Non-fungible tokens (NFTs) are among the newest trends in the cryptocurrency world. They allow people to own digital assets stored on the blockchain. Because there are many NFTs associated with celebrities and unique artwork, many people see them as opportunities to invest in one-of-a-kind items while supporting their enthusiasm for cryptocurrencies.
However, if you’re currently an NFT investor or may become one soon, there are some important details to know about capital gains taxes.
NFTs Are Property for Tax Purposes
In 2014, the Internal Revenue Service (IRS) confirmed that cryptocurrencies — including NFTs — are property. That means investors need to record capital gains and losses in a few situations related to NFTs:
- When they purchase NFTs with fungible crypto assets
- When they sell an NFT to acquire another
- When they sell an NFT in exchange for a fungible cryptocurrency asset
More specifically, a capital gain in those cases occurs when you profit by disposing of an asset. You’ll pay capital gains taxes on those profits. However, you also need to record losses, which happen if you sell an NFT for less than what you paid when purchasing it.
The good news is that you don’t owe any taxes on those losses — just the gains.
The Taxes You Owe Depend on How Long You Have the NFT
Besides keeping a record of your NFT transactions’ gains and losses, another best practice is to record the date you acquire them. That’s because the amount of time an NFT stays in your possession affects the associated tax rate.
If you have them for less than one year before selling them, they’re considered short-term capital gains. In that case, you’ll get taxed at your normal income tax rate.
However, if you hold onto them for more than a year before selling them at a profit, they’re considered long-term capital gains. Those receive a lower tax rate based on how much you earn. The rate ranges from 0% to 20% and depends on your income (or combined income if filing jointly with your spouse).
Some NFT investors incur transaction fees when listing these assets by putting them up for sale. They also often pay gas fees for activities occurring on the Ethereum blockchain. However, you may not realize that gas fees are tax-deductible. That means they could offset how much you pay in capital gains tax.
Will NFTs Increase My Audit Risk?
All taxpayers face the possibility of audits. Moreover, there are some state-based examinations concerning business owners. For example, in New York, sales tax audits assess companies for tax shortcomings that may incur penalties. New York charges at least 10% interest on all sales tax liabilities.
However, take comfort in knowing that holding an NFT or cryptocurrency is not an automatic audit trigger. Data from the IRS indicates that a person’s audit risk rises with the amount they earn. But, the organization’s most recent data showed that even someone making from $1 million to $5 million per year had only a 2.39% chance of an audit.
High Earners May Have NFTs Taxed at a Higher Rate
Earning more brings a slightly higher audit risk, but it could also mean your NFTs fall under a higher capital gains umbrella. A tax code called § 408(m)(2) means that the IRS considers some NFTs as “collectibles.”
This situation applies if you have taxable income exceeding $441,450 as a single filer or $496,000 as someone filing jointly. Then, the capital gains tax is as high as 28% rather than the maximum of 20% as it is in other cases.
Digital Assets Breaking Into the Mainstream
Not long ago, digital assets were niche topics that hadn’t yet caught many conventional investors' attention. That’s starting to change as more people accept and become curious about them.
Plus, in a July 2020 letter, the Office of the Comptroller of the Currency (OCC) mentioned that banks could begin providing custodial services for customers with cryptocurrency investments. That may mean more banking institutions start catering to crypto investors.
It’s anyone’s guess whether the recent boom in people getting more interested in NFTs will have staying power. An artist who recently sold an NFT for $69 million thinks the market’s a bubble but that cryptocurrency’s underlying technology is strong enough to stand on its own if it bursts.
Regardless, people’s desire to pay millions for digital assets is a strong sign that you should expect to see more NFTs soon.
Treat NFTs Like Cryptocurrency on Your Taxes
Keeping accurate records is the best way to prepare for tax time. In closing, remember that the IRS categorizes NFTs like other cryptocurrencies and views them as property. If you’ve filed taxes as a cryptocurrency holder before, having NFTs now doesn’t require a new filing practice.