ATLANTA, GA and WESTCHESTER COUNTY, NY — November 1, 2021 — Based on headline frequency, 2021 is the year of the NFT. But if you plan to dive into the world of this newly popular asset, you will need to brave a complicated tax landscape.
A non fungible token, usually abbreviated NFT, certifies that a particular digital asset is unique. It may be one of a kind, or it may be one of a limited run. Regardless, the “nonfungible” aspect means that only one person can own a particular asset. This is possible because NFTs are stored on a blockchain, most often the one that supports the cryptocurrency Ethereum. Because blockchains are decentralized and past entries are public and unchangeable, blockchain storage makes it possible for anyone to verify an NFT’s authenticity and current ownership.
In theory, creators can sell any digital asset as an NFT. Visual art, newspaper articles and even tweets have served as the basis for high-profile NFT transactions. (Some companies have experimented with using NFTs to authenticate nondigital items too, but so far this is much rarer.) While the underlying piece of art or text usually remains accessible to others, the NFT owner has the satisfaction of knowing that he or she is the “true” owner. The NFT serves as the equivalent of an autographed copy, by definition unique.
NFTs first appeared in 2017, but they have drawn increasing public attention in recent months. In March, my colleague Paul Jacobs wrote about NFTs in this space following the Christie’s auction that sold an NFT for approximately $69 million. Mike Winkelmann, an artist who goes by Beeple, offered an NFT connected to a collage of 5000 images he’d created daily for 14 years. The famous auction house’s involvement drew the notice of buyers beyond existing cryptocurrency enthusiasts. This attention has not flagged in the months that followed. Overall sales on the prominent NFT marketplace OpenSea reached $3 billion in August, Bloomberg reported.
NFTs are not only popular among art enthusiasts. They can also serve as digital collectibles. EtherRock is a collection of 100 JPEGs of cartoon rocks. According to EtherRock’s website, “These virtual rocks serve NO PURPOSE beyond being able to be brought [sic] and sold, and giving you a strong sense of pride in being an owner of 1 of the only 100 rocks in the game :)”. In late August, a buyer purchased the NFT corresponding to one of these virtual rocks for 400 ether, worth about $1.3 million at the time of the sale.
From a financial standpoint, NFTs have a lot in common with both art and collectibles. They can be tricky to value, because their worth is determined by what someone will pay for them rather than any intrinsic qualities. And, like cryptocurrencies, NFTs are new enough that tax authorities have issued little guidance. NFTs are likely to be considered intangible assets, but other aspects of their tax treatment are still unclear. At this writing, the Internal Revenue Service has not addressed NFTs specifically at all, though most tax professionals place them under the umbrella of “virtual currency,” with its corresponding rules. This guidance also covers Ether, Bitcoin and other cryptocurrencies; for more, see my colleague ReKeithen Miller’s article “Tax Complexities Of Cryptocurrencies.”
While NFTs, like cryptocurrencies, reside on a blockchain, their nonfungible nature means they raise certain tax issues that fungible property like Bitcoin does not. Taxpayers who buy or sell NFTs should take care to handle related tax concerns carefully.
Tax and NFTs for Investors
Whether they buy an NFT to support a particular artist, to secure bragging rights or to participate in a community, most NFT purchasers plan to hold their tokens for some amount of time. Some buyers might actively hope to turn a profit by reselling the NFT later. Others may simply end up selling it to raise funds or because they no longer feel the same connection to the underlying artwork or collectible. Regardless of motivation, NFT holders should be aware of what taxes they owe and when.
Most tax professionals expect the IRS to view NFTs sold by someone other than the creator of the underlying work as capital assets. This means that if the NFT has increased in value, the seller is subject to either short- or long-term capital gains tax on that appreciation. If the seller held the NFT for less than a year, the capital gains are taxable at ordinary income tax rates. After one year, more favorable long-term rates apply. Since an NFT is a unique asset, your cost basis will be what you paid for the token originally, so it is important to keep clear documentation of your purchase. Also note that, if you pay for an NFT with cryptocurrency, that exchange may also be taxable in its own right. (See the article linked above for more on cryptocurrency taxes.)
