NFT Tax Guide
While NFTs and cryptocurrencies are hot topics in the news, understanding the tax implications of NFT transactions is far from clear.
If you create or invest in non-fungible tokens (NFTs), it is essential that you learn your taxpayer responsibilities when buying and trading NFTs.
Table of Contents
- NFTs, or non-fungible tokens, are unique digital assets that are authenticated using blockchain technology whose value lies in being one-of-a-kind, and because these digital assets are new, the IRS has not yet provided specific taxation guidance for taxpayers.
- NFT transactions are taxed at different rates depending on whether the capital gains were considered short-term or long-term, the income tax bracket of the taxpayer, and whether the NFT is considered to be a collectible by the IRS.
- The three types of taxable NFT transactions include purchasing an NFT using fungible cryptocurrency, selling NFTs for fungible cryptocurrency or fiat currency, or trading one NFT for a different NFT. Transferring NFTs to a different wallet, donating NFTs, or purchasing NFTs using fiat currency are not considered taxable transactions.
- Taxpayers must report their NFT transactions to the IRS using their regular federal income tax return, IRS Form 1040 and IRS Form 8949, Sales and Other Dispositions of Capital Assets.
What Are NFTs?
An NFT, or non-fungible token, is a new type of digital asset that is verified for authenticity through blockchain technology.
NFTs may be in the form of an MP4, a JPEG, or possibly a GIF, allowing artists to digitize their intellectual property, including art, videos, text, music, or images.
By digitizing their work of art and minting it as an NFT, artists are able to sell the virtual equivalent of an autographed piece.
NFT Tax Implications
One of the factors that makes NFT taxes difficult to understand is that the IRS has yet to directly address the specific tax implications of NFTs, despite including NFTs when discussing digital assets.
For example, as cryptocurrencies are considered fungible and can be replicated, the rules for tax filing unique NFTs may be different.
Fungible Vs. Non-Fungible Tokens
The main difference between cryptocurrencies and NFTs is whether or not the asset can be directly exchanged for other goods, services, or currencies.
Cryptocurrencies such as Ethereum, fiat, and Bitcoin are considered fungible because they are non-unique tokens that can be exchanged for other items of value. Therefore, people use cryptocurrencies as a form of payment when purchasing other assets.
Non-fungible tokens are unique and unable to be divided or replicated. Therefore, NFTs are considered a deed or title to a type of unique asset.
Cryptocurrency Vs. Fiat Currency
Cryptocurrency is a digitally created form of payment that is able to exist without the assistance of a central bank. Fiat currency, on the other hand, is a form of payment that has a value derived from the decisions of central banks.
NFT Life Cycle
NFTs undergo a “life cycle,” during which the methods of taxation are approached differently. Here are the most important tax distinctions at each stage of the NFT life cycle:
Creation Of The NFT
When NFTs are first created, a person turns a piece of work into an NFT in a process called “minting” or tokenizing.” This process is similar to when an artist signs their artwork upon finishing the piece.
While converting a piece of work makes the NFT more valuable, the process of initially creating an NFT does not create income or a taxable event, according to the IRS. NFTs will only begin to be taxed once the work is sold to a buyer.
Original Purchase Of The NFT
When an NFT is sold to a buyer, the seller is subject to being taxed. Additionally, depending on the currency the buyer uses to make the NFT purchase, it is possible that the buyer will also have to pay taxes during this purchase.
Purchases Using Cryptocurrencies
In many situations, the buyer will utilize Ethereum, a fungible cryptocurrency, in order to purchase an NFT. Using cryptocurrencies to purchase an NFT is essentially like selling a stock and using the proceeds to purchase artwork.
During a situation where someone uses crypto to purchase an NFT, the cryptocurrency that was used must be evaluated for how the capital gains rate is applicable for taxes.
Depending on how long the taxpayer held the cryptocurrency and whether the cryptocurrency has increased in value since the initial purchase, the cryptocurrencies will be taxed at different rates.
The buyer may owe short-term capital gains tax on cryptocurrencies they used to purchase an NFT that they held for less than one year or long-term capital gains tax on the cryptocurrency held for more than one year.
Usually, the tax rate for short-term capital gain is higher than the tax rate for long-term capital gain, so it is beneficial for people who purchase a cryptocurrency like Ethereum with the intention of buying an NFT to wait until 12 or more months have passed so that their crypto taxes are lower.
The Original Creator
The original creator of an NFT may still be able to receive taxable income from their NFT after it is sold, along with the new owner, but this largely depends on the intellectual property licensing terms that were initially established.
Both the original creator and the new owner may be able to receive royalty payments every time someone views the NFTs. Additionally, if the new owner decides to sell the NFT in the future, the original creator may still receive a portion of the sale.
