The Uncharted Territory of Taxing Non-fungible Tokens (NFTs)

You may have read about digital artworks selling at auction for millions, or a family photo that went viral selling for $500,000. But the new owners of these works didn’t get anything tangible in return. Instead, they received a digital token — an NFT — which is like a certificate of ownership, of sorts. And as the New York Times, writes, “the market for ownership rights to digital art, ephemera and media, known as NFTs, is exploding.”

How does the NFT market operate and how are the often extraordinary proceeds taxed?  Read on to find out.

The volatility of cryptocurrency prices occupied many headlines in recent months. In October 2020, each Bitcoin traded for around $9,200, which then increased to a staggering $63,000 in April 2021. Bitcoin prices have since fluctuated and hovered between $35,000 and $40,000 in early June. However, whether cryptocurrency is the hidden gem that could revolutionize the investment industry or simply a speculative vehicle is still unsettled even among billionaire investors. Some believe cryptocurrency is digital gold while others describe it as rat poison.

The underlying technology that operates cryptocurrencies, the blockchain, also experienced rapid development. There has been a recent frenzy over non-fungible tokens (NFTs), which are unique digital assets that reside on a blockchain. One database reports NFT sales exceeded $6 billion dollars between January and May 2021; a large part of this enthusiasm is enabled by the high price of cryptocurrencies. Whether NFTs, like cryptocurrencies, are a short-term sensation or a new and valuable type of investment is still subject to debate. Regardless of one’s view about NFTs, it is critical to understand the tax applications of owning and trading these novel assets. This post briefly discusses the attributes of NFTs, key issues of NFT taxation, and potential regulatory developments.

Lifecycle of NFTs

NFTs are unique digital assets that feature distinctive digital representations of underlying items. They exist on a blockchain, which functions as a secured distributed ledger that simultaneously and permanently records transactions on a large number of computers in a network. NFTs are most commonly, although not exclusively, held on the Ethereum blockchain, and the vast majority of NFTs are purchased with cryptocurrencies such as Ether. In the current marketplace, the most common forms of NFTs include music, video, images, tweets, virtual avatars, and digital art. However, all digital forms of representation are plausible: In March, New York Times columnist Kevin Roose converted his column into an NFT, and the token eventually sold for 350 Ether, or roughly $560,000 at the time of sale.

NFTs are “non-fungible” because unlike cash or cryptocurrencies, these digital assets are not interchangeable. Disregarding transaction costs, owning one Ether provides the same value regardless which unit one owns. On the contrary, each NFT is unique because the blockchain provides a distinctive identifying code that is traceable by its location on a blockchain. An NFT creator can also include a digital signature, which essentially links the NFT to a unique Ethereum address and wallet.

These features help NFT holders prove ownership rights and establish subsequent transferability, which facilitate trusted transactions between two complete strangers, reduce costs associated with entering into and enforcing contracts, and speed up the exchanging process. For instance, anyone can easily view, snip, or download an image of Beeple’s Everydays: The First 5,000 Days, which auctioned for $69 million. However, the authenticity of the digital copy and its ownership can easily be verified.

People participate in the NFT market for various reasons. Advocates of NFTs indicate that an artist can have millions of followers, retweets, or likes from social media posts, but still lacks a channel to cash in on his or her popularity. These tokens provide artists opportunities to monetize their work. Some support the development of NFTs because they believe it is a pioneering form of art and a new model of ownership, which will evolve to reshape and redefine the modern art and media industries. Others view NFTs from an investment or speculative perspective: similar to collecting a rare first edition book or buying an artist’s oil painting before she becomes famous, they buy NFTs and hope its value will appreciate. New NFT investors typically purchase cryptocurrencies from exchanges, hold them in digital wallets, and shop for NFTs on popular marketplaces such as OpenSea.io, Rarible, or Foundation.

Minting an NFT is how a digital item becomes a part of the Ethereum blockchain. However, this process is not free for artists. If an artist decides to use a marketplace to sell his NFTs, he needs an account on the platform and a digital wallet to store cryptocurrencies, link NFTs, pay for transaction costs, and collect sales proceeds. NFT marketplaces may charge account initiation fees or commissions, and collect gas fees (costs of interacting with the Ethereum blockchain). For instance, an artist using Foundation typically mints an NFT by uploading a JPG or PNG image or an MP4 format video file, and pays the gas fee. If the piece is sold, Foundation charges 15% of the proceeds as a service fee.

Capital Gains Tax

After receiving the whopping $560,000 from his Times column NFT, Roose closed his follow-up article by saying that he needed to “figure out how to do the transaction without completely screwing up” his taxes. Indeed, there is no NFT-specific tax guidance from the IRS; as such, many practitioners follow an IRS notice for cryptocurrencies, together with general tax principles, as references for NFT tax reporting.

The IRS roughly settled the tax attributes of cryptocurrencies in 2014, indicating the cryptocurrencies are property, instead of currency, for federal income tax purposes. When a taxpayer disposes cryptocurrencies, the tax treatments of gains or losses depend on whether the underlying cryptocurrencies are capital assets. If the cryptocurrencies are considered capital assets, similar to stocks, bonds, or investment properties, the gains will be taxed at favorable capital gains rates for taxpayers who hold them over a year. Short-term capital gains are taxed at the same rates as ordinary income. If the cryptocurrencies are not capital assets, which generally include inventories held for sale to customers, the gains associated with sale or exchange of cryptocurrencies will be ordinary income subject to regular income tax rates.

