How To Avoid Common NFT Tax Pitfalls

How To Avoid Common NFT Tax Pitfalls

What Happened

The record-breaking NFT sale by Beeple in 2021 Q1 re-ignited market interest in NFTs after the initial foundation was laid out by the Cryptokitties project back in 2017. This was followed up by NFT projects like CryptoPunks and Board Ape Yacht club that soared in prices in a very short period of time. The sudden spike in market sentiment for NFTs made many investors millionaires overnight. That said, amidst all this excitement, NFT investors can easily fall victim to many tax pitfalls due to ambiguous tax guidance and lack of education on how to manage NFT taxes correctly.

Key Concepts

What are NFTs?

Non-fungible tokens (NFTs) are digital representations of assets — artwork, domain names, music, characters in games — created in limited quantities to maintain scarcity. Each NFT is unique and therefore not interchangeable with another in a similar manner to fungible digital assets such as bitcoin or ether.

For example, CryptoPunks is a collection of a thousand unique pixelated avatars with different facial features and characteristics. Since each character is unique, CryptoPunk #4835 is not interchangeable with CryptoPunk #5801.

You can buy and sell NFTs in dedicated marketplaces such as OpenSea, SuperRare and Nifty Gateway, among others. Additionally crypto exchanges like Binance, Coinbase, or FTX have announced or launched NFT platforms.

Tax Treatment of NFTs

How taxes work for NFT investors

NFT investors are individuals who buy and sell NFTs in marketplaces like OpenSea. They are subject to a similar set of tax rules (with some tweaks) as cryptocurrency investors.

How the IRS treats NFTs

Although the IRS has not issued any NFT specific tax guidance, most art-based NFTs such as CryptoPunks are likely classified as collectibles under the IRS § 408(m)(2)(A)). This tax classification is important to note because it subjects NFT gains to a slightly higher tax rate than regular cryptocurrency in some cases. Note that fractionalized NFTs will still preserve the same underlying tax classification.

When do Investors have to worry about NFT Taxes?

First, purchasing an NFT using a cryptocurrency like ether (ETH) triggers a taxable event. This is because you are disposing of a property to buy an NFT. For example, Sam spent 1 ETH to purchase a CryptoPunk valued at $5,000. Sam paid $100 to buy this ETH few years ago. Sam will have a $4,900 ($5,000 - $100) long term capital gain at the time he spends the ETH to buy the CryptoPunk. $5,000 will be his cost basis for the NFT.

Second, cashing out an NFT or trading one NFT for another also trigger capital gains tax events for investors. If Sam were to sell his CryptoPunk for 2 ETH valued at $12,000, he'd Incur a capital gain of $7,000 ($12,000 - $5,000)

Third, some NFTs also pay you royalties each time a subsequent sale occurs. In this case, royalties paid in cryptocurrencies are taxed when earned.

NFT Tax Pitfalls

You could owe NFT taxes without ever receiving cash

There are three situations where you could owe NFT taxes without ever receiving any cash in hand. These include purchasing an NFT using a cryptocurrency, trading one NFT with another and earning royalties in cryptocurrency. Unfortunately, most NFT holders are not aware of these rules. This could result in large and surprising bills come tax day, which you may not have the cash to pay.

You could incur penalties for not paying taxes on time

If you generated large amounts of profits from NFTs, you could have a quarterly tax obligation in 2021 for the first time. You may be unaware of this leading to underpayment penalties. To avoid getting penalized, you should consult with a tax professional to figure out your quarterly tax obligation or see if you qualify for a safe harbor.

At high-income levels, NFT gains could be subject to higher tax rates than you anticipated

A short-term capital gain occurs when you sell an asset after holding it for less than 12 months. If you are somebody who rode the NFT wave in 2021, most of your gains will be short-term. Short-term gains on NFTs can be subject to the maximum 37% If you are in the highest tax bracket. Also, be prepared to pay an additional 3.8% Net Investment Income tax if you exceed the applicable income thresholds for the year.

A long-term capital gain occurs when you sell an asset after holding It for more than 12 months. Generally, tax law favors long-term capital gains by subjecting them to a lower tax rate than short-term capital gains. The maximum long-term capital gains tax rate is 20% for stocks and cryptocurrencies (plus the 3.8% NII tax when applicable). Unfortunately, since NFTs are classified as collectibles, long-term NFT gains are subject to a maximum rate of 28% for high income earners.

Calculating NFT gains & losses is difficult

Currently, NFT marketplaces do not provide you with any tax documents nor any transaction history reports to figure out your NFT capital gains and losses. So, it is your responsibility to keep detailed records, figure out the correct cost basis & market values and accurately file taxes.

In the cryptocurrency world, there is tax software which helps you automatically reconcile capital gains & losses by connecting to your wallets and exchanges. However, when it comes to NFTs, the software support is at its infancy causing you to have to manually calculate taxes in some cases.

NFT Valuation concerns

NFTs are not like cryptocurrencies where you can actively see fair market values on websites like CoinGecko or Coinmarketcap. Therefore, if you trade one NFT with another, you will have to appraise the value of the receiving NFT to compute the accurate taxable gain or loss. Appraisal could become a big issue especially when the transaction amount is significant. Again, it is your responsibility to identify these events and seek professional help to accurately figure out your NFT taxes.

Next Steps

· Reconcile your NFT capital gains and losses.

· Consult with a qualified tax adviser and calculate your projected tax obligation for 2021.

· Determine If you are required to pay taxes quarterly or meet the safe harbor for 2021.

· If needed, liquidate some NFT's and/or other cryptocurrencies into cash to cover the upcoming tax bill

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