It is often the case that new products, services or other income streams develop in the U.S. economy before Congress and the Internal Revenue Service figure out if existing tax provisions apply or if a new law or guidance is necessary to let taxpayers know the proper treatment of these new developments. Such has been the case with the growth of the digital economy and virtual currencies. Now, in the last couple of years, a new variant has exploded onto the scene that comes with some additional tax uncertainty.
Non-fungible tokens are digital assets. Although they are stored on a digital ledger similar to cryptocurrency, each is unique, i.e. non-fungible, while a cryptocurrency is fungible. A number of digital tokens have made headlines for the high sales prices they have obtained. In just a short period of time, NFTs have grown into a multimillion-dollar industry.
Many museums, which had already been digitizing their collections and looking for new sources of revenue in the face of COVID attendance declines, have started or considered starting to create non-fungible tokens from their collections. Art exhibitions have just started to emerge featuring NFTs. Professional sports leagues have started to get into NFTs (e.g., a digital baseball card).
The IRS has issued some guidance on the tax treatment of virtual currencies, and the recently enacted Infrastructure Investment and Jobs Act is expanding cryptocurrency reporting requirements to try to get control of perceived widespread underreporting. It is not clear at present the extent to which cryptocurrency guidance applies to NFTs. The tax treatment of intangible assets and virtual currencies are the best indicators of how NFT transactions should be handled for tax purposes at present.
NFTs also suffer from some of the same issues as cryptocurrencies. There seems to be a great deal of volatility in the NFT market and some are concerned it will become active with illicit activities such as defrauding investors and money laundering, as well as tax evasion. Still, just as virtual currencies are continuing to evolve and grow, it is anticipated that NFTs will not fade away but become an ever-growing part of the economy, with the usual assortment of winners and losers.
Creators
An NFT could be an original creation or a digital version of an existing physical asset. As is generally the case with the creation of an asset, the act of creation alone is not a taxable event. The sale of the NFT by the creator is likely to result in ordinary income. There could be some question as to the basis of an NFT that is a digital version of an existing physical asset. Is it a completely separate new asset or is some of the basis in the physical asset appropriately allocated to its NFT cousin?
There are also likely some expenses associated with effecting the sale. Some of the traditional auction houses have been active in the NFT market. The process of creating and effecting the sale of an NFT can also involve what are referred to as gas fees, which some artists complain are excessively high.
The purpose of the purchase
The purchase of an NFT may be motivated by different reasons, just as the purchase of other assets may be motivated by different reasons, with different tax consequences. Investors are generally considered to be purchasing the asset with a goal of financial gain. Collectors are purchasing it primarily for personal enjoyment. In either case, the subsequent sale of the NFT would likely be subject to capital gain taxation. If the IRS deems an NFT to be a “collectible” as defined in the tax law, the sale could be subject to the higher 28% capital gain rate on the sale of a collectible. It is also possible that a business could be undertaken to deal in NFTs, making the NFTs part of inventory and subject to ordinary income tax rates.
The difference in tax treatment would be even more significant if the sale of the NFT results in a loss, which, given the volatility of the NFT market, may be a common experience. The investor would likely be entitled to a capital loss deduction subject to the net capital loss deduction limitations and passive loss rules. A holder of an NFT for personal enjoyment may be denied any net capital loss deduction under the hobby loss rules. A corporation engaged in the sale of NFTs may be entitled to a business loss deduction subject to the current net operating loss carryback and carryforward rules. A pass-through entity engaged in the sale of NFTs may be subject to business loss limitations introduced by the Tax Cuts and Jobs Act and subsequently modified in response to COVID-19.
Charitable donations
The tax deductions available for donations of NFTs to charities are likely to be influenced by the charitable purposes of the recipient charity and by the intangible character of the NFTs.
Tax reporting
The current versions of Form 1040 include a question as to whether the taxpayer at any time during the year received, sold, sent, exchanged or otherwise acquired any financial interest in a virtual currency. The IRS defines a virtual currency as a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. With this definition it seems quite possible that an NFT could be considered a virtual currency, with the acquisition of an NFT requiring an affirmative answer to the Form 1040 question.
The new reporting requirements under the Infrastructure Investment and Jobs Act require reporting by persons responsible for regularly providing services effectuating transfers of any digital representation of value that is recorded on a cryptographically secured distributed ledger or any similar technology. This language would also appear broad enough to apply to effectuating transfers of NFTs. Efforts are underway in Congress to modify these reporting requirements to exclude persons from the definition who might not have access to the information necessary to comply with the reporting requirements. It is not clear that, even if those amendments were enacted, NFTs would be excluded from the reporting requirements.
Summary
The IRS at some point is likely to provide some clarity as to the tax treatment of NFTs. It is also likely, however, that the guidance may not be forthcoming in time for those who have engaged in NFT transactions in 2021. Analogies to the tax treatment of virtual currencies and intangible assets provide the best guidance available at this point to the likely tax treatment of NFTs.
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