3 things every NFT investor should know to avoid a tax nightmare

2021 will be remembered as the year of non-fungible tokens (NFTs). In a year where names like Beeple and Bored Ape Yacht Club have been making headlines, NFTs are believed to have generated over $23 billion in trading volume.

The rise of NFTs has ushered in a new generation of investors who spend time browsing platforms like Discord and OpenSea in search of the next 100x opportunity. However, it is important for today’s NFT investor to keep tax implications in mind. Otherwise, they risk repeating the mistakes of the past.

After the 2017 bull run, many crypto traders found themselves in a difficult position. Although they ran up large tax debts as the market rose, they no longer had the money to pay their tax bills after the crash. Many of these traders were simply unaware of the tax implications of their transactions and did not prepare accordingly.

In this article, we’ll share three things every NFT investor needs to know about taxes if they want to make a profit without getting in trouble with the Internal Revenue Service, or IRS.

Related: What to Know (and Fear) About the IRS’ New Crypto Tax Reporting

You are probably taxed when you buy your NFT

Handing over your cryptocurrency is considered a taxable event and buying an NFT with Ether (ETH) or another cryptocurrency would fall into this category. You will incur a capital gain or loss depending on how the price of your crypto has changed since you originally received it.

Many NFT traders incur significant tax liabilities because the price of their coins has appreciated significantly since their initial receipt. To avoid having problems paying taxes, you should calculate your potential tax bill for each transaction you make and try to put the money aside before tax season.

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You are taxed when you sell your NFT

Selling your NFT is also considered a taxable event, whether you are selling for fiat, crypto, or trading it for another NFT. NFTs are taxed in the same way as cryptocurrencies – the taxable income from the sale of your NFT is determined by calculating the difference between your original cost basis when purchasing the NFT and the gross proceeds you receive sales.

If the value of your NFT has decreased since you originally received it, you can claim a capital loss and reduce your tax liability as long as you own your NFT as an investment, rather than for use. staff.

You can tell if an NFT is for investment or personal use by looking at the reason for your purchase. Do you intend to make a profit or do you intend to just profit from the NFT for your own use without worrying about whether the asset will go up in value?

Capital losses from an investment can offset your capital gains for the year and up to $3,000 of ordinary income. Capital losses from personal use are not deductible.

Your NFTs can be considered collectibles

Part of what makes classifying NFTs so difficult for tax purposes is that they are a new type of asset class. Unfortunately, this means that the IRS has yet to issue clear tax guidelines on whether certain NFTs will be considered collectibles and taxed at a higher rate.

Related: More IRS Crypto Reports, More Danger

Some physical assets are considered collectibles under tax law. This includes art, metals such as gold, and stamp or baseball card collections. When these assets are sold after one year, they are taxed at a maximum rate of 28%, compared to the typical long-term capital gains rate which ranges from 0-20%.

It is reasonable to conclude that some NFT art objects would be considered collectibles for tax purposes. This would likely include 1/1 artwork such as Fidenza generated artwork.

Related: Fidenza: Tyler Hobbs wrote software that generates art worth millions

And what about profile picture collections like the Bored Ape Yacht Club collection? It’s easy to see why they would be considered collectibles by the IRS, with 10,000 unique images all part of a “collection.” The question, however, is not yet completely settled.

Any NFT that is not a work of art would likely not fall under collectible tax rules without additional guidance from the IRS. For example, it is reasonable to assume that NFTs representing Uniswap v3 liquidity positions would not be considered collectibles.

Some NFT investors opt for a more aggressive tax option. They argue that without guidance from the IRS, NFTs should not be considered collectibles due to their intangible nature. These investors are taking this approach because collectibles tax law refers to tangible property – it muddies the water.

This seems like a tough case to present to the IRS in the event of an audit. But, without guidance, it’s hard to know for sure, and there may be taxpayers who decide to lean into the uncertainty and take a more aggressive tax approach, knowing that the IRS’ guidance on this matter could take years.

Collectibles tax law is complex, and when assessing the collectible status of your digital assets, it’s a good idea to speak with a tax professional to determine the best position to take for your situation.

Related: Crypto in the crosshairs: US regulators eyeing the cryptocurrency sector

Of course, this issue may not matter to most NFT investors at this time. Because NFTs are so new, most sales are likely to involve NFTs that have been held for less than 12 months. These NFTs are taxed as short-term sales at less favorable ordinary tax rates, whether they are classified as collectibles or not.

By keeping the tax implications of NFTs in mind, you can avoid unknowingly incurring a very large tax liability in the coming year. Remember that you will most likely pay taxes when you buy and sell your NFT, but deciding whether your NFT can be collectible for tax purposes will require a closer look.

You can always turn to the IRS for clarity on how to classify NFTs — that clarity might not come anytime soon. In the short term, the IRS may instead focus on NFT investors who choose not to pay any taxes.

This article does not contain investment advice or recommendations. Every investment and trading move involves risk, and readers should conduct their own research when making a decision.

The views, thoughts and opinions expressed herein are those of the author alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.

Miles Brooks is a CPA and Director of Tax Strategy at CoinLedger, a cryptocurrency tax software platform designed to automate the entire crypto tax reporting process. Miles holds a Master of Science in Taxation from California Polytechnic State University – San Luis Obispo. Prior to joining CoinLedger, Miles previously worked at Apercen Partners, a tax firm specializing in serving founders and ultra-high net worth investors with income and wealth planning strategies. Miles is a crypto tax expert and has worked on cryptocurrency taxation since 2017.