How Are NFTs Taxed by the IRS?

 Posted on November 12, 2021 in Taxation Law

In today’s digital world, there are a multitude of lucrative opportunities for investors. Recently, many people have been able to make significant gains by investing in non-fungible tokens, or NFTs. These digital tokens use blockchain technology, similar to what is used for cryptocurrency, and they allow a person to maintain or transfer ownership of certain types of intangible assets, such as digital images, videos, or video game characters. As the buying, selling, and trading of NFTs has increased, the IRS has taken notice, and taxes will apply to these transactions. NFT creators and owners will need to be sure to understand what types of taxes they may be required to pay when engaging in these types of transactions.

Taxes on Digital Transactions

While the IRS has not yet issued guidance on how transactions involving NFTs will be taxed, investors will most likely be able to avoid potential penalties by treating these transactions the same as those involving virtual currencies. Since NFTs are often purchased with or traded for cryptocurrency, buyers and sellers may also need to address additional tax-related issues during these transactions. 

If an NFT is purchased using virtual currency, the buyer may need to report a gain or loss in the value of the currency. For example, if a person purchased a certain amount of virtual currency for $500, and the currency was valued at $1,000 when they traded it for an NFT, they will need to recognize a capital gain of $500.

Capital gains taxes will also apply when selling an NFT or when trading one NFT for another NFT. Gains or losses will be based on the amount an NFT was originally purchased for and the amount received in exchange. If an NFT is exchanged for cryptocurrency, the gains or losses will be calculated based on the value of the cryptocurrency at the time of the transaction. If a person sells an NFT after owning it for less than 12 months, short-term capital gains taxes will apply. These tax rates are based on a person’s income tax bracket, and the maximum tax rate is 37 percent. Long-term capital gains tax rates will apply in cases where a person sells an NFT after holding it for more than 12 months. Since NFTs are likely to be classified as collectibles, the maximum long-term capital gains tax rate is 28 percent.

Creators of NFTs generally will not be subject to taxes until they sell an NFT to a new owner. Income taxes and self-employment taxes will apply to these sales. In some cases, a creator may receive royalties in the form of cryptocurrency each time an NFT is sold to a new buyer, and these royalties will also be subject to income taxes.

Contact Our San Jose, CA Tax Law Attorney

Determining how taxes apply to NFTs and other transactions involving virtual currency can be a complex matter. Failure to properly report these transactions and pay applicable taxes may lead to IRS tax audits and tax penalties. At John D. Teter Law Offices, we can provide legal help with these matters, and we can help determine the best ways to report information to the IRS and minimize potential taxes and penalties. Contact our San Jose tax lawyer at 408-866-1810 to get legal help with cryptocurrency-related issues.

Sources:

https://www.forbes.com/sites/shehanchandrasekera/2021/10/28/how-to-avoid-common-nft-tax-pitfalls/?sh=10be1276176a

https://www.cnbc.com/2021/03/17/tax-surprise-looms-for-nft-investors-who-use-crypto-.html