NFTs have similar features to intangible assets, also known as non-physical assets. Some intangible assets undergo amortization, a process of expensing costs such as trademarks and patents that are associated with intangible assets, and NFTs can be amortized as well.
While not all NFTs have to be amortized, if an NFT that was amortized is purchased, it may be subject to taxation.
Sale Of The NFT
Depending on whether an NFT was held as a capital or non-capital asset, the tax implications of selling the NFT are different.
Non-Capital Asset Vs. Capital Asset
If the NFT was created by the taxpayer, it would be considered a non-capital asset. Therefore, any gains and losses accrued when an NFT is sold would generate ordinary gains and losses.
If an NFT is held by anyone who is not the original creator, it is likely to be considered a capital asset. Selling an NFT that is a capital asset generates capital gains and losses.
NFT Transactions Taxation Requirements
Certain NFT transactions are considered taxable, meaning the taxpayer must pay capital gains tax on the changes to the price of their cryptocurrency assets, while other NFT transactions are not subject to federal taxation.
Taxable NFT Transactions
Certain NFT transactions are subject to capital gains tax when the transaction involves an increase in the value of the crypto assets. Some examples of taxable NFT transactions include:
- Purchasing an NFT using fungible cryptocurrency
- Selling NFTs for fungible cryptocurrency or fiat currency
- Trading one NFT for a different NFT
Non-Taxable NFT Transactions
- Transferring an NFT to a different wallet
- Donating or gifting NFTs
- Purchasing NFTs using fiat currency
NFT Tax Rates
The IRS does not implement one set tax rate for all NFT transactions. Rather, the tax rate for NFT transactions will vary depending on several factors, such as whether the capital gains are considered short-term or long-term, their income tax bracket, and the type of asset.
Short-Term Vs. Long-Term Capital Gains Tax Rate
Short-Term Capital Gains Tax Rate
Taxpayers who sell an NFT within 12 months of first receiving it will be subject to the short-term capital gains tax rate that falls between 10-37% of their gains, depending on their regular income tax bracket.
Long-Term Capital Gains Tax Rate
NFTs that are not considered collectibles that are sold after being held for 12 months or more will be subject to long-term capital gains tax instead of at the tax rate of short-term capital gains.
Income Tax Bracket Tax Rate
Creators who earn revenue through selling NFTs will be subject to regular income tax. At the federal level, income is taxed between 10-37%, just like for short-term capital gains, depending on the person’s filing status and annual taxable income.
Collectible Tax Rate
The IRS considers certain NFTs as collectibles in terms of the taxation requirements, which makes a difference in how much a taxpayer will owe, as collectibles are a part of a special class of capital asset, and this class is taxed at a higher tax rate.
When considering the tax implications of collectible NFTs, it is important to note that this tax rate is only applicable when assets are sold in the long-term, or after holding the asset for more than 12 months. Assets that are disposed of less than 12 months after the initial acquisition cannot be subject to the collectible tax rate. NFTs that are considered collectibles will be taxed at a minimum rate of 28%, which is a higher tax rate than the usual tax rate for long-term capital gains.
Which NFTs Are Considered Collectibles?
According to an IRS statement, the method for determining whether an NFT is considered a collectible will be determined by the IRS directly evaluating the NFT, particularly the rights and benefits the NFT represents. For this reason, there is a large gray area for what the IRS may consider a collectible.
Sometimes it can be difficult to judge whether an NFT is considered a collectible that would be taxed at a higher tax rate or if it would be considered a regular NFT. Consulting with a tax relief expert is the best approach to understanding which category their NFT falls into and how they should proceed with their tax plans.
Capital Gains Vs. Ordinary Income
While many of the taxpayers who intentionally purchase NFTs must comply with the tax rules for capital gains and losses, there are other situations during which an individual may come across an NFT in a way that would create ordinary income instead of capital gains. If NFTs are included in an individual’s ordinary income, this will impact which income tax bracket they fall into.
Here are some ways a taxpayer could acquire an NFT that would count as ordinary income:
- An NFT being airdropped or sent directly to their account
- Receiving cryptocurrency as a form of payment in exchange for goods or services
- Being rewarded an NFT for staking or mining
- Earning interest in the form of cryptocurrency
NFT Gains and Losses Taxation Examples
The tax consequences of purchasing and selling NFTs differ depending on whether the situation resulted in a capital gain or capital loss.
NFT Capital Gains
In this situation, John used $200 to purchase Ethereum in 2022, and 8 months later, he sold the NFT for $1,000, generating a capital gain of $800 ($1,000 – $200).
Due to the fact that John held Ethereum for less than 12 months, this is considered a short-term capital gain, and his gains will be taxed at the short-term capital gains rate, which is higher than the long-term capital gains rate.
