NFT sales hit $25 billion in 2021, according to DappRadar, driven by everything from crypto art to metaverse land sales. While just 10% of traders accounted for 85% of all NFT transactions, a growing number of multinational brand names (like Coca-Cola and Gucci) are entering the market, paving the way for greater mainstream adoption.
Let's take a closer look at five tax tips to help NFT owners lower their tax bills and avoid any surprises.
NFT sales hit $25 billion in 2021—but collectors and traders could be facing a surprise tax bill in 2022.
What Are NFTs?
Non-fungible tokens, or NFTs, are blockchain-based tokens that encode specific metadata that makes them unique. In practice, the metadata encoded into NFTs represents everything from simple images (e.g. CryptoKitties) to items in metaverse games. Most NFTs are bought and sold as artwork or collectibles, although there are a growing number of use cases.
Some up-and-coming use cases include:
- Authentication - Smart contracts can mint NFTs with codes to authenticate NFT holders using just their crypto wallets. In addition, NFTs can be helpful to verify attendance at a meeting or event and even enable voting capabilities.
- Gaming - Many blockchain-based games have in-game economies that leverage NFTs to represent unique items. The prices of these items can then vary based on rarity, uniqueness, and other factors, adding to the experience.
- Transactions - Many financial transactions involve a significant amount of paperwork and overhead. By replacing intermediaries with smart contracts, these transactions can use NFTs to verify ownership of assets, such as real estate.
The growing number of NFT use cases suggests that they may become more commonplace, making it essential to understand their tax implications. For instance, you may receive an NFT ticket to enter a concert or need an NFT to prove ownership of an asset. All of these transactions could involve taxes and necessitate careful tax planning.
#1. Purchasing NFTs with ETH is Taxable
Individuals who use cryptocurrency to purchase NFTs realize a capital gain or loss under the "disposition of assets" principle. According to the IRS, "if you exchange virtual currency held as a capital asset for other property, including for goods or for another virtual currency, you will recognize a capital gain or loss."
For example, suppose an early investor bought Ethereum in 2018 for $100 and purchased an NFT for 30 ETH. They would owe capital gains on the $48,000 increase in ETH value (assuming a current price of $1,700), which could total around $9,600 if they're in the 20% tax bracket. This is assuming the price of the NFT in ETH does not fluctuate. But, of course, these numbers could be much more significant.
#2. Airdrops & Giveaways Are Taxable
Airdrops and giveaways occur when tokens are sent to a wallet free of charge—but not free of tax. According to the IRS, "if a hard fork is followed by an airdrop and you receive new cryptocurrency, you will have taxable income in the taxable year you received that cryptocurrency." The only exception is when you don't have "dominion" or control.
For example, suppose that you have a few Ethereum domains, and received 1000 ENS tokens airdropped by the Ethereum Name Service. Once you claim the airdrop, you must report the newly acquired tokens as ordinary income (not a capital gain) regardless of whether or not you sell them. If you sell them, you will also owe capital gains tax if they've increased in value from your original cost basis.
#3. Count Gas Fees in Your Capital Gains
Gas fees are the amount you pay to confirm transactions on the blockchain. When many people want to make transactions at once, gas fees rise to compensate miners responsible for adding transactions. During periods of high network congestion, it's not uncommon to see gas fees in the hundreds of dollars—a significant impact on NFT costs.
When you sell a cryptocurrency to purchase an NFT, you can deduct the gas fees from the proceeds when computing your capital gain or loss. For example, if you bought ETH for $100 in 2018, purchase an NFT for 1 ETH, and pay $45 in gas fees, your cost basis would be $145. ($100 Cost + $45 fee).
#4. NFT Sales May Be Taxable as Collectibles
NFTs are taxable as capital gains or losses if they're held as an investment, ordinary income if they're sold for income, or collectibles if they are considered art or other collectible assets. Of these categories, ordinary income is often the highest tax rate (depending on your tax bracket), followed by collectibles at a 28% tax rate.
If you're unsure of the classification of an NFT, you should consult a tax professional to ensure that you're taking a defensible position. Prolific NFT collectors and traders may also want to watch for NFT guidance from the IRS over the coming quarters. With the growing NFT market, the agency is likely to provide updated advice.
#5. Include NFTs in Your Tax Planning
NFTs can significantly impact your tax obligations each year, making them an essential part of tax planning. If you plan to sell an NFT, make sure you plan to offset potential capital gains with tax-loss harvesting, charitable contributions, or other strategies. Otherwise, you could find yourself stuck with a huge tax bill at year-end.
Crypto tax software, like ZenLedger, can help you stay on top of tax obligations. In addition to year-end reporting, the platform makes it easy to identify tax-loss harvesting opportunities in your portfolio while keeping your accountant in the loop with periodic reports. That way, you can proactively take action to reduce your tax liabilities. Try it for free!
The Bottom Line
NFTs are becoming increasingly popular among collectors and traders. When buying and selling NFTs, keep in mind that it's almost always a taxable event. You should carefully compute your tax obligations and ensure that you accurately pay what's due (while taking advantage of potential tax deductions) to avoid trouble with the IRS.
ZenLedger can help you keep your taxes organized each year by aggregating your crypto transactions, computing your capital gains or losses, and pre-populating popular IRS forms that you can then hand off to your accountant. You can even integrate with TurboTax to automate your crypto tax filings if you have relatively straightforward taxes.