Last year, digital artist Beeple sold his NFT-based artwork, Everydays: The First 500 Days, at Christie’s for an astounding $69,346,250. It was the first time a major auction house sold an NFT. Although NFTs are still fairly new to many people, it’s grown into a multibillion-dollar market. Before you consider creating, selling, or buying NFTs, however, be sure you understand what they are and how they are taxed.
What is an NFT?
Non-fungible tokens (NFTs) are unique digital assets that are created in limited quantities. They are bought and sold like tangible collectibles. This may include artwork, memes, sports collectibles, music, games, and even tweets. Unlike cryptocurrency, they are one-of-a-kind and not interchangeable.
The main appeal for this type of digital investment is the ability to ensure authenticity, record ownership, and track transactions. Artists can even earn royalties on subsequent sales. There are several marketplaces where you can sell or buy NFTs, such as OpenSea and Mintable, which is backed by billionaire Mark Cuban.
NFTs And Taxes
Although the IRS hasn’t issued any formal stance regarding the tax treatment of NFTs, it’s possible that some may be considered collectibles and subject to a higher tax rate. It’s more likely, however, that they will fall under the same tax treatment as cryptocurrency since it’s used in the majority of NFT transactions. When someone purchases an NFT using cryptocurrency, both the seller and buyer have engaged in a taxable transaction. Depending on whether you’re a creator, dealer, or investor, there are multiple tax consequences to consider.
As an NFT creator, you are not subject to tax unless you sell your work. Once sold, any profits are taxed at your ordinary income tax rate and are subject to self-employment taxes. If you are paid royalties in cryptocurrency on subsequent sales, you’ll also be taxed when these are earned.
If you purchase an NFT using cryptocurrency, you will be subject to either short- or long-term capital gains, or a loss. For example, if you buy digital artwork valued at $10,000 using Ethereum (ETH) you originally purchased for $1,000 two years ago, you’d have a long-term capital gain of $9,000 ($10,000 – $1,000). Any NFTs classified as collectibles, however, may be subject to the long-term capital gains rate of 28% for high-income earners.
If the same situation occurred but the purchase was less than 12 months from the date you acquired the ETH, you would have to pay the higher short-term gains tax rate. Depending on your federal income bracket, this can be as high as 37 percent.
Conversely, if the ETH was purchased for $15,000, you’d have a loss of $5,000 ($15,000 – $10,000). You are also subject to potential gains and losses when you trade one NFT for another or sell it outright.
Keep in mind that you’ll need to keep detailed records of your transactions to help figure out your cost basis and market value since most NFT marketplaces do not provide any documentation.
Non-Taxable NFT Transactions
There are certain instances when purchasing an NFT may not trigger a taxable event. This includes:
- Purchasing with U.S. currency or credit card instead of cryptocurrency.
- Buying new cryptocurrency to purchase an NFT instead of drawing from an existing account.
Once you sell or trade the NFT, however, you’ll need to determine if you have any capital gains or losses.
Don’t Forget State Taxes & Penalties
In addition to federal taxes, buyers and sellers of NFTs may also be responsible for state income, sales, and/or use tax. It’s important to check your state’s rules regarding capital transactions. Depending on where you reside, your capital gains could be taxed as ordinary income.
It’s also important to speak with a tax professional about making quarterly tax payments. If you generate large profits from the sale of NFTs but fail to pay enough throughout the year, you could be hit with an underpayment penalty. By making quarterly payments, you can avoid being penalized.