NFTs and Taxes: New Rules and What You Need to KnowTax Planning
Non-fungible tokens (NFTs) are a type of digital asset that can be bought and sold.
Some people have made a lot of money from NFTs.
Many people have lost money.
Where there’s money, there are taxes.
Here’s what you need to know about taxes for NFTs.
What’s an NFT?
Don’t feel dumb if you don’t know what an NFT is. This is one of the odder creations of the crypto universe.
Let’s start by looking at the phrase “non-fungible token.”
- “Non-fungible” means that each NFT is unique. Thus, they differ from Bitcoin and other forms of cryptocurrency, which are fungible—interchangeable with other crypto or real currency.
- “Token” means a digital code that provides proof of ownership of the NFT.
When NFTs are created, or “minted,” they are listed on an NFT platform, where NFTs can be sold or traded in accordance with “smart contracts” that govern the transfers. There are hundreds of such platforms. Some smart contracts give NFT creators a cut of any future sale of the NFT.
The ownership and transfer of NFTs is registered online on a shared ledger called the blockchain, similar to cryptocurrency such as Bitcoin. Because NFTs can be easily sold and resold with a transaction history securely stored on the blockchain, they can function as investments that can store value and increase in value over time.
To put this in another frame: NFTs are basically digital certificates of ownership for virtual or physical assets.
NFTs commonly include:
- Digital art, including drawings, paintings, photographs, and other visual media
- Collectibles such as trading cards, sports memorabilia, or limited-edition toys
- Gaming NFTs, such as in-game characters
- Virtual real estate in virtual worlds
- Domain names
NFTs underwent a boom during the darkest days of the pandemic (much like land in Florida during the 1920s). A few NFTs sold for millions. Many sold for thousands.
Sales and prices are now off substantially from the peak, but people are still creating, buying, and selling NFTs.
Some—for example, those created by renowned artists—have retained their value or appreciated. Most NFTs sell for less than $300.
NFTs Are Digital Assets
The IRS made clear that NFTs are digital assets, just like cryptocurrency.1 Digital assets are digital representations of value that are recorded on a cryptographically secured distributed ledger.2
This means you must answer “yes” to the digital assets question on the first page of Form 1040 if you do any of the following during that tax year:
- Purchase an NFT
- Sell an NFT
- Gift an NFT
- Receive an NFT as a reward or gift
- Trade an NFT for another NFT
Starbucks. You may or may not be privy to the Starbucks Odyssey program that allows participants to earn and purchase one-of-a-kind, limited-edition stamp artwork. In an online article at Tax Notes, the tax professionals interviewed by author Nathan J. Richman opined that Starbucks Odyssey participants would have to check the NFT “yes” box on Form 1040.
IRS Deems Collectible NFTs as Collectibles
In Notice 2023-27, the IRS announced that (until further notice) it will treat NFTs that are tax-law-defined collectibles as collectibles for tax purposes. For you, this is not good for the following reasons:
- The tax code subjects the sale of a collectible held for more than one year to a maximum capital gains tax rate of 28 percent whereas the rate for other assets is a maximum of 20 percent.
- The tax code treats the amount paid by an individual retirement account (IRA) or an individually directed stock bonus, pension, or profit-sharing plan to acquire a collectible as a (get ready for this) taxable distribution to you by the plan. Such a taxable distribution is subject to ordinary income taxes and possible early withdrawal penalties.
The definition of “collectible” is also relevant to the new markets tax credit, enterprise zone businesses, tax shelter registration, and permissible investments for health savings accounts. The tax code defines a “collectible” as any
- work of art,
- rug or antique,
- metal or gem,
- stamp or coin, or
- alcoholic beverage.
In addition, the tax code allows the IRS to name any other tangible personal property as a collectible. The IRS has not named anything else since this tax code section came into existence in 1997.
As to coins, the tax code excludes certain coins and bullion from the definition of “collectibles.”
Tax Treatment of NFTs
Digital assets such as NFTs and cryptocurrency are treated as property for tax purposes, much the same as gold or corporate stock. You recognize taxable gain or loss when you exchange an NFT for cryptocurrency, U.S. dollars or other fiat currency, another NFT, or other property.
