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NFTs on Your Tax Return: A Modern Dilemma

NFTs on Your Tax Return: A Modern Dilemma

From understanding NFT transactions to leveraging tax loopholes, we cover everything you need to navigate the evolving landscape of NFT taxes.

The popularity of NFTs has worn off in recent years, but the tax consequences remain. Whether you’re sitting on a massive gain and are looking to sell or have a portfolio of worthless NFTs, savvy tax moves can help you save on taxes (or at least avoid overpaying).

This guide considers the constantly evolving tax rules surrounding NFTs, six actionable strategies to reduce your tax burden, and how software can transform tax season from high stress to a few clicks.

Let’s dive in.

What Are NFTs?

Non-fungible tokens, or NFTs, are unique digital assets verified by blockchain technology. While cryptocurrencies are fungible (tokens are interchangeable), NFTs have a unique identifier and a verified transaction history.

What Are NFTs?
Axie Infinity is a popular play-to-earn game involving NFT-based creators. Source: Axie Infinity

NFTs come in many different forms:

  • Beeple’s “Everydays: The First 5000 Days” is one of the most famous NFTs, having sold for over $69 million at Christie’s auction house.
  • NBA Top Shots are officially licensed NBA collectible highlights, where fans can buy, sell, and trade moment clips from their favorite players and games.
  • The Kings of Leon’s “When You See Yourself” album had an NFT offering special perks like limited edition vinyl and concert tickets.
  • Decentraland is a virtual reality platform where you can buy and develop parcels of land as NFTs, creating experiences and monetizing content.
  • Axie Infinity is a blockchain-based play-to-earn game where players raise, breed, and battle NFT creators known as Axies.

IRS Tax Rules for NFTs

The IRS considers most NFTs digital assets, which it deems “property” from a tax standpoint. Generally, you do not owe any tax when you buy or hold an NFT, but you may owe tax when you earn, receive (airdrop), sell, or otherwise transfer an NFT.

There are three common questions concerning taxable NFT transactions:

  • NFT Creator Taxes. Creators selling NFTs must generally claim any sale proceeds as ordinary income. However, if you’re selling NFTs as a business, you may be able to deduct business expenses associated with producing and selling NFTs.
  • NFT Airdrop Taxes. If you receive an NFT as an airdrop as part of a marketing campaign, the IRS considers it ordinary income subject to income tax upon receipt. Then, if you sell it later, you may owe capital gains taxes on any appreciation.
  • NFT Gifts. Gifting an NFT is not typically a taxable event unless you exceed your annual gift exclusion amount. In that case, you may need to file IRS Form 709 and pay taxes on the amount that exceeds the limit.

If you sell an NFT within 12 months of receiving it, you’ll have to pay the short-term capital gains tax rate, anywhere from 10% to 37% of your gains. However, if you wait longer than 12 months, you’ll owe the lower capital gains tax rate of between 0% and 20%.

You must report these transactions on Form 8949 and carry over the capital gain or loss to Form 1040 Schedule D. If you’re selling NFTs as a business, you may need to report any income generated from the sales on Form 1040 Schedule C or your business tax return.

Changes to NFT Tax Rules

NFT tax rules and regulations are still in a state of flux.

In 2023, the IRS issued Notice 2023-27, indicating some NFTs may be “collectibles” subject to the higher collectibles tax rate. Whether an NFT is a collectible will likely hinge on a “look-through analysis,” which looks at whether NFTs provide the rights and benefits associated with art, antiques, gems, coins, beverages, or other collectibles.

States could also start to impose their own taxes on NFTs. Thus far, Washington and Pennsylvania are the only states charging sales tax on NFTs. However, other states could follow their lead and introduce taxes over the coming years.

With these changes on the horizon, it’s a good idea to consult with a tax professional or use crypto tax software like ZenLedger to ensure accurate filings.

6 NFT Tax Loopholes

The IRS is doubling down on crypto tax enforcement, so you should always report the taxes you owe. But that said, you shouldn’t ignore NFT tax loopholes that can help you legally minimize the tax you owe each year.

Here are five ways to reduce your NFT taxes:

  1. Buy with Fiat. When you purchase an NFT with cryptocurrency, you are technically selling the cryptocurrency to make the purchase, triggering capital gains taxes. But if you buy with U.S. dollars, you don’t owe any taxes when buying NFTs.
  2. Deduct Any Fees. The IRS allows you to deduct any fees from your gross proceeds when calculating your capital gain – but you must justify it! Document any gas or transaction fees to minimize the tax you’ll owe.
  3. Hold Longer Than One Year. Short-term capital gains are taxed at your marginal tax bracket, whereas long-term capital gains typically incur a more modest 15% tax. So, if possible, it pays to hold any NFTs for longer than one year before selling.
  4. Sell in Low-Income Years. Your marginal tax bracket depends on your income. If you sell during low-income years, you could pay less in taxes – especially if you will incur short-term capital gains (and potentially even if you have long-term gains).
  5. Gift NFTs to Avoid Taxes. If you provide an NFT as a gift, you do not owe capital gains taxes on any increase in value during your holding period. And the recipient’s cost basis resets to the NFT’s value at the time of the gift.

NFT Tax Loss Harvesting

A final NFT tax loophole is known as tax-loss harvesting (TLH). If you have an NFT that has become worthless over time, you can sell the NFT to realize the loss for tax purposes and then use the loss to offset capital gains in other parts of your portfolio. And if you don’t have any capital gains, you can offset up to $3,000 in ordinary income!

Unsellable NFTs and other services make it easy to harvest tax losses, providing you with a verified and auditable smart contract as well as CPA-ready receipts.

Of course, this is another area where tax laws could change. Lawmakers have sought to eliminate tax-loss harvesting for crypto assets without success in 2023, but they could revive efforts in 2024 or beyond and enact changes.

NFT Tax Software

Taxes are stressful for everyone, but even more so if you hold crypto assets. With new tax forms and constantly changing regulations, even tax professionals have a hard time keeping up. So, it’s crucial to find a tax professional with crypto experience.

NFT Tax Software
ZenLedger makes it easy to connect your wallets and exchanges. Source: ZenLedger

ZenLedger and other crypto tax software solutions can also help fill knowledge gaps. For instance, our platform connects to your wallets and exchanges, aggregates your transactions, and computes your capital gains and losses. This programmatic approach helps minimize math errors when doing the calculations by hand.

In addition, our platform automatically categorizes transactions and matches up buy and sell orders. While that’s not a big challenge for NFTs (only one purchase and one sale), it’s invaluable for cryptocurrencies requiring complex cost-basis calculations.

The Bottom Line

NFTs may not be as popular as a few years ago, but the tax consequences remain for anyone holding them. And, as the market stabilizes, they could become a central part of many crypto asset portfolios. Fortunately, taxes don’t have to be a challenge.

By keeping the tips we’ve discussed in mind, you can enter tax season armed with the right knowledge and our six tax strategies; you can avoid overpaying and even use that old portfolio of worthless NFTs to offset your gains or income this year!

If you want to try out ZenLedger, sign up for free and see how to start streamlining taxes and saving money today!

The above is for general info purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.

Justin Kuepper