5 Ways Non-Fungible Tokens (NFTs) are TaxedMar 20, 2021
Non-fungible tokens better known as NFTs are the hottest thing in crypto. 2021 may go down as the “Year of NFTs”. You may be wondering how are NFTs taxed?
Let’s start with the NFT meaning. Then we’ll discuss the taxability.
NFTs are a byproduct of crypto or virtual currency. Bitcoin and Ether are native tokens of their respective networks and one of the most important economic value propositions is fungibility. This means any given token is the same as any other given token regardless of its prior history, who owned it, how long it’s been in circulation and so on. The history and ownership of these tokens can be cryptographically proven at any point in time.
The power of a blockchain like Bitcoin means the attribute of cryptographic proof can be repurposed for an unlimited number of non-financial use cases. Just think fraud, shenanigans and document manipulation and you get the point. Those things can be eliminated in some cases.
Fungibility is super important in networks designed for value transfer and other financial use cases. In other cases, fungibility is NOT desired. Just think about art and all things rare. The reason rare items can be insanely valuable is because there aren’t many of them. How can a rare item be proved? Assuming the art is not fake, for example, your possession of that rare piece of modern art is proof that it’s real.
The Digital Problem
Prior to blockchain it was essentially impossible to keep digital artwork, a song or software from being copied and identified as unique. Since math is your friend and the history and ownership of a bitcoin can be proven, digital artwork can also be proven in the same way. The Ethereum network has an ERC-721 token standard for creating unique non-fungible tokens. ETH, the native token of the Ethereum network, is a fungible token and its ERC-20 token standard is also used for creating fungible tokens.
A Record NFT Sale
If you want to create a unique provable digital item then an NFT token is the way to go. Beeple sold a record setting $69MM NFT artwork at Christie’s auction house. Wow! One thing is for sure, if digital art was not provably rare, it wouldn’t command that price tag.
Primer on Collectibles Taxation
The most common use case for NFTs is the aforementioned digital art. From an IRS perspective art is considered a collectible which has a special maximum 28% capital gain tax rate. The Taxpayer Relief Act of 1997 lowered the max long-term capital gains rate to 20% but kept the old 28% intact for collectibles. The IRS has broad authority to deem property as collectibles, therefore NFTs are an obvious candidate. As of early 2021 there is no specific IRS guidance on the treatment of NFTs.
The 5 Ways NFTs are Taxed
Let’s look at a comprehensive example
1) NFT Ordinary Income as the Original Seller:
The person or entity who creates NFTs has a potential product for sale. The revenue from sales is considered ordinary income the same as selling other goods and services.
The tax rates for individuals for 2021 range from 10% to 37%. You can see what a tax table looks like here and here. It’s not worth reproducing because the amount of income subject to a tax tranche is based on filing status so click on the links if you want to drill down. The majority of Beeple’s revenue from the $69MM sale would be subject to the 37% tax bracket. (We’re excluding a C Corp scenario for simplicity purposes)
2) NFT Ordinary Income as the Secondary Seller:
MetaKovan was bought Beeple’s “Everyday”: The First 5000 Days” NFT. Let’s assume MetaKovan is an NFT art dealer and is therefore in the business of buying and selling NFT artwork. The “Everyday” NFT is added to inventory and then Alice comes along in late 2021 and buys the NFT for $80MM from MetaKovan.
MetaKovan will also have ordinary income of $11MM ($80MM sale price - $69 cost basis = $11MM) which would also be subject to the highest tax bracket of 37% (assuming they are US person for example purposes)
3) NFT Long-Term Capital Gain as a Collectible:
Alice is an art collector and buys the NFT as an investment. The NFT space continues to explode in 2022 and “Everyday”: The First 5000 Days” has gotten so much press in the art world Alice decides to send it back to Christie’s for another auction 13 months after her purchase. The NFT fetches $99MM and triggers a long-term capital gain at the collectibles rate of 28%.
4) NFT Short-Term Capital Gain as a Collectible:
Let’s assume the same facts except Alice wasn’t paying attention and sold the NFT in 11 months (less than one year) rather than waiting for more than one year. In this case Alice has a short-term capital gain which defaults to the highest 37% tax bracket because there are no special short-term rates. (short-term rate are the ordinary income rates)
5) NFT Long-Term Capital Gain as a Capital Asset ("regular crypto"):
The range of NFTs is already diverse and worth covering in a separate blog. The SYNCbond is the first ever “Crypto Bond.” A SYNCbond is created by bonding a Uniswap LP token (a pair of crypto assets like ETH/WBTC) with the SYNC token (the native asset of the SYNC Network). The result is a financial NFT which also has a dynamically created beautiful piece of bond artwork attached. Here is a SYNCbond example:
Bob creates a 3-year SYNCbond #2147 and he immediately falls in love with the NFT bond certificate. The bond is substantially financial in nature and even though the artwork component may have perceived value, the bond art is burned when the bond is redeemed on the maturity date. The potential value of the bond art component can’t be separately extracted or monetized, therefore this type of NFT is actually a crypto asset for tax purposes the same as ETH or BTC.
We’ll consider the taxability of a matured crypto bond in another segment.
Let’s assume Bob sells bond #2147 for $25,000 14 months after he created it. Bob's cost basis was $5,000 so he recognizes a long-term capital gain of $20,000 (Bob held it longer than one year) and based on his tax bracket Bob is subject to a 15% long-term capital gain. If Bob held the bond less than one year he’d have a short-term capital gain once again defaulting to the ordinary income tax rates.
NOT all NFTs are the SAME for Tax Purposes
When it comes to NFT taxable you can’t assume all NFTs will be or can be considered collectibles. Depending on the situation for an individual taxpayer the difference in tax could be significant. We'll all to dig deeper into what NFTs represents and in some cases it's possible an NFT could be taxed as part collectible and part capital asset with different tax rates applied. NFTs will continue to evolve and so will the need for NFT tax coverage.
Good luck and remember your goal is a always a Crypto Bullseye™
DISCLAIMER: The information in this newsletter can not be construed as tax, legal or investment advice because professional advice can only be dispensed with an official engagement letter.
Yours in Crypto,
Kirk Phillips, CPA, CMA, CFE, CBP
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