Guide

Non-Fungible Tokens (NFTs) & Crypto Taxes - 2021 Edition

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October 11, 2021
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    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 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 for both creators and investors.

    What Are Non Fungible Tokens?

    NFT Taxes
    Source: Bored Ape Yacht Club

    Non-fungible tokens, or NFTs, are a special type of cryptographic token that represents a unique asset. For example, The Bored Ape Yacht Club NFTs, pictured above, each have unique properties via metadata that are verifiable along with ownership on the blockchain. These dynamics differ from fungible tokens, like Bitcoin, as they are non-unique and interchangeable with each other.

    ‍Conventional Tokens

    • Fungible
    • 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 recording real estate ownership to providing special access or privileges. 

    There are many emerging use cases for NFTs:

    • Artists are shifting their creative assets to NFTs which allows them to build a stronger community and collect royalties from secondary sales, as well as prevent piracy.
    • 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, can eventually be stored on the blockchain with NFTs.

    NFTs are relatively novel, and their main use cases will likely change as they gain mass adoption. In today's world, most people know NFTs as art/collectible pieces—most with little to no utility. In the future, NFTs will be used for everything from music royalties and fan tokens with special privileges, to making things like education diplomas and biospecimen verifiable on the blockchain. 

    NFT Taxes
    Source: Cyberscrilla

    When Do I Owe Taxes On An NFT?

    The IRS has made it clear that transacting in 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 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.

    What Is The Tax Rate On NFTs?

    Whenever you earn profit from increasing demand in cryptocurrency, it is subject to regular capital gains taxes. But in the case of NFT transactions, this doesn’t stand true. This is because NFTs can be considered collectibles and will therefore qualify for higher capital gains tax. However in some rare circumstances, it can be considered as inventories, thus being subjected to income tax rates.

    NFT Taxes: What Are Investor Taxes?

    Most of the individuals dealing with NFTs are investors. These are the people who are involved in buying and selling NFTs in the open market. For them, taxes work the same way as they do for crypto trading.

    Purchasing NFTs 

    When you buy NFTs using cryptocurrency, it is taxable.

    For example, years ago Kim purchased 2 ETH @ $500/ETH ($1000 total). In March 2021, Kim used this same 2 ETH to purchase a Bored Ape NFT, but ETH is now worth $1000 so the purchase of the Bored Ape is for $2000. Kim incurred a capital gain of $1000, from the increase in value of her 2 ETH, and is taxable upon exchange for the NFT. 

    Selling NFTs

    Another taxable event is selling your NFT for crypto, fiat currency, other NFTs, or even goods and services. 

    Let’s take the same example. If Kim sells her NFT for $12,000 after 6 months, it would qualify for short-term capital gains of $10,000 ($12,000-$2,000). Short-term gains are taxable as ordinary income rates of tax.

    NFT Taxes: What Are Creator Taxes?

    The creation of NFTs is not taxable. However, any crypto transactions related to NFTs are considered taxable according to the Internal Revenue Service (IRS).

    Creators are the ones who mint or create NFTs and list them for sale on various marketplaces, such as SuperRare and OpenSea. 

    NFT creators are of two types:

    • Hobby creators
    • Professional creators

    Hobby creators mint NFTs for fun, whereas professional creators mint NFTs as a full-time trade. 

    Minting NFTs

    Gas expenses paid for minting NFTs are taxable. Let’s understand this with an example.

    Tim mints NFTs as a hobby. He spent 0.2 ETH to mint a Bored Ape NFT. When he initially purchased this ETH, it had a value of $200. At the time of the NFT mint, this same 0.2 ETH increased in value to $400. Therefore, minting the NFT with this ETH will incur a $200 ($400-$200) capital gain, whereas the cost basis for the NFT that he minted is $400.

    On the contrary, had Tim been a professional creator, $200 would be his ordinary income and the cost basis would’ve been $400.

    Selling NFTs

    Selling NFTs for any crypto or even exchanging an NFT for another NFT is taxable for NFT creators.

    Suppose Tim holds his Bored Ape for 9 months and sells it for 5 ETH, now worth $15,000. Since he held the NFT for less than 1 year, Tim will now incur a short-term capital gain of $14,600 ($15,000 - $400{cost basis}). If Tim had held the NFT for more than 1 year, his profit would be considered a normal capital gain (not short-term).

    If Tim was a professional creator, his $14,600 would have been reported as ordinary income. He could also offset his gains by filling the Schedule C for deducting internet, utilities, and other business expenses.

    Selling NFTs
    Source: Opensea

    NFT Royalties

    Earning recurrent royalties is taxable as well.

    Suppose Banksy releases a piece of artwork as an NFT, with 1% royalties attached in perpetuity. After the initial mint, the NFT was resold several times on the secondary market, and Banksy received 1% of each sale as his royalty. After the first secondary sale, Banksy earned 0.30 ETH in royalties, so he would have to report an ordinary income equivalent to the USD value of this ETH at the time that he received it.  

    NFT Airdrops

    Holders of popular NFT projects like Cryptopunks and Bored Ape Yacht Club will often find that they're being airdropped (given for free) coins or other NFTs that have monetary value. Oddly enough, airdropped tokens is one of the few things that the IRS has provided explicit guidance on; airdrops are to be taxed as ordinary income. The amount of this income being the value in USD of the airdropped coins/tokens at the time they hit the wallet.

    How to Report NFT Transactions on Your Taxes

    Reporting NFT transactions is different for hobby creators and investors than professional creators and investors.

    Hobby Creators And Investors

    • IRS Form 8949 and Schedule D
    • Mention collectibles NFTs as code C in column F

    Professional Creators And Investors

    • Report NFT income and business expenses
    • Schedule C or Form 1065, Form 1120, or Form 1120-S

    Some Common NFT-Related Misconceptions

    Tax Cuts & Jobs Act (TCJA)

    • Enacted: 1st January 2018
    • Provisions do not have implications on NFT taxes

    Utility NFTs

    • Not music, graphics, digital art, etc.
    • Provide other utilities like a game, domain name, and so on.
    • Different tax treatments than collectibles, property, and inventory.
    nft taxes
    Source: Axie Infinity

    Final Thoughts On Non-Fungible Tokens

    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 NFTs or other crypto assets, ZenLedger can help you easily calculate your crypto taxes, and also find opportunities for you to save money and trade smarter. Get started for free now or learn more about our tax professional prepared plans!

    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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