If you thought NFTs were crazy, wait til you see how they’re taxed

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The mar­ket for non-fun­gi­ble tokens — unique dig­i­tal assets that are often trad­ed like col­lectibles — soared to more than $44 bil­lion in 2021 as art hous­es and sports leagues cap­i­tal­ized on the lat­est craze in cryp­to. But while surg­ing demand for NFTs has unlocked new rev­enue sources for online cre­ators and star­tups, it has also forced con­sumers to grap­ple with a tax code that doesn’t for­mal­ly address how such tokens can be used to denote dig­i­tal ownership. 

At the most basic lev­el, using cryp­to to pur­chase NFTs can trig­ger a cap­i­tal gains event for both the buy­er and the sell­er. Depend­ing on the NFT, own­ers could also wind up on the hook pay­ing more tax­es if their new token con­fers own­er­ship of a phys­i­cal asset or addi­tion­al eco­nom­ic benefits.

Law­mak­ers have launched a bipar­ti­san effort to mit­i­gate the tax hit from small­er cryp­to trans­ac­tions, but as celebri­ties from Steph Cur­ry to Roger Stone dive into dig­i­tal col­lectibles, the boom­ing mar­ket is cre­at­ing new risks that cryp­to traders might be run­ning up their tax bills with­out know­ing it. Notably, while NFTs rep­re­sent only a small frac­tion of crypto’s ecosys­tem, the IRS is train­ing its sights on dig­i­tal assets, which Com­mis­sion­er Chuck Ret­tig iden­ti­fied as a sig­nif­i­cant con­trib­u­tor to the government’s esti­mat­ed $1 tril­lion in uncol­lect­ed revenue.

So far, his agency has strug­gled to keep pace with the market.

“It would be very help­ful for the IRS and state tax author­i­ties to clar­i­fy how gains and sales of NFTs should be treat­ed,” said Lawrence Zlatkin, the vice pres­i­dent of tax at the cryp­to exchange Coin­base. “Many cryp­to par­tic­i­pants don’t think of tax­es until long after sales occur and are caught flat-foot­ed when they have to take tax­es into account.”

The con­fu­sion over the tax impli­ca­tions of NFTs comes as pol­i­cy­mak­ers attempt to nav­i­gate a dizzy­ing array of online mar­ket­places and trad­ing plat­forms where new pay­ment sys­tems have dis­placed tra­di­tion­al modes of com­merce. Uneven over­sight of these mar­kets prompt­ed Pres­i­dent Joe Biden to sign an exec­u­tive order ear­li­er this month demand­ing a whole-of-gov­ern­ment assess­ment of U.S. cryp­to policies. 

NFTs are typ­i­cal­ly pur­chased using pop­u­lar cryp­tocur­ren­cies, most com­mon­ly Ether, and the trans­ac­tions are record­ed on decen­tral­ized pub­lic ledgers known as blockchains. Pur­chas­ing an NFT usu­al­ly doesn’t con­fer the buy­er copy­right to the image or art­work — sim­i­lar to own­ing an art print or a rare trad­ing card — but sell­ers can offer a vari­ety of oth­er div­i­dend-like ben­e­fits to dri­ve up inter­est in the dig­i­tal asset.

Suss­ing out those oth­er ben­e­fits can com­pli­cate an NFT’s tax pro­file. Coin­base and some trad­ing plat­forms — includ­ing the most wide­ly used NFT mar­ket­place, OpenSea — are part­ner­ing with tax spe­cial­ists to help users deter­mine their oblig­a­tions. How­ev­er, with the IRS unlike­ly to offer con­crete guid­ance on the new assets any­time soon, accoun­tants say they’re only mak­ing an edu­cat­ed guess in deter­min­ing how the tax code applies to NFT transactions.

“It’s so ephemer­al,” said Robert Tobey, a part­ner at the account­ing firm Gras­si Advi­sors & Accoun­tants and a mem­ber of the Amer­i­can Insti­tute of Cer­ti­fied Pub­lic Accoun­tants’ Vir­tu­al Cur­ren­cy Task Force. “It’s like grab­bing smoke.”

Depend­ing on the token, the tim­ing and who’s doing the sell­ing, NFT trans­ac­tions can be taxed as income, short- or long-term cap­i­tal gains, col­lectibles or as dividends. 

