Collectors went on a bender buying nonfungible tokens, or NFTs, last year, driving up sales to $24.9 billion from $94.9 million in 2020, according to industry publication DappRadar, and many are only now realizing that an unexpected guest wants in on the fun: the Internal Revenue Service. The tax implications for folks who trade, receive, or sell NFTs can be onerous and confusing, and the IRS is beginning to crack down.
“There are a lot of misconceptions that NFTs aren’t taxable until you sell them for dollars,” says
an enrolled agent at MDM Financial Services in Rochester, N.Y., who specializes in crypto accounting and has himself accrued a tax bill for receiving NFTs as rewards in a videogame. “I am the bearer of bad news for many clients.”
NFTs, which are usually bought and sold using the cryptocurrency Ethereum, are digital tokens that certify the authenticity of a digital creation, typically art, videos, virtual trading cards, or memes. The digital assets broke into mainstream popular culture at the beginning of 2021 with a series of stunning sales fetching multimillions of dollars. That triggered a torrent of new NFTs and sales—and an entirely new collectibles category was born.
But here’s the killjoy: NFTs, like cryptocurrencies, are considered property by the IRS. There are a number of scenarios with different tax implications:
Creators of NFTs—who typically collect Ethereum when they sell—must report their crypto income to the IRS; folks who receive NFTs as compensation or rewards, such as in a videogame, must report them as income; and anyone who sells an NFT—who is not its creator—is required to report gains or losses, the same way investors would for stocks or mutual funds.
What’s more confusing to some taxpayers is that a tax bill can be triggered simply by purchasing an NFT, since the purchase is made with cryptocurrency that may have appreciated since it was bought.
“If you buy Ethereum for $1 and it goes to $10 and you then use it to buy an NFT, you have a $9 gain—people don’t realize that,” says
senior vice president at BNY Mellon Wealth Management in Boston.
For folks who report NFTs as income, regular income tax rates of up to 37% apply. Creators of NFTs who are self-employed will also owe the 15.3% self-employment tax, Doyle says.
Collectors who have short-term realized gains—meaning those held for less than a year—face tax rates up to 37%. Folks with long-term realized gains face a lower tax rate, but the law is murky when it comes to the exact rate.
The IRS hasn’t defined how it classifies NFTs, whether as collectibles or a form of cryptocurrency, says
tax director at Moss Adams, a national accounting firm in Seattle. That’s a key detail: The top long-term tax rate on realized gains for art and collectibles is 28%, while for cryptocurrencies it is 20%.
Until the IRS clarifies the tax rate for NFTs, Weinapple recommends that taxpayers use the 28% rate to be safe.
Starting last year, the IRS added a checkbox on the Form 1040 asking taxpayers if they were involved in digital assets. Accountants say the agency is laying the groundwork for enforcement.
“If you give a false answer, you’re going to be subject to potential taxes, interest, penalties, and possibly even criminal charges,” says
national director of wealth planning at Evercore Wealth Management.
The challenge for taxpayers is in tracking their cost bases in both cryptocurrencies and NFTs to determine their taxable gains. Unlike stock and bond traders whose brokers issue a 1099 reporting gains and losses for the tax year, “NFT platforms do not typically send 1099 forms with cost basis information,” says
U.S. director at Ageras, a company that matches businesses with accounting services, based in Philadelphia. “It’s crucial to keep detailed records of the cryptocurrency used to purchase NFTs and the NFTs themselves to calculate capital gain and related taxes.”
This article appears in the June 2022 issue of Penta magazine.