Taxing Tokens: The CPA’s Guide to NFTs
A new digital asset is making waves. Here’s what CPAs need to know—and teach their clients—as regulation catches up to NFTs.
By Jeff Stimpson |
Three new letters have burst onto the scene: NFTs, or non-fungible tokens. And as confusing as that is as a concept, it’s even more confusing when taxes come into play.
NFTs are digital assets, essentially unique, with a growing multi-billion-dollar market. At least for the moment, the NFT market still revolves around such collectibles as digital artwork, sports cards, novelty sneakers, celebrity self-portraits, and tweets. NFTs use the same technology and have many of the same tax challenges as cryptocurrency, and like cryptocurrency are virtual assets that the IRS and state tax authorities are only beginning to build compliance standards around.
According to a 2021 Security.org survey
, over 4 million people in the United States have bought or sold NFTs and 20 percent of survey respondents were familiar with NFTs—not bad for a somewhat esoteric and relatively new asset class.
“NFTs are growing in popularity and are here to stay, but most practitioners aren’t familiar with the technology or the tax rules,” says Andrew Gordon, a CPA and attorney with the Northfield, Ill.-based Gordon Law Group Ltd., and a founding director of The Blockchain Institute. (He’s also participated in creating an NFT Tax Guide as an NFT.)
Because of this surge in popularity and consequent rise in regulatory attention, CPAs should wrap their heads around both NFTs as a concept and the way they should be taxed.
NFTs vs. Cryptocurrency
What’s most confusing right now about taxing NFTs? “Classification,” says Mark Eckerle, CPA, senior manager of technology and emerging growth and team leader of digital currency and blockchain technology with Withum. “The classification can go many different ways and I’m sure there are gray areas where users can receive some tax advantages since the IRS hasn’t explicitly released guidance yet on NFTs. Accountants are using the current accounting guidance by analogy.”
A recent search for “non-fungible tokens” on the IRS and the Illinois Department of Revenue websites, for instance, returned no results. A broader search on the taxability of NFTs turns up conflicting information and interpretations, though consensus is that NFTs, which are digital, will be taxed as a physical asset.
Despite the lack of formal guidance on NFTs, the IRS has told news outlets
that both NFTs and cryptocurrencies have the potential for “mountains of fraud.”
NFTs, like cryptocurrencies, use blockchain technology and are generally encoded with the same underlying software. But NFTs differ from cryptocurrencies in that the former contains specific and unique information. “An NFT cannot be exchanged for another NFT, unlike how cryptocurrencies are exchanged,” says Jim Brandenburg, CPA, tax partner at Sikich. “The lack of IRS guidance is somewhat similar to the uncertainty that existed when cryptocurrency was first rolled out.”
“If you exchange one cryptocurrency for another, it’s taxable. If you exchange or sell one NFT for another, it’s also taxable,” Gordon says, adding that some NFTs also entitle the holder to rewards or “airdrops.” “These are typically taxable as income at the fair-market value at the time received,” he notes. “This means the taxpayer may owe tax on an unsolicited airdrop even if they don’t sell for cash.”
“Buying NFTs with cryptocurrency is also a taxable event since you have a new basis in a new asset. You’ll pay tax on any realized capital gains on your cryptocurrency sale. You can also leverage any losses incurred from transactions to offset gains,” Eckerle explains.
Clients are often shocked to learn of the tax implications of buying and selling NFTs. “For instance, NFTs are almost always purchased with cryptocurrency,” Gordon says. “When you convert the cryptocurrency to an NFT, it’s treated as if you sold the original cryptocurrency, generating a taxable gain or loss. Additionally, when you later sell the NFT, you have another capital gain or loss to account for.”
Untangling Tax Treatment
While NFTs are currently being framed as collectibles, it’s unclear whether the tax law on collectibles will apply to NFTs for a couple of reasons. “First, are NFTs actually similar to art or collectibles? For some NFTs, the answer is certainly yes, especially unique art NFTs,” Gordon says. “Second, the tax law on collectibles refers to ‘other tangible property,’ but NFTs aren’t tangible. Therefore, a strict reading of the tax law would make it seem that a collectible must be tangible. However, a looser reading while considering Congress’ intent would likely be that NFTs can be collectibles. I expect that we’ll get clarity from the IRS or Congress on whether NFTs are collectibles soon.”
Gordon notes that NFTs currently follow the general tax rules on property, so sales or exchanges of NFTs would be subject to short-term or long-term capital gains tax depending on the holding period. If they’re deemed collectibles, NFTs would carry a 28 percent top federal tax rate on long-term capital gains, according to tax experts. That’s opposed to the 20 percent top federal rate that applies to long-term capital gains on stocks, bonds, and cryptocurrencies such as bitcoin. Under “rare circumstances,” Eckerle says, NFTs can be classified as “inventory” subject to income tax rates.
Additionally, NFT transactions come in what Brandenburg calls “many formats.” Some offer full transfer of all rights of the underlying digital assets linked to the NFT, while others offer limited transfer of rights. “There are separate platforms, each with unique features and provisions, and varied processes for NFTs that are ‘minted,’ a process where the NFT is connected to a digital asset, which is often warehoused separately,” Brandenburg explains.
“Each of these steps and processes, each on different platforms, creates questions on the appropriate federal tax treatments,” he says. “Might the NFT transaction be treated like a leasing arrangement, a royalty, or might it qualify as a sale or exchange? If it’s a sale or exchange, does it qualify for favorable capital gain treatment? If it’s a capital gain, could some of the NFT transactions be treated as collectibles and subject to the higher capital gains rate? How should the NFTs that are minted be handled for tax purposes? What other federal tax rules might be applied for NFTs that are now in place for computers, software, and digital assets?”
Complex international and foreign tax issues can also apply, and state tax consequences of NFTs will need to be dealt with, especially as the IRS unveils new guidance.
“For instance, where should NFT transactions be sourced for state tax purposes? This can be a complex matter, and again could vary depending on the specific terms in an NFT contract, its platform, and other factors,” Brandenburg says. “Hopefully, states will work together to have a consistent set of rules from one to another, but it may take a while to sort out all these issues.”
Count on it: Clients are going to start arriving with questions. Brandenburg says CPAs and other tax practitioners should understand and educate clients on:
- NFTs’ functions, basic features, and underlying terms.
- Major players in the NFT space.
- Existing NFT platforms and how they differ, as well as alternative ways to create NFTs.
- How one can invest in NFTs.
- How one can distinguish themselves in the NFT marketplace.
Brandenburg expects more continuing professional education opportunities on the topic of NFTs will start to crop up. Congress recently expanded the reporting requirements on cryptocurrencies in the Infrastructure Investment and Jobs Act and the IRS is expected to provide additional guidance on implementing this new law later this year, which could include some insights on taxing NFTs.
“Even once IRS guidance is issued, impacted parties and tax practitioners may have different views on the guidance and suggest changes,” Brandenburg cautions. “They may also look at new features in NFTs to develop better tax treatments.”
Above all, don’t expect this new technology to just vanish into the ether: “The metaverse and NFTs are growing in popularity and are here to stay,” Gordon says. “CPAs that stay ahead of the curve will be able to deliver high-value advice and stake a claim to a nascent market.”
Jeff Stimpson is a New York-based writer covering tax concerns for more than 20 years for various industry publications, including Accounting Today and Financial Advisor.