Cryptocurrencies have become a trillion-dollar asset class in recent years, with more and more individuals and businesses getting involved. As their popularity grows, CPAs and other tax professionals need to understand the tax implications of crypto assets, including conventional cryptocurrencies and new crypto assets – like NFTs.
In this guide, we will look at what NFTs are, how they work, and their tax implications.
What Are NFTs?
Non-fungible tokens, or NFTs, are digital assets representing ownership of a unique piece of content. These unique properties set them apart from Bitcoin and other cryptocurrencies, where each unit is identical and interchangeable. Since their introduction in 2014, they have grown into a nearly $500 million asset class in early 2023.
The blockchain-based nature of NFTs enables anyone to buy, sell, and trade them like a physical asset while maintaining a secure and transparent record of their ownership and provenance.
Examples of NFTs
Most people associate NFTs with digital artwork, but the concept is evolving to include everything from concert tickets to representations for real-world assets, like real estate.
Some examples of NFTs include:
- Bored Ape Yacht Club – The Bored Ape Yacht Club is an NFT collection built on the Ethereum blockchain consisting of algorithmically-generated cartoon apes.
- Decentraland – Decentraland is a browser-based metaverse where users can purchase virtual plots of land, where they can host events, sell virtual items, and more.
- POAP – The Proof of Attendance Protocol is an NFT proving that you attended an in-person or virtual event. Essentially, they're digital stickers or badges sent to your crypto wallet.
- Axie Infinity – Axie Infinity is a play-to-earn (P2E) mobile and web-based game where players purchase NFT characters (Axies) that they battle or complete missions with to earn crypto tokens.
Non-fungible tokens have two distinct characteristics relative to other crypto assets: Non-fungibility and metadata.
Fungibility refers to the interchangeability of one asset with another asset of the same type. For example, a specific denomination of dollar bills and a corporation's common stock are fungible because every unit is identical to every other unit in circulation. As a result, five-dollar bills have the same purchasing power and shares trade at the same price.
On the other hand, non-fungibility means an item is unique and not a substitute for another asset of the same type. For example, Ethereum's ERC-721 standard requires each NFT to have a globally unique `tokenId`. These identifiers also enable NFT owners to prove ownership and provide an auditable activity trail via the blockchain.
NFTs contain metadata that typically links to an underlying item, such as a digital, intangible, or physical asset. For instance, a Bored Ape NFT links to an image of a cartoon ape hosted on an external server. While it's possible to host the data on the blockchain, storing large amounts of data on the blockchain can prove very expensive.
NFT Tax Treatment
The IRS considers non-fungible tokens digital assets under its updated 2022 guidance. As a result, they're subject to the same income and capital gains taxes as any other cryptocurrency.
Individuals or businesses that mint and sell NFTs may generate taxable income. In addition, the smart contracts governing NFTs make it possible to generate royalty income from secondary market sales. At the same time, the fees to mint the NFT may also be deductible business expenses, including gas fees or marketplace fees.
Individuals or businesses that purchase an NFT may incur an immediate capital gain if they sell another cryptocurrency to fund the purchase. And, then, if they sell or exchange the NFT, they may also incur a capital gain or loss. The tax consequences of these transactions depend on the holding period and the taxpayer's marginal tax bracket.
If an individual or business receives an NFT via an airdrop, they must report the value as ordinary income at the time of receipt. Unfortunately, that opens the door to the possibility of owing more tax than an item is worth if the value rapidly falls after the airdrop. As a result, taxpayers should exercise caution when participating in volatile airdrops.
Finally, in addition to minting, buying, and selling NFTs, validating NFT transactions may generate taxable revenue. For example, Ethereum validators will typically owe tax on any income they generate. And NFT marketplaces may also generate taxable income by charging minting and transaction fees to consumers and businesses.
NFTs can prove challenging from a corporate accounting standpoint. For example, while the GAAP says they fall under ASC 350 (intangibles), there's no specific guidance on valuation or other matters. As a result, companies are on their own regarding revenue recognition, fair value, impairment, amortization, and cost accounting.
The Journal of Accountancy provides an excellent starting point by dividing NFTs into four categories:
- Single Use – NFTs with limited resale or reuse value, such as virtual event tickets or game items only available in a single game.
- Reusables – NFTs that have collectible, display, or reusable value, such as artwork, trading cards, or avatars.
- Perpetuals – NFTs that represent permanent digital locations, such as domain names or metaverse land.
- Real Assets – NFTs that represent real-world physical assets and are used solely to authenticate ownership and simplify transactions.
Most companies mint and sell NFTs through marketplaces, meaning revenue recognition often boils down to who was the principal and agent. However, companies must also evaluate if NFT transactions are subject to the ASC 606 standard, which depends on the NFT's nature. For instance, single-use NFTs are very different from real assets.
While valuing an NFT is simple at the onset, it can be challenging over time since there may not be readily-available comps. For example, NFTs with a finite life may need amortization, whereas those with an infinite life may need annual impairments to their valuation.
And finally, companies must determine how to account for development costs. While most costs fall under ASC 350-40 (internal use software) or ASC 985-20 (costs of software), the choice between the two often depends on whether the end-user will own the final software. That’s not always the case in instances like in-game items.
The Bottom Line
Non-fungible tokens, or NFTs, have become extremely popular over the past few years thanks to the popularity of the Bored Ape Yacht Club and other high-profile projects. While the IRS' classification of NFTs is fairly straightforward, there are some risks to watch out for. Corporate tax treatment of NFTs remains far from clear.
If you trade NFTs or other crypto assets, ZenLedger can help aggregate transactions across wallets and exchanges, compute your capital gain or loss, and auto-complete the IRS forms you need.