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NFTs, US Taxes, and Best Practices
The United States tax system is very complicated and taxes on NFTs are no exception.
Most NFT exchanges are international entities that enable pseudonymous accounts so it is difficult to keep track of all the activity by US taxpayers. The IRS did not take crypto seriously for a decade and is now scrambling to catch up. Over $10 billion in NFT sales occurred in three months’ time – you know the IRS will want to get their piece.
Taxation authorities may not have a resolution soon but before they do, you’ll want to do everything you can to be prepared.
What to Consider
The IRS considers every purchase of an NFT with ETH or another cryptocurrency to be a taxable event. When the buyer adds an NFT to their wallet, the IRS sees it as a gain or a loss on the buyer’s ETH or SOL.
This gain or loss will most likely be taxed at the ordinary income level (your tax rate given how much you have earned within the last year) but the IRS has not released their rules so it is unclear.
Secondly, when an NFT is sold, that is also a taxable event for the seller. If the seller originally bought an NFT for 2 ETH when ETH was $1,000, then the IRS would consider that a $2,000 purchase and realization of a gain or loss (depending on how much they originally purchased the ETH for).
If that same NFT is sold for 1 ETH when the price of ETH is $3,000, then the IRS will view that as a $1,000 gain on an investment. The tax rate here has also not been decided.
When it comes to taxes, don’t break the rules now and ask for forgiveness later. That can be expensive. Simply document all your buying and selling activity, stay updated with the laws, and plan accordingly.
Best Practices
For personal tax advice, please contact a professional accountant. The following is for informational purposes only.
The best practices are relatively straightforward at the moment.
1. Maintain adequate records of all buys/sells of any cryptocurrency or NFT. Include the token prices at the time you purchased the NFTs.
2. Maintain adequate records of all your wallets across various blockchains. This is a no-brainer. If you lose access to non-custodial wallets, then the tokens and NFTs within them are unrecoverable.
3. Report your crypto exchange records in your taxes. This is the same process as reporting your Stock purchases. The exchange will mail you a report of all your accounts activity, which can be easily put into tax software like TurboTax. If you are not emailed or mailed these forms, then contact your exchange and request them.
4. Connect your wallet address(es) to a Crypto tax software like CoinTracking. As these technologies are relatively new, they may not cover all the aspects of your DeFi activity. Still, they will be helpful if the IRS contacts you about any crypto activity done outside of your exchange accounts.
5. Contact a crypto tax accountant like Polygon Advisory Services. When in doubt, let a professional handle it.
Are NFTs Securities?
This question has not been answered. While some NFTs have attributes that mimic the behavior of how securities are traditionally identified, it is not very black and white. Even if an NFT presents attributes of a security, it does not do so all the time.
One person may look at a particular NFT as an art piece and choose to buy it. This transaction may be taxed as a collectible.
Meanwhile, someone else may look at the exact same NFT and see an opportunity to lend it out and generate a yield. If this second person were to buy it and lend it out, the NFT would act as a security. Securities and collectibles are treated differently in the eyes of the taxman, so these differentiations matter.
The amount of utility and use cases that NFTs can bestow is part of the reason that they are so difficult to value when it comes to price and taxation.
An Example of NFT’s Complexity When It Comes To Taxes
Video games are the next territory for NFTs to really take over. Well over $1,000,000,000 has been earned in the game Axie Infinity. This game utilizes the groundbreaking Play to Earn (P2E) framework, where players get monetary rewards for their achievements.
This game has really taken off. The primary in-game currency, AXS, has been up over 97,000% since December 2020.
Users buy NFTs of Axies, which are used to either battle other Axies or breed new ones. There are guilds where you can borrow Axies for a fee and use them in battles or bred for new Axies. There is effectively an international Axie lending and borrowing market.
How are Axies taxed? How are your battle winnings taxed? These are tough questions for the taxing authorities around the world.
Either way, Axie Infinity is enabling people worldwide to generate roughly $50 to 100 worth of consistent income per day through playing the game.
In some parts of the world where the game has really taken off, like the Philippines, this $100 can be 10x or more what the next best option is in terms of working wages.
Video games and the metaverse can replace sweatshops, but that’s a topic for another article.
NFTs and Taxes: Final Thoughts
The SEC and IRS are notoriously slow. Crypto and NFTs have not been taken seriously until recently as they were generally regarded as the latest form of Tulip Mania.
The asset class now accounts for over $2.5 trillion in market capitalization, so DeFi protocols hold over $250 billion. As stated, there was over $10 billion in NFTs traded over three months, the SEC and IRS have begun picking up the pace.
To stay ahead of impending tax liabilities, just keep track of your buys and sells. That’s all you have to do.