Because an NFT is an asset, it is almost certainly a capital asset in the hands of a purchaser. Thus, gains or losses when a purchaser later sells an NFT are capital gains or losses. If you hold the NFT for more than one year, your gains are taxed at the favorable long-term capital gains rates. Gains or losses from NFTs held for less than one year are taxed at ordinary income rates.
NFT purchasers can deduct capital losses from selling NFTs against other realized capital gains during the year— for example, gains from the sale of corporate stock. You can also deduct capital losses up to $3,000 from ordinary
income, such as regular business income or employee wages. Losses over $3,000 are carried forward to be deducted in any number of future years.
NFTs are non-capital assets in the hands of their creators. The creator of an NFT will receive ordinary income upon the sale of the NFT.
Taxes for NFT Purchasers
If you are able to purchase an NFT with dollars (that is, “real money”), there will be no tax impact for you as a buyer, except for certain IRA and retirement plan buyers as explained above.
Most NFTs are not purchased with “actual” currency. Instead, they are bought and sold on online NFT trading platforms with the cryptocurrency called Ethereum (Ether or ETH for short; sign: Ξ). To make the purchase, you must create a digital wallet and stock it with ETH by converting dollars to ETH.
Creating the wallet and purchasing ETH with dollars is not a taxable transaction.
But there is a taxable transaction when you purchase an NFT with your ETH. You effectively engage in two separate transactions for tax purposes. First, you sell your ETH for real currency, and then you immediately exchange it for the NFT you buy. The ETH sale usually results in a taxable capital gain or loss. Your basis in the
NFT is equal to the fair market value of the ETH at the date of purchase.
Example 1. Peter acquired 1 ETH for $1,400 two months ago. He uses the 1 ETH to purchase an NFT from an online platform. At the time of purchase, 1 ETH is worth $1,500, so Peter has a $100 short-term capital gain.
He must pay tax on this short-term ETH gain at ordinary income rates, which means $35 in tax because his marginal rate is 35 percent.
Had Peter acquired the NFT with ETH he purchased over one year ago, he’d pay tax on his gain at long-term capital gains rates. This would have been a 15 percent tax for Peter at his income level. Following the purchase, Peter’s basis in the non-collectible NFT is $1,500.
Example 2. One year later, Peter sells his NFT for 0.5 ETH. On the date of the sale, ETH is worth $1,000, so Peter has a long-term capital loss of $1,000 ($1,500 - $500 = $1,000). He may deduct his loss from other capital gains that year. If he has no capital gains, he may deduct his $1,000 loss from ordinary income.
Planning tip. There are NFT platforms, such as unsellablenfts.com, that specialize in buying worthless NFTs for 1 cent plus fees so the owners can recognize a deductible loss.
Taxes for NFT Creators
Creating an NFT—also called “minting” or “tokenizing”—is not a taxable event. Creators of NFTs recognize ordinary income when they sell an NFT.
- If selling NFTs is a business activity for the creator, he or she will also owe self-employment tax on the income and may deduct any business expenses.
- If the NFT activity is a hobby, the creator does not owe any self-employment tax, but he or she gets no deductions.
Example 3. Julia, a struggling artist, digitizes a painting of her cat, and mints an NFT. She sells the NFT for 2 ETH. At the date of the sale, ETH is worth $1,550, so she recognizes $3,100 of ordinary income.
- If Julia is in the business of being an artist, she will have to pay self-employment tax on her $3,100.
- If Julia is only a hobby artist, she’ll owe only income tax.
Donating NFTs to Charity
If you purchase an NFT, hold it for more than one year, and then donate it directly to a qualified charity—a Section 501(c)(3) organization—then you may deduct its fair market value on the date of the donation. If you owned the NFT for less than one year, your charitable donation is limited to the lesser of the NFT’s basis or fair market value.
If the NFT has declined in value since your purchase, it would be better to sell it and then give the proceeds to charity. This way, you would have a deductible capital loss and a charitable contribution of cash.
If an NFT held for over one year is worth more than $5,000 when donated, you must obtain an appraisal from a qualified appraiser and attach it to your tax return along with IRS Form 8283, Noncash Charitable Contributions.
