Everything you want to know about NFTs

NFTs, NFTs, NFTs, everywhere. Tune into a podcast or TV, read an article in The Economist or on a gossip site, and it’s NFTs. Maybe you even know NFT stands for: non-fungible token. If I own, buy, or sell one, how do I report that on my taxes? Because, guess what, the IRS has been silent on NFTs.

What are NFTs?

First things first. What are NFTs? Turns out non fungible tokens are a bad place to start. How can you explain non fungible unless you understand fungible? So, I’m going to start with fungible tokens and the concept of fungibility.

Fungible is a fancy word economists and other intellectuals who make consistently wrong predictions use. What it really means is interchangeable. Let’s illustrate with a simple example.

I have a $20 bill (or I have one bitcoin. You also have a $20 bill and one bitcoin. I can give you mine, and you can give me yours. We both still have exactly same thing. In fact, if you have $1,000 and 10 bitcoins, then I can still trade mine with a $20 bill and one bitcoin portion of what you have. That’s because they’re interchangeable.

In a different example, say we both have salads. If I have tomatoes, I can trade them for your zucchini. But tomatoes aren’t zucchini. So, tomatoes and zucchini in salads are non fungible, even if they are tradeable. Similarly with cars. I can trade my 327cc 1965 Corvette engine for yours if we have the same model. But if you have a Mustang, that’s not going to work.

The bottom line is that if two people exchange what each of them has—and you still can’t tell the difference because they are the same thing—they are fungible. If you can’t do that, they are non fungible.

Why NFTs are non fungible

Each NFT has a unique characteristic that makes it different from any other NFT. You can trade one for another or negotiate a deal involving other considerations, but you can’t just exchange them. This is because every NFT had digital content. Digitally, each NFT is unique and the owner of the NFT therefore owns that digital content. Artists have been creating NFTs and selling them. People who buy NFTs thus become the owners of the digital content in that NFT.

Is there more to it than just digital content ownership? Sure, but this is all you need to know to understand the tax consequences.

NFTs and taxes

There are three common tax cases here:

• You create NFTs for sale as a business.
• Your NFT activities are just a hobby.
• You are an NFT investor, where you buy, sell and trade NFTs.

Let’s examine the most common differences.

NFT creators

If you are an artist or part of a team that’s creating NFTs, you are operating a business. That means your income is subject to the same rules that the IRS uses for any trade or business. This means you are subject to both income tax (varies based on your income and deductions) and self-employment tax.

However, you are also allowed deductions for operating your business. Examples of deductions you should be aware of are:

• Cost of the computer(s) used to design your NFTs.
• Software expenses: Canva, Photoshop, Illustrator, Shutterstock, and other programs.
• Cost of setting up your business entity.
• Advertising, branding, and marketing expenses.
• Internet expenses, including domains, hosting, security, payment processing, and website content and maintenance.
• So called gas fees for minting the NFTs—if you mint and pay the gas fees yourself.
• Online classes you take to learn more about your trade.
• Home office deduction.
• Business use portion of your phone.

To calculate your NFT business net income, take all the income from the sales of your NFTs and subtract all your deductions. Remember, you will have to pay income tax and self-employment tax on your NFT business net income.

NFT hobbyists

The IRS has different rules if you create and sell NFTs as a trade or business vs. just as a hobby. There are pros and cons to being an NFT hobbyist.

• Pro: You will no longer be subject to the extra self-employment tax.
• Cons: You will no longer be able to deduct expenses and will not get the home office deduction.

In order for it to be a for-profit activity, you would need to show profit motive. The IRS looks at eight main factors:

1. How you carry on the activity.
2. Your expertise.
3. Time and effort you put into the activity.
4. Your expectation.
5. Your success in other activities.
6. History of profit or loss from the activity.
7. The 3-of-5 year test: If you’re not profitable for 3-of-5 years, the IRS may claim it’s a hobby.
8. Are there recreation or personal motives ties to the activity?

NFT investors

When you’re trading NFTs as an investor, there are different tax rules than there are for business operators. The tax rules for investors are similar to trading stocks, as in capital gains taxes. In other words, if you are trading like an investor, there is no self-employment tax on the flipping of NFTs. However, there are some things you should be aware of:

• Capital gains: If you flip an NFT in less than one year, it’s classified as a short-term capital gain, which is subject to ordinary income tax. If you hold on to the NFT for one year or longer, the gain is classified as a long-term capital gain.
• Gas fees: When you purchase an NFT, your fas fee—the cost of the transaction—is added to the basis of the NFT. When you sell the NFT, the gas fee is subtracted from the proceeds.
• USD: In the United States, all gains and losses should be calculated on the value of USD (U.S. dollars) at the time of the transaction.
• Collectibles tax (28%): The jury is not out yet on whether NFTs are collectibles, which are subject to a special “collectibles” 28% long-term capital gains tax. The IRS code defines collectible subject to 28% as “any work of art,” or “any other tangible personal property.” NFTs are clearly not tangible, but they are works of art. To complicate matters further, some large CPA firms and law firms have taken the position of “statutory construction,” where works of art really mean tangible works of art. NFTs are digital content, so they’re non-tangible.

Other crypto tax stuff you should know

Airdrops

Airdrops should be reported as ordinary income, not subject to self-employment tax) on Schedule 1, Line 8z of a tax return.

Your basis in the airdrop will be the amount you pay ordinary income tax on; for example, if your airdrop was worth $2,000 USD when you received it, that is what you report on your tax return as ordinary income, and $2,000 is your basis in the Airdrop.

What if you receive an NFT as an airdrop? Same rules apply. However, if there’s no value that can be determined and no market, your basis will be zero. However, if there’s a market already established, you must report the value as ordinary income.

Note: Any gains after you sell the airdrop will therefore be capital gains, either short-term or long-term, depending on how long you hold the NFT.

Mining income

If you are a cryptocurrency miner (not talking about physical mining of minerals), then you should know that mining income is classified as ordinary income; however, you can deduct or depreciate your mining rig and the business portion of electricity as an expense against your ordinary income.

Staking income

As of this writing, there is a case in the District Court of Tennessee called Jarrett v. United States. A couple, the Jarretts, are suing the IRS. They allege that the income from staking is not taxable. They argue that when a baker bakes a cake, there is no taxable effect until the cake has been sold. Written in the brief to the court: “Like [a] baker or the writer, Mr. Jarrett will realize taxable income when he first sells or exchanges the new property he created …”

All CPA and tax attorney eyes are on this case to see the court decision. I’m certain, whichever way it falls, the loser will file an appeal elevating it from District Court to U.S. Tax Court.

Front page of a tax return

The IRS no requires you to check a box on the front page of your tax return if you have bought, held, or sold any virtual currency, during the taxable year.

The future is uncertain

Is this everything about NFTs and taxes? Of course not; the IRS hasn’t even weighed in yet. But now you have an idea of what to expect . Eventually, the IRS will get more involved and, as always, we will be sure to update you.

Editor’s note: This article was previously published on TaxedRight.com.