NFT Tax Guide: How to Stay in Compliance with the IRS
Similar to the early days of cryptocurrency entering the mainstream lexicon and popularity, the IRS has not released any formal guidance on the taxation of NFTs (non-fungible tokens).
That’s why it’s important to speak with a tax advisor familiar with taxation and regulation of digital assets, such as a Kugelman Law tax attorney, to be proactive about compliance with IRS reporting requirements.
Here are some basics to NFT taxes and what should be reported on your tax return.
What is an NFT?
An NFT ("non-fungible token") is a unique digital token that represents a specific image, item of text, music, or video.
This token is created and recorded on a decentralized distributed ledger (i.e. blockchain) that tracks the NFT and who owns it. NFTs can then be bought and sold on an online marketplace that is linked to the blockchain.
Do I have to report my NFT activity to the IRS?
Any and all gains from the production and sale of NFTs are reportable to the IRS.
An NFT may be classified as a capital asset subject to capital gains tax if it is bought and sold on a marketplace. However, income derived from NFT creation and sale may be considered ordinary gains and losses.
NFTs have unique characteristics that make them different from cryptocurrency, especially with regards to the different types of gains they may produce, which may be classified as either capital gains or ordinary income.
What's more, as NFT technology and mainstream adoption develops, NFTs may come to represent more than simply ownership in a digital asset. Instead, an NFT may represent ownership over a tangible non-digital asset. That said, NFTs may be subject to existing tax laws to the extent they represent ownership over traditional tangible assets.
How are NFTs similar and different from cryptocurrency?
NFTs are similar to cryptocurrency because they are digital tokens that are tracked on a blockchain.
Cryptocurrencies, however, are "fungible" and all tokens have the same value. For example, Bitcoin is a fungible token. If you borrow one Bitcoin from a lender, you can pay that lender back with a different Bitcoin, and the lender would be receiving the same value in return.
By contrast, an NFT represents a unique, one of a kind token that has its own value and therefore cannot be replaced by another NFT.
How are NFT royalties treated?
NFTs may include certain terms and conditions associated with ownership and resale. For example, an NFT may include a so-called "royalty" payment to the original creator on resale.
Those royalties are most likely going to be treated as ordinary income. However, this depends on the underlying characterization of the NFT and should be discussed with your tax advisor.
How should taxpayers account for NFT activity on their tax returns?
The treatment of NFTs on a tax return depends on how you acquired the NFT. Those details surrounding how your gains from NFT production and sales are characterized should be reviewed with a Kugelman Law tax and NFT attorney to ensure compliance with the IRS. Contact us today for a thorough review.