Last year, 2021, was the year non-fungible tokens (NFT) became mainstream as trading volume skyrocketed to $24.9 billion, up from just $94.9 million in 2020. Hundreds of thousands of crypto aficionados joined in on the hype, some of whom became multimillionaires in a matter of months.
This piece is part of CoinDesk’s Tax Week
While platforms and wallets such as Opensea, Metamask and Phantom make NFT trading quite simple and accessible, they’re severely jeopardizing their customers by not providing any clarification on taxes at the time of transaction.
I can guarantee that 95% of NFT traders don’t know how much they owe.
We’ve heard countless stories of NFT traders asking for help across social media because they are desperately looking for tax guidance. To support the community, we’ve been putting together a crypto tax guide, which you can see here.
In this piece, we’re going to talk about how NFTs are taxed and various scenarios that will create taxable moments for you!
How are NFTs taxed?
Investing in NFTs may have up to three taxable events.
→ 1st event: Paying with ETH
If an NFT is purchased using crypto such as ether (ETH), this transaction would trigger a capital gain/loss taxable event. The U.S. Internal Revenue Service views this transaction as you selling your ETH for fiat and then using the fiat to buy the NFT, thus creating a taxable event for you. You will be taxed on the price appreciation from when you first bought your ETH to when you "sold" it to buy the NFT.
→ Sold for ETH
If an NFT is sold for crypto such as ETH, or swapped for another NFT, this would trigger a new capital gain/loss taxable event. Similar to the first event, the IRS views this as you selling your NFT for fiat and then rebuying ETH or another NFT with fiat. You will be taxed on the price appreciation of ETH from when you first bought the NFT to when you sold it. So there’s a chance that you sold your NFT for less ETH but still owe taxes because the price of ETH went up from the time you bought the NFT.
→ Back to Fiat
Converting your ETH proceeds from NFT sales back to fiat, you will be taxed on the price appreciation from when you received your ETH proceeds to the current market price at time of fiat conversion.
Creators of NFTs are taxed in a different way from NFT investors. While creating the NFT does not trigger a taxable event, selling an NFT in exchange for crypto or other compensation would. For example, if NFT creators sell a digital collectible for ETH on OpenSea, the creator would be taxed as ordinary income on the compensation received. In this example, if creators do not convert the ETH to U.S. dollars (USD) immediately, a new capital gains holding period begins for the ETH the creators received in the sale.
Taxes on NFT Airdrops
What happens if I’m airdropped a token or another NFT because I held the original, like how Bored Ape Yacht Club holders received a Mutant Ape?
Read More: US Crypto Tax Guide 2022
This is a scenario with little guidance from the IRS. Based on precedent, airdrops like this will be taxed as ordinary income (i.e., short-term capital gains rates), generally, when the assets are recorded on ledger and/or enter your wallet. So if you don’t claim, you won’t have control of the asset and shouldn’t get taxed. When you sell the airdrop, it’ll be subject to capital gains tax rates.
Note: This isn’t definitive guidance but merely how I and other folks construe the law. For a counterpoint, §1.451-2(a) says, "Income although not actually reduced to a taxpayer's possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given.”
With this doctrine, you could be taxed on the value when you could have claimed it, not when you do. However, many airdrops have no liquidity or fair market value, which complicates this even further.
What should I do with worthless NFTs if I was rugged?
Rug pulls aren’t technically considered thefts or scams by the IRS, so there’s no direct rule that helps NFT owners.
So your best bet is to try selling them for 0 ETH on OpenSea or Harvest.art. This way you can at least record a loss that offsets your other capital gains.
Keep in mind, selling NFTs to your friends at a loss in order to tax-loss harvest is potentially tax fraud!
What happens to all the gas fees I paid when buying and selling NFTs?
Just like with commission fees when buying and selling stocks, your crypto gas fees get added to the cost of your transaction (e.g., trade, swap, etc.).
You bought an NFT for 1 ETH and paid .05 in gas fees. Your transaction cost, or cost basis, is now 1.05.
When you sell the NFT, you would consider the purchase price of it to be 1.05 ETH instead of 1.
Note: While the IRS hasn’t explicitly mentioned how crypto gas fees are taxed, we can assume they’ll be included in the cost basis per Publication 551.
Will I pay taxes on NFTs that I’m gifted?
Most likely not! Receiving a gift is not a taxable event. However, the donor will likely owe a “gift tax” if the value is above $16,000 and file IRS Form 709.
However, keep in mind that when you sell your gifted crypto, you’ll owe capital gains tax (if sold at a profit) and your cost basis will be the price at which the original buyer bought it at.
While the crypto tax space currently feels like the Wild West, we – and along with everyone in the NFT market – look forward to clearer guidance from the IRS and other tax authorities. In the meantime, you can expect continuing tax help and education from Reconcile and CoinDesk!
This article is provided for informational purposes only and is subject to change. This article is not intended to substitute for tax, audit, accounting, investment, financial nor legal advice. For financial, tax or legal advice please consult your own professional.
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