Blockchains are great digital asset registries since they are secure and immutable. While cryptocurrencies have become synonymous with blockchain, the same technology can be used to store all kinds of digital items. The rise of non-fungible crypto tokens, or NFTs, marks a step in that direction and opens the door to the digitization of many different assets.
Let’s take a closer look at non fungible tokens, how they differ from traditional tokens, and how they will likely be treated from a tax standpoint.
What Are Non Fungible Tokens?
Non fungible tokens, or NFTs, are a special type of cryptographic token that represents something unique. For example, CryptoKitties enables people to purchase, collect, breed, and sell unique virtual cats—including some worth more than US$100,000. These dynamics differ from fungible tokens, like Bitcoin, they are non-unique and interchangeable with each other.
- Maybe securities
- Standardized and regulated
NFTs Non Fungible Tokens
- Every item is unique
- Not usually securities
- A diverse set of use cases
- A diverse set of regulations
On a technical level, fungible ERC-20 tokens contain a name, balance, token supply, and symbol. The non-fungible ERC-721 (and other) tokens contain rich metadata, which can be used to provide asset details or other authenticated information. These metadata capabilities give NFTs the ability to do everything from verifying academic credentials to record real estate ownership.
There are many emerging use cases for NFTs:
- Publishers can turn their creative assets into NFTs, such as Gods Unchained.
- Marketplaces can help create liquidity for NFTs, such as OpenSea.
- Infrastructure providers can use NFTs for licensing, domain names, or certificates.
- Physical assets, like real estate, could eventually digitize assets with NFTs.
Many crypto experts agree that NFTs are in the early stages of growth. As companies invest in blockchain technology, the primary use cases are likely to shift from games to digital assets (e.g., licenses) and digitized physical assets (e.g., real estate), which could fundamentally alter the way that many different industries operate.
What Are Non Fungible Tokens - The Tax Implications
The IRS has made it clear that transacting in any virtual currencies will result in some sort of tax on any gains. According to IRS Notice 2014-21, virtual currencies are a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value—and both conventional crypto tokens and non fungible tokens fall under that definition.
Most conventional crypto tokens are considered securities since they are fungible and standardized. While the IRS may not be able to track individual tokens, exchanges are compelled to report aggregate activity. The agency has used that data in order to generate letters sent to crypto traders and investors urging them to pay their fair share of taxes.
Since non fungible tokens are unique by nature, it’s much easier to identify units that were sold—just like you would with a bond’s CUSIP or a stock’s certificate number. The tax on NFTs might be classified as regular income, capital gains, or tax-exempt depending on what the NFT is and what the substance of the activity is with the NFT given its many use cases.
For example, suppose that you purchase an NFT that represents a real estate asset. The token is merely a digital representation of a physical asset, which means that the taxation of the asset will mirror that of real estate rather than cryptocurrencies. You may be eligible for real estate-related deductions, such as depreciation, to offset gains.
How to Report Your Crypto Gains & Losses
The IRS has been clear that crypto users owe tax on any gains that arise from transactions. Unfortunately, the agency has been unclear when it comes to the specifics of computing gains or losses. Calculating the cost basis, capital gains, or capital losses is notoriously challenging for individuals or businesses with a large number of complex transactions.
There are four parts to the crypto tax filing process:
- Record Transactions: The cost basis for a transaction isn’t limited to the account where the transaction was made—you must include all of your accounts.
- Compute Gain or Loss: You must compute the capital gain or loss from the transaction using FIFO, LIFO, or HIFO accounting methods.
- Determine Tax Rate: The tax rate that you pay depends on the holding time for the asset and your ordinary income tax bracket, among other things.
- Handle Tax Losses: Harvesting tax losses can help offset capital gains from other parts of your portfolio, as well as up to $3,000 in ordinary income.
These processes can be very expensive for an accountant to undertake since they must go through records at each account and compute the gain or loss with each transaction. Fortunately, crypto tax software can help automate the process in order to reduce billable hours and ensure that there aren’t any costly mistakes.
ZenLedger streamlines the process by aggregating transactions across exchanges, automatically computing the capital gain or loss, and highlighting tax-loss harvesting opportunities. You can even generate the appropriate tax forms or integrate with TurboTax to send them automatically and avoid much of the paperwork.
Paying Taxes on NFTs Webinar
ZenLedger recently hosted a webinar and Q&A with Pat Larson, CEO of ZenLedger, and Matthew Gould, Founder, and CEO of Unstoppable Domains, to discuss what NFTs are, how they are different from other digital currencies, and how to pay taxes on them. Check out our Paying Taxes on NFTs webinar to learn more about these new and exciting blockchain assets.
Final Thoughts On The Non-Fungible Token
Cryptocurrencies are only scratching the surface of what’s possible with blockchain technology. With the rise of non fungible tokens, blockchain technology is being applied to everything from digital artwork to digital representations of physical real estate assets. Of course, these transactions have tax consequences for traders and investors.
If you trade or invest in crypto assets, ZenLedger can help you streamline your taxes each year. Our tax-loss harvesting tool can help you minimize your tax liability each year while automatic calculation of capital gains and losses can tell you when you’ve overpaid.