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Despite Non Fungible Token (NFT) sales hitting nearly US$21 billion by the end of 2021, making NFTs almost as valuable as the global art market, they are currently completely ignored by the US Internal Revenue Service (IRS) in the agency’s pronouncements on the taxation of cryptocurrencies.

An NFT is a unique, digitised certificate (a token) stored on a blockchain. It can be a representation of something tangible, e.g., a piece of music, or it can be an original creation that exists only in digital form.

NFTs are “smart contracts”; their embedded metadata allows relevant information to be visible and stored on the blockchain in a transparent and immutable way. The token is non-fungible because its metadata cannot be duplicated or replicated: even if multiple replicas are created using the same content, each NFT has unique metadata.

Without specific guidance from the US Government, general tax principles must be examined to determine, by analogy, how NFTs are likely to be taxed.

TAXING BUYERS AND SELLERS

The IRS treats convertible cryptocurrency as property, not currency. As a result, the general tax principles that apply to property transactions apply to convertible virtual currency. Although Notice 2014-21 (2014-16 I.R.B. 938) and the March 2019 updated Frequently Asked Questions does not address non-convertible cryptocurrencies or NFTs, it is likely that NFTs are property for tax purposes.

Property transactions are taxed as barter transactions. If the buyer pays for an NFT with “property”, such as cryptocurrency, both the buyer and seller have a taxable transaction to the buyer if the fair market value of the cryptocurrency used to buy the NFT is greater than the taxpayer’s tax basis in that cryptocurrency. The seller has taxable gain/loss equal to the difference between the seller’s tax basis and the value of the property received in payment for the NFT.

If the NFT is purchased with actual currency, such as US dollars, the seller has a taxable sale but the buyer does not. The seller’s gain/loss is the difference between the NFT’s adjusted tax basis and the amount of currency used to purchase it.

The taxpayer bears the burden of proving investment intent with respect to NFTs.

If the buyer uses appreciated property to buy the NFT (i.e., the fair market value of the property used to buy the NFT is greater than the buyer’s tax basis), the buyer has taxable gain equal to the amount of this appreciation. The buyer’s tax basis in that property is what is relevant for tax purposes.

Loss and Gain

Gain or loss is treated as capital or ordinary, depending on whether the taxpayer is an investor or trader (capital), or a creator or dealer (ordinary). Ordinary losses are fully deductible but capital losses are subject to the special loss limitations that apply to capital assets. As a result, some capital losses might not be deductible. In addition, if the taxpayer holds an NFT as a personal asset, losses can be permanently denied under Code § 183, which prohibits deductions for losses incurred on activities that are not engaged in for profit.

In addition, a taxpayer’s intent in acquiring an NFT must be established to determine if the NFT is a “personal use” asset not held for investment.

Collectibles

Collectibles are a unique category of items subject to a higher capital gain tax rate of 28%. NFTs that are similar to collectibles and are held for the long-term holding period, are subject to the higher rate. Shortterm capital gains are subject to the same tax rates that generally apply to capital assets, without regard to whether they would be treated as collectibles. Losses on the sale of collectibles are subject to the limitations on losses that generally apply to capital assets.

Other types of NFTs, such as those that represent ownership of actual assets or provide for experiences, might not be classified as collectibles, and are instead subject to regular capital gain tax rates.

Personal Use Assets

The taxpayer bears the burden of proving investment intent with respect to NFTs. A taxpayer’s NFTs would probably be treated as personal use assets if the taxpayer’s activities are too infrequent to rise to the level of investment activities, or the taxpayer does not maintain adequate books and records to support an investment intent.

TAXING CREATORS

Although the market for NFTs is too new to make sweeping generalisations, the tax treatment of creators of NFTs should be fairly straightforward. Minting (the process by which the creator initially records the NFT on the blockchain) an NFT should not be a taxable event because it does not arise from or represent the sale or exchange of property. The creator does have a taxable event, however, when the NFT is sold or exchanged for real currency or property, including cryptocurrency or another NFT.

Whether an NFT sale triggers ordinary or capital gain or loss turns on whether it is an ordinary or capital asset in the hands of the taxpayer. For creators, an NFT is an likely to be an ordinary asset in the taxpayer’s hands.

NFT donations are treated as any other noncash contribution of property.

The creator’s tax basis is determined by reference to the creator’s costs and expenses in creating the NFT. Ordinary and necessary expenses are deductible if paid or incurred by a taxpayer in carrying on the trade or business of creating and selling NFTs, e.g., the costs of creating the NFT, adding it to a blockchain, or selling it.

Gain or loss is taxable when it is realised or sustained. It is the amount by which the value of the cash or property received on the sale or exchange is more, or less, than the amount of the taxpayer’s adjusted tax basis.

Rules for computing the amount of gain or loss are contained in Code § 1001 and the regulations issued under that section. Although NFTs are intangible assets, the tax rules that allow for the amortization of the tax basis in certain intangible assets do not apply to creators of intangible assets. Only holders of NFTs who did not create them and who are in a trade or business can amortize NFT tax basis.

CHARITABLE CONTRIBUTIONS

As nonfungible assets, NFTs are not suitable for most direct charitable contributions. The few charities that are set up to accept cryptocurrency generally convert crypto to fiat currency as soon as possible. They cannot do this with NFTs because they are not convertible. Direct contributions of appreciated NFTs can, however, provide donors that are not NFT creators with significant tax advantages, so they are worth exploring.

From the Donor’s Perspective

Donors that can meet IRS reporting requirements can avoid paying tax on the amount of gain they would otherwise incur if they had sold the appreciated NFT in the market and donated cash to the charity. Donors can receive a deduction for an appreciated NFT’s full value up to the percentage cap of their adjusted gross income. This means that the best NFT for a direct charitable contribution is one that has significantly appreciated in value and has been held by a taxpayer classified as an investor for more than one year.

NFT donations are treated as any other noncash contribution of property. It is therefore more tax efficient for a taxpayer with a loss in an NFT that is a capital asset to sell it in the market, report a capital loss for tax purposes, and donate US dollars to the charity to receive a charitable contribution equal to the amount of cash contributed.

From the Charity’s Perspective

Charities must address several issues before accepting donations of NFTs or cryptocurrency received from sales of NFTs. They must determine the protocols for accepting NFTs and cryptocurrency, and the ways in which donated digital assets can be converted to US dollars. In addition, a charity must also familiarise itself with the unique issues raised by accepting, storing, and displaying NFTs.