Full-time artists who sell NFTs might view their pro­ceeds as income. Oth­er per­mu­ta­tions can occur if the token has been frac­tion­al­ized — mean­ing if mul­ti­ple own­ers pur­chase par­tial shares of the same NFT. In instances where own­er­ship enti­tles the hold­er to oth­er dig­i­tal assets that are “air­dropped” into their dig­i­tal wal­lets at a lat­er date, that could be viewed as a div­i­dend or an inter­est pay­ment. If the token has been linked to own­er­ship of a phys­i­cal asset — any­thing from a pair of sneak­ers to a Flori­da home — those could car­ry tax oblig­a­tions as well.

This being the first tax sea­son since the tokens went main­stream, accoun­tants are nav­i­gat­ing their clients’ fil­ings by draw­ing par­al­lels between NFT-linked trans­ac­tions and sit­u­a­tions where there’s clear­er IRS guidance.

“Because there’s no direct guid­ance for NFTs, as for much of cryp­to, you have to sort of do this by anal­o­gy,” said Liz Chien, the glob­al head of tax at decen­tral­ized research and devel­op­ment firm Pro­to­col Labs.

A fun­da­men­tal chal­lenge is that most of these trans­ac­tions are con­duct­ed entire­ly with dig­i­tal assets, said Dan Han­num of the cryp­to tax soft­ware com­pa­ny ZenLedger.

Buy­ing an NFT with dig­i­tal assets is equiv­a­lent to sell­ing your cryp­to for U.S. dol­lars, then using those dol­lars to pur­chase the token. The reverse would be true for who­ev­er is mak­ing the sale.

Each link in that chain is poten­tial­ly sub­ject to cap­i­tal gains tax­es. If you’re buy­ing, sell­ing and trad­ing tokens fre­quent­ly — some­thing that has become com­mon in video game and meta­verse appli­ca­tions where users trade cryp­to for char­ac­ter avatars and dig­i­tal para­pher­na­lia (often rep­re­sent­ed as NFTs) — your tax return can become exceed­ing­ly complicated.

The process becomes even more dif­fi­cult if peo­ple use mul­ti­ple self-host­ed dig­i­tal wal­lets — which are used to hold cryp­to — to facil­i­tate their trad­ing activ­i­ty. And since most trad­ing plat­forms are decen­tral­ized, and don’t have access to the trans­ac­tion data includ­ed in each user’s wal­let, it’s ulti­mate­ly on the trad­er to assess what they owe the IRS.

“We are def­i­nite­ly see­ing a major increase in not only cus­tomer counts but also com­plex­i­ty in the cus­tomers’ activ­i­ty,” said Han­num, whose firm has been tapped by the IRS to pro­vide foren­sic account­ing and tax­a­tion soft­ware around cryp­to assets. “They are sur­prised at the fig­ures that they’re look­ing at.”

Many of these tech­nolo­gies are still in their infan­cy and it’s unlike­ly the IRS will offer direct guid­ance on NFT-relat­ed trans­ac­tions in the near future.

“While the IRS is aware of and mon­i­tors devel­op­ments with dig­i­tal assets, the IRS has not issued spe­cif­ic guid­ance on NFTs,” agency spokesper­son Bruce Fried­land said in an email.

With thorny tax issues pop­ping up around even the small­est cryp­to trans­ac­tions, Reps. Suzan Del­Bene (D‑Wash.) and David Schweik­ert (R‑Ariz.) have intro­duced leg­is­la­tion that would exempt per­son­al trans­ac­tions made with vir­tu­al cur­ren­cy from tax­a­tion if the gains are $200 or less.

“The dig­i­tal econ­o­my is rapid­ly evolv­ing, but our tax code is lag­ging behind. Cur­rent­ly, the bur­den to report and cal­cu­late gains on vir­tu­al cur­ren­cy trans­ac­tions falls on the con­sumer,” Del­Bene said in a state­ment to POLITICO. “This includes pur­chas­ing NFTs.”

In the mean­time, with the IRS now ask­ing Amer­i­cans to log their vir­tu­al cur­ren­cy trans­ac­tions on the first page of their indi­vid­ual tax forms, the part­ner­ships between cryp­to com­pa­nies and tax spe­cial­ists are intend­ed to help users with their returns.

“In the absence of any type of soft­ware, I would say it’s vir­tu­al­ly impos­si­ble for any­body who has a cou­ple of wal­lets — and mul­ti­ple coins or NFTs — to fig­ure out their tax­es,” said She­han Chan­drasek­era, who leads tax strat­e­gy for the soft­ware firm Coin­Track­er. Chandrasekera’s firm has part­nered with both Coin­base and OpenSea to assist users with their taxes. 

“This is not like you’re buy­ing a stock,” Chan­drasek­era said. “These are plat­forms — these are not com­pa­nies that have vis­i­bil­i­ty into what’s going on in your wallet.”

Aaron Loren­zo con­tributed to this report. 

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