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NFT Tax Loopholes - 3 Things To Be Aware Of

Published
May 9, 2022
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    NFTs, unique non-fungible tokens have been around since 2014, but they have captured a lot of attention lately. NFTs are revolutionizing consumerism in the most unconventional way possible, by making people invest in art, music, and sports, especially in digital art. 

    When it comes to NFTs, creators use blockchain technology to establish their uniqueness, and ownership of the digital art and sell it via a platform. In the first half of 2021 itself, NFTs crossed 2.5 billion in sales. 

    This exponential growth has caught the attention of the U.S government. NFT investors and creators who became millionaires overnight have to pay taxes on their profits. And amidst this, NFT investors can fall into many NFT tax loopholes due to the unclear tax guidance and instructions on managing NFT taxes. In this guide, we will look at a few NFT tax loopholes, and even though we know what NFTs are, let’s look at their definition to make it even clearer. 

    What are NFTs?

    NFTs are a digital representation of an asset such as artwork, music, or video game assets that are minted in limited numbers to maintain their uniqueness. NFTs are all unique, unlike fungible tokens such as Ethereum and Bitcoin.

    Let’s take an example to understand this concept better. CryptoPunks is a well-known series of a thousand one-of-a-kind pixelated avatars all with distinct characteristics and facial features. Since all characters are unique, CryptoPunk #3498 cannot be interchanged with CryptoPunk #2969. Meanwhile, every Bitcoin that is mined is not discernible from one another. 

    There are dedicated marketplaces to buy/sell NFTs such as SuperRare, OpenSea, Nifty Gateway, and others. Crypto exchanges such as Coinbase, Binance, and others have also launched their respective NFT platforms

    How do NFT Taxes Work?

    NFTs are subjected to the same tax laws as cryptocurrencies or fungible tokens. If an artist sells their NFT and earns money in return, they need to report the earnings as income on their tax return. Furthermore, if an NFT investor sells the non-fungible token and books a profit, their proceeds will be subject to capital gains tax as NFTs are considered property. 

    The most common taxable NFT events are:

    • Selling an NFT for crypto tokens
    • Buying an NFT with crypto tokens
    • Exchanging NFTs

    How the IRS Sees NFTs?

    The IRS has not provided any tax guidance specific to NFTs yet, but the majority of art-based NFTs are likely to be rated as collectibles according to the IRS § 408(m)(2)(A)). It is important to note this classification because in some cases, it subjects some NFTs to greater tax rates compared to regular crypto tokens. 

    Investors and NFT Taxes?

    As mentioned earlier, when you buy an NFT with cryptocurrency, it triggers a taxable event. For instance, Dave used 1 BTC to buy CryptoPunk worth $4,000. Dave bought the BTC for $100 a few years ago. Now, Dave has to pay long-term capital gains tax on $4000 - $100 = $3,900 because he is disposing of a property to buy an NFT. As he bought the NFT for $4,000, this value becomes the cost basis for the NFT. 

    When you sell an NFT to exchange one for another, it is also considered a taxable event. If Dave sells his NFT for 2 BTC worth $14,000, he will have a capital gain of $14,000 - $4,000 = $10,000. In some cases, NFTs also pay royalties when a sale occurs. If royalties are paid to the investors in crypto-token, they are taxed when earned. 

    NFT Tax Loopholes

    Now, let’s discuss some of the loopholes that an investor can face. 

    NFT Tax Loophole #1

    You might be liable for taxes without ever getting cash in the following three scenarios:

    • Buying an NFT with crypto tokens
    • Exchanging NFTs
    • Earning royalties in crypto tokens

    Unfortunately, the majority of NFT holders aren’t aware of these loopholes and come tax day, they might be surprised by a large tax bill. 

    NFT Tax Loophole #2

    If you’ve earned huge profits from NFTs, you could be surprised by tax obligation once a quarter. This could lead to underpayment fines. For this reason, you should talk to a certified tax professional to determine any tax obligation per quarter. 

