticulous records of cost basis and sale price for every NFT. This could be extremely difficult given the complexity of tracking NFT transactions across multiple wallets and marketplaces.

Other Key NFT Tax Rules

Aside from the proposed collectibles tax treatment, there are other important NFT tax rules to keep in mind:

NFTs as Business Income

If you create and sell NFTs as a business, the income is subject to ordinary self-employment taxes of up to 37% instead of lower capital gains rates. You may also be able to deduct business expenses like fees and gas costs.

Trading NFTs for Crypto

Whenever you exchange one crypto for another – including trading an NFT for ETH – it’s a taxable event. You’ll owe capital gains taxes on any appreciation in the cryptocurrency since you acquired it.

NFT Airdrops & Rewards

Receiving an NFT airdrop or as a reward triggers ordinary income tax when you receive it. The value is whatever the NFT is worth in USD at that time. This income may also be subject to self-employment tax.

NFT Mining/Staking Rewards

If you mine or stake NFTs, the rewards are taxed as ordinary income when received. The value is based on the USD fair market value of the NFT reward at the time it’s received.

Gifting NFTs

Gifting an NFT to someone else or donating it to charity is not a taxable event for you as the giver. However, the recipient takes over your cost basis and holding period. So if they later sell at a profit, capital gains taxes still apply based on your original acquisition price.

Key Takeaways

Here are some key points to remember when it comes to NFT taxes:

• The IRS intends to tax certain NFTs as collectibles, with a higher 28% tax rate for high earners.
• Look-through analysis will evaluate each NFT’s underlying asset and use.
• Final rules are still pending – public feedback is being collected in 2023.
• Trading NFTs for crypto triggers capital gains taxes.
• NFT income from sales, mining, staking, airdrops, etc. is generally ordinary income.
• Meticulous cost basis records are essential with the complexity of NFT transactions.

Taxes for NFTs are still a gray area in many respects. But this guidance from the IRS gives us an idea of how they view NFTs and how they are likely to be treated. As with all crypto tax matters, working with a knowledgeable CPA can help you navigate the uncertainties and complexities to report NFT transactions accurately.