Finding a qualified appraiser for an NFT could prove difficult. There is no appraisal requirement for NFTs owned less than one year.
Special rule for collectibles. There could be complications if an NFT held for over one year is classified as art or a collectible.
In this event, the donation could be subject to the related use rule. If such a collectible NFT is used for the nonprofit’s exempt purposes for at least three years, you may deduct its fair market value at the time of the donation.
If the collectible NFT is not so used or is sold within three years, the deduction is limited to the NFT’s basis. For example, if an NFT classified as art is donated to an art museum, and the museum sells it within three years, the deduction is limited to the NFT’s basis.
Rules for creators. What about charitable donations by NFT creators? NFTs created by a donor are not treated as a capital asset because they are created by the personal efforts of the taxpayer. The charitable deduction is limited to cost basis, not including the value of the creator’s time or labor. This could include the cost of minting the NFT—the fees paid to get it listed on an NFT trading platform.
Gifting an NFT has no tax impact on the recipient of the gift.
The donor who made the gift must file a gift tax return if the total gifts he or she makes during the year to a single donee exceed $17,000 ($16,000 for 2022).
If the recipient later sells the NFT, he or she will owe tax on any gain or could have a deductible loss.
- To determine a gain, the NFT’s basis is equal to the donor’s basis, plus any gift tax the donor paid on the gift.
- To determine a loss, the NFT’s basis is equal to the lesser of the donor’s basis or the fair market value of the NFT at the time of the gift.
- If there is no documentation to substantiate the donor’s basis, the NFT’s basis is zero.
Freshly minted NFTs are sometimes distributed for free to multiple members of a given community.
The distributions are called “airdrops” and are made for promotional purposes, or as added value for participating in an experience or purchasing a digital asset.
NFT airdrops are taxed as ordinary income. The taxable amount is the value in dollars of the airdropped NFTs at the time they enter the holder’s wallet.
The online trading platforms that are used to purchase and sell NFTs charge users fees that are called “gas fees.”
Purchasers of NFTs may add the amount of these fees to their tax basis in the NFT. Creators of NFTs may deduct the fees as a business expense, if the NFT creation is a business activity. If the NFT is a hobby, there is no deduction.
What Capital Gains Rate Applies?
NFTs held for less than one year are taxed at short-term capital gains rates, which are the same as for ordinary income—anywhere from 10 percent to 37 percent depending on the taxpayer’s income.
NFTs held for more than one year are taxed at long-term capital gains rates. These are 15 percent for most people and 20 percent for higher-income taxpayers (plus the 3.8 percent net investment income tax for some taxpayers). Thus, the top rate is 23.8 percent.
But a higher maximum long-term capital gains rate applies to NFT collectibles: 28 percent. Collectibles include tangible works of art, rugs and antiques, metals and gems, alcoholic beverages, stamps, and coins (other than coins not treated as collectibles, as explained above).
If an NFT is a collectible and is sold after being held for over one year, the tax rate on any gain would be the lower of the applicable ordinary income rate or 28 percent. For example, if your top income tax rate is 24 percent, that’s all you’d have to pay. If your top rate is 37 percent, you’d pay 28 percent. And if you are subject to the 3.8 percent net income tax, you have to pay that too.
NFTs are unique digital certificates of ownership for virtual or physical assets such as digital artwork, video, music, and collectibles. NFTs are traded on online platforms, but unlike cryptocurrency such as Bitcoin, NFTs are not interchangeable or freely convertible into dollars or other forms of cryptocurrency.
NFTs are classified as digital assets by the IRS. This means you must answer “yes” to the digital assets question on the first page of Form 1040 if you purchase, sell, or otherwise acquire an NFT during the year.
NFTs are capital assets for purchasers. Thus, gains or losses when a purchaser later sells an NFT are capital gains or losses.
NFTs are non-capital assets in the hands of their creators. The creator of an NFT will receive ordinary income upon the sale of the NFT.
Because NFTs are ordinarily purchased with cryptocurrency, purchasers usually recognize a capital gain or loss when they exchange their crypto for an NFT.
Donations of NFTs to charity can result in charitable deductions.
Gifts of NFTs are not taxable events for the recipient.