    NFT Tax Loophole #3

    If you sell your NFT within 12 months, you will be liable to pay short-term capital gains tax. And if you were aboard the NFT bandwagon in 2021, you are most likely to pay short-term capital gains tax. Investors in the highest tax bracket might have to pay 37 percent for short-term gains. Additionally, you have to pay 3.8 percent net investment income tax in case you surpass the applicable income threshold for the year. 

    When you dispose of your NFTs after a year, you’ll be liable for a long-term capital gains tax. Generally, the tax law is favorable for long-term capital gains and subjects the investor to lesser tax as compared to short-term capital gains. For cryptocurrencies and stocks, the long-term capital gains tax is 20 percent but unfortunately for NFTs, long-term gains stand at 28 percent for high-income earners. 

    NFT Gains & Losses Calculation is Challenging

    At the moment, NFT marketplaces don’t offer any tax documents to determine the NFT capital gains and losses. Ultimately, it comes down to the investor to determine the accurate cost basis and market values and file taxes properly. 

    This is where ZenLedger makes a world of difference. With the ZenLedger software, you can track your trades, view your profits and losses, and get your NFT taxes done in minutes. Not only this, but ZenLedger can also find opportunities for you to save money and trade smarter.   

    NFT Valuation concerns

    Even though NFTs are considered as property as cryptocurrencies they are a bit different. Their market value cannot be actively seen on websites such as Coinmarketcap or CoinGecko. Thus, if you exchange NFTs then you have to manually appraise the worth of the NFT received to calculate the correct taxable gain or loss. The appraisal of the value can become a problem when the amount of the transaction is significant. 

    Note: It is the responsibility of the investor to determine taxable events and consult a professional to accurately identify their NFT taxes. 

    Final Thoughts

    Whether you are investing in an NFT or creating one, it is important to keep the tax implications in mind. It is also important to note that the more transactions take place, the more complicated tracking and calculating NFT taxes get. Also, the majority of NFT platforms don’t issue 1099 forms with cost basis information. Thus, it is your responsibility to keep track of the crypto tokens used to buy NFTs and the actual NFTs.

    NFT Tax Loopholes FAQs

    1. What is NFT in crypto?

    NFTs are a digital representation of an asset such as artwork, music, or video game assets that are minted in limited numbers to maintain their uniqueness. NFTs are all unique, unlike fungible tokens such as Ethereum and Bitcoin.

    2. Do I have to pay tax on my NFT?

    If you sell your NFT within 12 months, you will be liable to pay short-term capital gains tax. If you are in the highest tax bracket, you might have to pay 37 percent short-term gains. Additionally, you have to pay 3.8 percent net investment income tax in case you surpass the applicable income threshold for the year.
    When you sell your NFTs after a year, you’ll be liable for a long-term capital gains tax. For cryptocurrencies and stocks, the long-term capital gains tax is 20 percent but unfortunately for NFTs, long-term NFT gains stand at 28 percent for high-income earners.

    3. How are NFT airdrops taxed?

    NFT airdrops are rewards and these rewards are considered ordinary income and taxed based on the fair market value at the time of gain. If you sell the rewards then you will be required to pay either capital gains or losses based on the price fluctuations since you received them.

    4. Can you depreciate an NFT?

    When a creator receives payment on a subsequent sale, it is considered ordinary income just like payments of royalties on patents, copyrights, and other intellectual properties. Since these payments are perpetual, the rights cannot be depreciated.

    5. What can you do with NFT?

    NFTs can be used to represent the ownership of a unique item. NFTs allow us to tokenize collectibles, art, and even real estate. Also, the non-fungible tokens have only one official owner at a time. They are secured by the Ethereum network and thus, the ownership records cannot be modified.

    Disclaimer: This material has been prepared for informational purposes only, and is not intended to provide tax, legal or financial advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.

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