Yes, NFTs Can Be Taxed, Too

According to industry publication DappRadar, collectors went on a buying spree for non-fungible tokens, or NFTs, last year, pushing sales up to $24.9 billion in 2020 from $94.9 million in 2020, and many are only now realizing that an unexpected guest wants in on the fun: the Internal Revenue Service. The tax implications for everyone who trades, receives, or sells NFTs may be onerous and complex, and the IRS is beginning to crack down.

"There are a lot of misunderstandings that NFTs aren't taxable until you sell them for dollars," says Matt Metras, an enrolled agent with MDM Financial Services in Rochester, N.Y., who specializes in crypto accounting and has incurred a tax bill for getting NFTs as a reward in a video game. "I have bad news for a lot of clients."

NFTs are digital tokens that authenticate the validity of a digital product, generally paintings, films, virtual trade cards, or memes. They are commonly bought and sold using the cryptocurrency Ethereum. With a series of astonishing sales collecting millions of dollars, the digital assets entered mainstream popular culture around the beginning of 2021. This resulted in a flood of new NFTs and sales, spawning a completely new collectibles industry.

But here's the bummer: The IRS considers NFTs, like cryptocurrencies, to be property. There are several possibilities with various tax implications:

NFT creators — who typically receive Ethereum when they sell — must report their crypto income to the IRS; people who receive NFTs as compensation or rewards, such as in a video game, must report them as income; and anyone who sells an NFT — who is not its creator — must report gains or losses, just like investors would for stocks or mutual funds.

What's more perplexing for some taxpayers is that a tax bill might be generated merely by acquiring an NFT because the transaction is done using crypto, which may have been gained since it was purchased.

"If you purchase Ethereum for $1 and it rises to $10, then you have a $9 gain — people don't appreciate that," says Jere Doyle, senior vice president at BNY Mellon Wealth Management in Boston.

Regular income tax rates of up to 37 percent apply to people who declare NFTs as income. Self-employed NFT creators will also be subject to the 15.3 percent self-employment tax, according to Doyle.

Collectors with short-term realized profits (those held for less than a year) incur tax rates of up to 37%. Long-term realized profits are subject to a reduced tax rate. However, the exact rate is unclear under the statute.

According to Erik Weinapple, tax director at Moss Adams, a national accounting company in Seattle, the IRS has not clarified how it defines NFTs, whether as collectibles or a type of cryptocurrency. That is an important point: The highest long-term tax rate on realized profits in art and collectibles is 28%, whereas it is 20% for cryptocurrency.

Weinapple advises taxpayers to utilize the 28 percent rate until the IRS establishes the tax rate for NFTs.

Beginning last year, the IRS inserted a checkbox on Form 1040 asking filers if they have any digital assets. Accountants say the government is preparing for enforcement.

"If you offer a fraudulent response, you might face taxes, interest, fines, and even criminal charges," says Justin Miller, national director of asset planning at Evercore Wealth Management. The difficulty for taxpayers in determining their taxable profits by tracking their cost bases in both cryptocurrencies and NFTs. Unlike stock and bond traders, whose brokers issue a 1099 reporting gains and losses for the tax year. "NFT platforms do not typically send 1099 forms with cost basis information," says Mikkel Jensen, U.S. director at Ageras, a Philadelphia-based company that connects businesses with accounting services. "It is critical to keep thorough records of the cryptocurrency used to acquire NFTs, as well as the NFTs themselves, in order to compute capital gains and related taxes."