The ceiling on the capital gains tax rate is higher for items the IRS deems “collectibles,” such as art or valuable coins. The IRS has not yet ruled whether NFTs count as collectibles for tax purposes. If some or all NFTs turn out to be collectibles, appreciation may be taxed up to 28%, rather than the upper limit of 20% that applies to most capital gains.
Like other artwork or collectibles, NFTs could also create complications when calculating gift or estate taxes if you pass them on rather than selling them. Hard-to-value assets, digital or analog, notoriously cause headaches for executors. Luckily, under current law, few Americans need to worry about federal gift or estate tax at all. The unified credit currently covers $11.7 million per taxpayer. However, for those who may approach or exceed this threshold, or if the law changes significantly, it is wise to get professional advice. An estate planning expert can help you to plan the best way to leave NFTs to heirs.
You may want to donate your NFT to a tax-exempt charitable organization. Even if your recipient has no use for the underlying digital asset, the charity can sell the token without owing tax on any appreciation. This can stretch your gift further than selling the NFT yourself and donating the after-tax proceeds of the sale. This donation strategy applies to many sorts of appreciated assets; at this writing, there is no reason to believe it would not work for NFTs as well. As with gifts to noncharitable recipients, you may want to be sure your target organization has the ability and know-how to use your gift in advance. Clear communication is key. In cases where such a gift is welcome, a donation can allow you to achieve philanthropic goals while sidestepping a potentially complicated tax obligation.
Not every NFT will appreciate in value, of course. If you sell your NFT for less than what you paid for it, you can use the resulting capital loss to offset any other capital gains you may have recognized in the same tax year. However, if an NFT becomes worthless, you cannot take a related deduction. Internal Revenue Code Sec. 165(c) specifies that individuals generally may only deduct losses incurred in the course of a trade or business. That said, depending on how you approach your NFTs, there may be some situations in which this rule applies so you can claim a deduction.
Tax and NFTs for Small Business
Some NFT buyers may hope to make money on the token not only through a future sale, but through building income streams from the NFT while he or she owns it.
One way to monetize an NFT is to “fractionalize” it. In this scenario, an owner deposits an NFT into a vault on a platform designed to handle this process. Owners can then mint as many “shares” as they want and put some portion up for sale. Typically, owners retain enough shares to remain the majority stakeholder in the original NFT. Fractionalized NFT shares are, unlike the original NFT, interchangeable with one another, simplifying the market to buy, trade and sell them. Fractionalizing an NFT can effectively raise its overall value. The original “Doge” meme image climbed from $4 million to nearly $550 million soon after the owner offered fractional shares in it. The value per share has since dropped, but the transaction allowed the NFT’s owner to capture additional value without selling the NFT outright.
Regardless of how you earn income with the NFT you bought, that income is taxable. But how it is taxed depends, in part, on whether the IRS views your income stream as the result of a hobby or a business. If your NFT activity rises to the level of a business, you may be able to amortize your adjusted basis over a 15-year period under existing rules for intangible assets. If you plan to take the position that your NFT activity is a business, or if you are simply curious as to whether it might be, it is a good idea to consult a tax professional. The rules can be complex, and their application to NFTs is so far untested.
If your activity rises to the level of a business, you will also need to determine whether your gains — and any losses — are ordinary gains or capital gains. Usually gains or losses incurred in the course of doing business, as well as the sale of noncapital assets, are classified as “ordinary.” Selling or exchanging a capital asset generally results in a capital gain or loss.
In addition to the more favorable tax rates that apply to long-term capital gains, capital losses can reduce the business’s overall taxable income. Capital losses may offset capital gains, as well as up to $3,000 of ordinary income annually, just as they do for individuals. Excess capital losses may carry forward to future years. If your NFT activity is connected to a business, it is likely that you may also deduct the value of the token should it become worthless, in contrast to individual investors.