Creators who mint and sell NFTs in marketplaces usually receive cryptocurrencies as payments. The net proceeds will be taxed as the sellers’ ordinary income, and the taxable portion will be the sales price minus the tax basis. The basis generally includes fees associated with the sales, such as the gas fee, the commission charged by the marketplace, and potentially the expenses connected to creating the NFT.

For buyers, practitioners believe NFTs are likely capital assets unless the buyers are in the trade or business of buying and selling NFTs, such as digital arts dealers. In the latter case, the NFTs will be treated as inventories instead of capital assets, and gains will be taxed under ordinary income tax rates. On the other hand, most infrequent buyers purchase NFTs for investment purposes (they hope the value will go up) or personal use (they appreciate the art) and do not depend on gains from NFT as a primary means of support. Therefore, the gains or losses associated with NFTs transactions are generally treated as capital gains or losses.

Because NFT transactions are completed using cryptocurrencies, investors’ capital gains or losses are two-fold. For each transaction, an investor not only needs to consider the sales price and tax basis of the NFT, she also needs to review the market price and the tax basis of the underlying cryptocurrencies she uses in the transaction. In both cases, the duration of the holding period determines whether the gains are long-term or short-term in nature.

For instance, when an investor purchases an NFT with cryptocurrency and sells the NFT a few months later, there are two taxable events to consider. The first taxable event happens when the investor trades her cryptocurrency for the NFT. For instance, when she used 5 Ether to buy a digital image in March 2021 and each Ether was $1,800, the market price of the NFT was $9,000. Assuming the taxpayer purchased these units of Ether at $200 each in February 2020, her tax basis of the NFT purchase was $1,000. Because she has been holding the Ether units for more than one year, her gain of $8,000 ($9,000 minus $1,000) as a result of disposing the cryptocurrency will be taxed at a long-term capital gains rate.

The second taxable event occurs when the investor sells the NFT and gets her payment in Ether. When she sold the NFT for 3 Ether in May 2021, when the price was $3,800 per Ether, her basis was $9,000 and she collected $11,400. Disregarding transaction costs, she realized short-term capital gains of $2,400 because she held the NFT for less than a year.

Although many rely on the IRS’ 2014 notice as high-level guidance for NFT tax compliance, some believe it is possible that the agency may classify NFTs as collectibles. Under current tax rules, collectibles are typically art, stamps, coins, metals, or antiques; they may also include any other tangible personal property that the Treasury determines is a collectible. Although NFTs are usually viewed as intangible properties, some could be considered as work of art. As such, if a digital asset is classified as a collectible, it will be subject to a special collectibles long-term capital gains rate of 28%. However, this classification does not affect taxpayers who hold the underlying NFT for less than one year – whether an asset is collectible or not, the short-term gains will be taxed as ordinary income.

Beyond tax attributes, NFTs generate an intriguing new form of ownership for digital work. In some cases, an NFT creator may retain copyrights to the NFT and can receive a portion of future sales as royalty when the NFT changes hands. In other cases, the creator is only selling a digital representation of the underlying physical artwork instead of the artwork itself. The burgeoning but fragmented NFT market may create certain challenges from an intangible property valuation perspective. These issues range from valuation of fractional ownership rights, the different types of ownership granted, uncertainty of resale value, and the difficulties for tax authorities to appraise these assets.

Regulatory Developments

The continued volatility of cryptocurrency and the surging popularity of NFTs have definitely gained the attention of regulators. In April, IRS Commissioner Charles Rettig told the Senate Finance Committee that both NFTs and cryptocurrencies are vulnerable to tax evasion. A Treasury Department Tax Compliance Agenda issued in late May recognizes cryptocurrencies as a major concern when it comes to tax evasion and other illegal activities. The document states that tax dodgers who had traditionally used offshore bank accounts or cash to avoid attention now resort to cryptocurrencies as a new way to preserve anonymity, making detection difficult for tax authorities.

In addition, SEC Chairman Gary Gensler has recommended regulating crypto exchanges to prevent fraud, avoid market manipulation and protect investors. He believes crypto tokens are securities and that the SEC therefore should have the authority to regulate them.  Accordingly, he has asked lawmakers to formally grant the SEC authority to regulate these assets.

It is unclear whether the NFT craze will be long-lasting or transient. It is equally uncertain whether NFT purchases will spread to regular consumers or be largely limited to cryptocurrency pros. However, more regulations can be expected for cryptocurrency transactions and cryptocurrency exchanges, which will indirectly impact the NFT marketplaces. Although more regulations mean more rules to follow and higher compliance costs, some observers believe additional regulations may help the industry improve its reputation and attractive more investors. Both are positive developments.

This material may be quoted or reproduced without prior permission, provided appropriate credit is given to the author and Rice University’s Baker Institute for Public Policy. The views expressed herein are those of the individual author(s), and do not necessarily represent the views of Rice University’s Baker Institute for Public Policy.