In this situation, John used $200 to purchase Ethereum in 2020, and in 2023 he used Ethereum to purchase an NFT valued at $1,500. The Ethereum incurred a long-term capital gain of $1,300 ($1,500 – $200).
Because Ethereum was held for over 12 months, this is considered a long-term capital gain and will be subjected to the long-term capital game tax rate for his tax bracket.
NFT Capital Losses
If John purchased $2,000 worth of Ethereum in 2020 and a year later used the Ethereum to purchase an NFT valued at $1,300, the transaction would have resulted in a capital loss of $700 ($2,000 – $1,300). If this was the only capital asset sale he had for the year, he could deduct the full capital loss, up to $3,000, from his tax liability to offset his income. If the capital loss was greater than $3,000, the remaining amount that wasn’t able to be deducted will carry forward to other tax years.
If this NFT that was purchased at a value of $1,300 was sold two years later for $1,000, John experienced a capital loss of $300. If John is classified as an investor and has no other capital asset transactions, up to $3,000 can be deducted from his income for the first tax year, the remaining amounts carrying forward into future tax years.
However, it is important to note, that if John is not classified as an investor, this would be considered as a personal loss and not a capital loss.
How To Purchase NFTs
The most popular method of purchasing non-fungible tokens is using the cryptocurrency Ethereum. In order to purchase Ethereum, taxpayers must use a crypto exchange platform, transfer the currency into a crypto wallet, and then use it to purchase an NFT.
Some places also allow buyers to purchase NFTs using fiat currency, such as regular dollars, instead of using a cryptocurrency, but in general, most NFTs are purchased using crypto.
How To Report NFT Taxes
Taxpayers are responsible for reporting the gains and losses from their capital assets, such as NFTs, using IRS Form 8949, Sales and Other Dispositions of Capital Assets, included with their IRS Form 1040, U.S. Individual Income Tax Return.
IRS Form 1040
The first tax form that people who invest in crypto must use to report their NFT taxes is the regular IRS 1040 Form, U.S. Individual Income Tax Return. The taxpayer is required to check “yes” on the IRS 1040 Form asking the cryptocurrency question: “At any time in 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
Investors and creators of NFTs can use the Schedule D tax form to report their capital gains and losses from NFT trading. Professional creators can use the Schedule C tax form to report business expenses and NFT-generated income.
IRS Form 8949
If taxpayers are trading an NFT or multiple NFTs that are not considered a collectible item, they can report all of their capital gains and losses from assets including NFTs on a single Tax Form 8949.
However, if one or more of the NFTs being traded are considered collectibles, tax experts recommend that they report all of their collectible disposals in a separate tax form to their other non-collectible capital assets.
Tips For Minimizing NFT Taxes
While the tax law states that NFT assets must be reported to the IRS, there are strategies that taxpayers can take advantage of to minimize their tax liability.
Hold Onto NFT Assets For The Long-Term
Holding onto NFT assets for longer than 12 months or one year is the simplest strategy for taxpayers to reduce the taxes they are required to pay on digital assets. This is because the tax rate for long-term capital gains is lower than the tax rate for long-term capital gains.
Get Rid Of NFTs During Low-Income Years
The rate at which taxpayers are taxed depends on their tax bracket, a categorization based on an individual’s annual income and filing status.
For this reason, if taxpayers who own digital assets have a low annual income for one year, they may choose to dispose of some cryptocurrencies and NFTs they own so that their tax liability is minimized.
NFT Tax-Loss Harvesting
Taxpayers whose NFTs are currently at a lower market value than at the time they were purchased have the option to sell their NFTs at a loss and claim the capital loss when they file their federal income tax return.
If an individual chooses to use this strategy, their NFT capital losses can offset what they would have had to pay in capital gains tax on up to $3,000 of income and the sales of other NFT, cryptocurrencies, or stock sales.
Purchasing Using Fiat Currency
Purchasing NFTs using fiat currency is another tax-advantaged strategy for taxpayers to lower their NFT tax liability because, according to the IRS, buying assets using fiat is not considered a disposal of property. Using cryptocurrency coins that have seen significant appreciation, on the other hand, is a less favorable option in terms of tax liability as there will be capital gains tax incurred on the price change of the coins.
In order to ensure 100% tax compliance at the local, state, and federal levels when you have purchased or sold NFTs, a newer digital asset that is yet to be fully defined by the IRS, consulting with an experienced tax professional is a beneficial strategy.
If you have any questions about how to report NFT taxes to the IRS, the tax pros at Ideal Tax are here to help. Set up a free consultation today if you have questions about the taxability of NFTs or how to take advantage of tax-deferred or tax-exempt investments.