This raises the question of how to classify NFTs as business assets. If your activity rises to the level of a business and you bought an existing NFT, you can treat it the way you might treat, for example, a patent you bought from another individual or business. Classifying the NFT as a Section 1231 asset, named for the relevant part of the Internal Revenue Code, allows you to amortize it over time. If you sell a Section 1231 asset for more than you paid, that results in a long-term capital gain; if you sell it at a loss, it is an ordinary (rather than a capital) loss. Note that if you take amortization, the asset is likely subject to amortization recapture rules under Section 1245 of the Internal Revenue Code.
Whether or not your NFT activity rises to the level of a business, you will need to report any income you earn to the tax authorities. Use IRS Form 4797 to report any gains or losses related to a trade or business, including from the sale of a Section 1231 asset. Gains and losses related to personal assets belong on Schedule D of IRS Form 1040 as part of your individual income tax return. And if you use the same asset for both business and personal purposes, you should allocate gains between these forms.
As this section suggests, the tax considerations for a business enterprise involving NFTs can become highly complex. It is best to consult a tax professional who can help you to meet your reporting obligations fully and accurately.
Tax and NFTs for Artists and Creators
Much of the guidance above does not apply in the same way to the artists who mint NFTs connected to their own intellectual property. Generating an NFT arguably creates wealth, since the combination of the underlying work and the NFT has value that the work alone does not. But minting an NFT to increase the value or marketability of a work is not a taxable event, any more than an author or an artist signing a copy of their work would be. In addition, unlike investors, creators likely do not need to treat NFTs they have created as capital assets when they sell them. This is because, for artists, NFTs will likely fall under the umbrella of rules applying more broadly to intellectual property.
However, just because minting an NFT usually isn’t taxable does not mean the process is free. In many cases, artists must pay a “gas fee” to offset the resources necessary to host the new token on the blockchain. Originally, this was often an upfront cost. Now some exchanges, including OpenSea, offer the option to delay this fee until the creator sells or trades the new NFT. Exchanges may charge creators certain transaction fees for a sale as well. It is important to bear these potential costs in mind when pricing a new NFT.
Depending on the way the NFT is structured, creators may also earn a percentage of every subsequent sale or exchange. This mechanism can give artists an ongoing stake in their work as it grows in popularity. Any resulting income is taxable as ordinary income, just like royalties or other ongoing streams of revenue tied to intellectual property. Note that, like selling many forms of traditional art, selling an NFT seldom transfers any of the underlying intellectual property rights to the buyer.
Assuming your art is a business and not a hobby, you should be aware of tax rule exceptions related to self-created works. The IRS is likely to treat NFTs as intangible assets, regardless of whether the underlying art is digital or physical. This means that if you create the NFT yourself, you generally cannot amortize its adjusted basis the way a buyer may under certain circumstances. Also, in general, small business taxpayers who produce “real or tangible personal property” cannot claim costs of materials or production as current deductions; instead, they must capitalize them and recover them through depreciation, amortization or cost of goods sold. Whether and to what extent these rules will apply to NFTs is not yet clear.
Like other NFT owners, artists who create NFTs can donate their tokens and deduct the value of the charitable donation. The NFT likely counts as a noncapital asset for its creator, so the deduction would ordinarily be minimal, since it would be limited to the creator’s tax basis. This might include gas fees or other costs of tokenizing the work, though since NFTs are new, there is not much precedent. Regardless, donating a self-created NFT is likely to offer little tax benefit, though there are plenty of nontax reasons an artist may make such a donation.
NFTs in their current form are less than five years old, and the tax authorities have not yet turned their attention to them. But given the sometimes high prices they can command, guidance will surely arrive. In the meantime, artists and investors should pay attention and meet their tax obligations to the best of their knowledge. NFTs represent a brave new world for art and for taxes alike.
Client Service Manager Thomas Walsh, who is based in our Atlanta office, is the author of several of the chapters in the firm’s most recent book, The High Achiever’s Guide To Wealth. His contributions include Chapter 2, “Saving vs. Spending vs. Debt Repayment,” and Chapter 18, “Retirement Planning.” Thomas also contributed to the firm’s previous book, Looking Ahead: Life, Family, Wealth and Business After 55.