Non-Fungible Tokens and Their Special Taxation
Non-fungible tokens (NFTs) have exploded in use and popularity in recent months. NFTs have some special tax considerations to be aware of that can be different than fungible tokens, but before we get into that, let’s look at exactly what NFTs are.
What are NFTs
Economically speaking, fungible assets are those that can be broken down into units and readily interchanged, like cash. For example, you can take a $100 bill and exchange it for five $20 bills nearly anywhere without an issue. Non-fungible assets cannot be exchanged in such as way because they have unique properties that prevent this. Non-fungible assets are things such as houses, a sculpture like Michelangelo’s David or an Andy Warhol painting. There is only one real original.
NFTs are “one-of-a-kind” digital assets that can be thought of as certificates of ownership for virtual assets. They can be bought or sold like any other piece of property, but do not have a tangible form themselves. Similar to cryptocurrencies, a blockchain ledger keeps track of ownership; these records can’t be forged because the ledger is maintained by thousands of computers around the world. They are most often used to prove ownership of an “original” digital art piece.
NFT Tax Basics
Similar to cryptocurrencies like Ethereum or Bitcoin, NFTs are taxable property. The big difference in taxation depends on if you are the creator or an investor.
Creators are taxed when they sell an NFT. If an artist created NFT art and sold it for 4 Ethereum coins worth $3,000 (they are typically traded in cryptocurrencies), then the artist would claim the $3,000 as ordinary income for tax purposes.
Investors are those who buy and sell NFTs. Similar to other trading activities profits, they are subject to capital gains tax rules.
Let’s look at an example of how taxes work for an NFT investor. Assume Jane bought an NFT valued at $3,500 in February 2021 by exchanging 2 Ethereum coins (ETH) she bought a few years ago when they cost $350. At the time of the acquisition of the NFT, Jane would have a long-term capital gain on the exchange of her ETH of $2,800 ($3,500 value of the NFT less her cost basis in the ETH exchanged of $700). Essentially, the exchange of the cryptocurrency triggers taxation of that asset and a new basis is established in the NFT as it’s not really an exchange but a disposal for tax purposes.
Half a year later in July, Jane sells the NFT for $8,500. Here she realizes a short-term capital gain of $5,000 (sale price of the NFT of $8,500 less her basis of $3,500). As with other short-term capital gains, this would be taxed as ordinary income.
Special Circumstances for High-Income Earners
Certain NFTs can be considered “collectibles,” leading to unfavorable tax treatment for high-income earners and subjecting them to a 28 percent tax rate on collectibles versus a 20 percent tax rate on regular long-term capital gains.