• NFTs: Why The Next Big Thing In The Digital Economy Is A Money Machine For The IRS

  • Nonfungible token (or NFT) sales and trading have gone from increasing to skyrocketing. They are brand new. Their values can fluctuate. However, for those who owe US taxes, they can be a goldmine for the IRS. Why? Because, unlike most other types of income and assets, NFTs can generate multiple taxation events for those who create them as well as those who trade them. In a recent Forbes.com interview, Shaun Hunley, a Georgia-based tax attorney and tax consultant for Thomson Reuters, stressed the importance of understanding all of the different ways creating and/or trading in NFTs can result in federal income tax.

    Creators of NFT

    NFTs, like many other performances or works of art, are classified as “self-created intangibles.” This means that the creator has no “basis” in what is being sold other than possibly the costs of creating it. The IRS, on the other hand, makes an exception for artists, allowing them to deduct expenses as they go rather than when the artwork is sold. If an NFT creator deducted expenses in a tax year prior to the year the NFT is sold, the creator has no basis in the NFT. That is, the profit or gain is equal to 100 percent of the sale proceeds. Someone who creates an NFT and sells it for $1 million makes a $1 million taxable profit.

    Although actual IRS guidance is woefully lacking, general tax principles indicate that NFTs are likely to be treated by the IRS as an inventor’s inventory (rather than capital assets). Whether someone is in the business of creating NFTs or is an artist or celebrity who is simply adding NFTs to their income stream, the sale of an NFT will be taxed as ordinary income (rather than the more favorable capital gains) and will be subject to self-employment taxes. And the tax hilarity doesn’t stop there. While the original NFT is a one-of-a-kind token on the blockchain, the artist or creator may retain ownership of whatever was used to create the NFT. For example, NBA Top Shot (currently one of the hottest NFT markets) allows a person to purchase a unique URL that links to a site where a specific NBA highlight can be found. The NBA retains the copyright to the highlight video, which the individual does not purchase. The person is purchasing a limited use license (that does not include making and distributing copies of the video).

    Similar to limited edition signed reprints or limited released copies of a live performance, an artist or performing artist may decide to sell multiple NFTs based on the same original artwork or performance. When copyright is retained and copies are sold, the income is considered royalties and must be reported on Schedule E and attached to the individual’s Form 1040 each year. What’s the bottom line? When NFT creators sell a self-created NFT, they may face three taxable events: income tax on the sale itself, self-employment tax on the sale, and income tax generated by royalties.

    Traders and Investors in the NFT

    But what if you’re not an artist? What if you’re just looking to buy NFTs to hold or trade? Unfortunately, trading NFTs is more difficult than trading other types of capital assets (like stocks or real estate). Currently, NFTs can only be purchased using cryptocurrency (specifically ethereum). Because the IRS still considers cryptocurrency to be property rather than currency, purchasing an NFT creates a taxable event: the conversion of cryptocurrency for the purchase of the NFT. The purchaser may realize a taxable gain or loss on the conversion depending on the taxpayer’s basis in the cryptocurrency exchanged (what was paid for the crypto). Furthermore, gains may be taxed as ordinary income (rather than at long-term capital gains rates) if the holding period for the cryptocurrency is insufficient to qualify for the preferential tax treatment. If the taxpayer’s income is high enough, the gain on crypto conversion may be subject to an additional 3.8 percent Net Investment Income Tax (NIIT). If the taxpayer decides to sell the NFT, they will also be subject to capital gains tax on the sale. However, unlike cryptocurrency, NFTs are classified as collectibles and are subject to a 28 percent tax on sale gains (plus NIIT if it applies).

    Consider a taxpayer who used $10,000 in ethereum to purchase a $100,000 NFT. The taxpayer made a $90,000 profit on the ethereum conversion. Depending on how long the taxpayer holds the ethereum, he or she will either pay ordinary income tax or capital gains tax on the $90,000. The NFT is now worth $500,000 after five years.

    The taxpayer makes the decision to sell it. The sale of the asset (the NFT) results in a $400,000 capital gain (due to the five-year holding period), but because NFTs are considered collectibles, the $400,000 is taxed at a flat 28 percent rate rather than the lower (and income-based) capital gains rates (0 percent, 15 percent, or 20 percent ). Finally, unless there are other losses on the tax return, a transaction of this magnitude will almost always result in NIIT as well.

    Compliance and Enforceability

    The IRS is currently focused on cryptocurrency transactions, and Hunley believes it will take a few years for them to catch up with taxation enforcement of NFT creation and trading. While NFT trading is growing, it is still small in comparison to cryptocurrency transactions. In other words, IRS enforcement of cryptocurrency transaction taxation casts a much wider (and more profitable) net in the short term. Nonetheless, Hunley believes that the IRS will be able to apply the lessons learned in cryptocurrency taxation and enforcement to NFTs and other emerging digital economy technologies in the future.

    Tax professionals who specialize in the digital economy have been calling for more guidance on cryptocurrency and non-traditional financial instruments (NFTs). The IRS has been tardy in responding. Hunley currently recommends that practitioners in the area rely on general tax principles and best practices, such as documenting the guidance used when deciding how to report the transaction on a client’s tax return. Hunley observes that “valuation, in particular, can be sticky.” Taxpayers who invest in NFTs should keep track of all cryptocurrency transactions, keep a record of their NFT purchase price, and keep a record of the NFT sale price or fair market value for reporting purposes. NFTs, like any other asset, can lose value and cause a trader to lose money. Losses incurred as a result of the decline in the value of personal assets, on the other hand, are not deductible on a tax return. When asked about a “blockchain-ending apocalyptic event that renders all NFTs worthless,” Hunley stated that, while such an event was extremely unlikely, if it did occur, the associated losses would most likely be non-deductible personal losses (similar to casualty losses in non-disaster areas) rather than deductible capital losses (which are limited but are at least available). However, in the absence of specific IRS guidance on such issues, most practitioners must rely on their knowledge of basic tax principles and do their best to apply them to the client’s specific facts and circumstances.

    Taxpayers who trade in cryptocurrency and/or NFTs should be aware that they may be required to report foreign accounts and possibly foreign-sourced income. The penalties for even inadvertently ignoring foreign reporting requirements are severe, and those for willful non-reporting are even harsher. In addition, as with cryptocurrency, the IRS is prioritizing enforcement of foreign account and income reporting requirements.

    Finally, cryptocurrency is already being securitized, and the possibility of securitizing NFTs held for investment is always a possibility, though Hunley believes it is unlikely in the near future. Hunley reminds readers that the best way to avoid surprises is to inform their tax professional about their cryptocurrency and NFTs each year and to be truthful when answering their questions. However, keep in mind that communications for return preparation purposes are not privileged, so if you haven’t been doing contemporaneous reporting, you should consult an attorney before working with your tax professional to correct prior year reporting and non-compliance.

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