What Is an NFT and What Are the Tax Consequences?

It might be difficult to understand NFTs and their tax consequences. Find out how purchasing, selling, and generating NFTs may affect your taxes.

What you’ll discover:

What exactly is an NFT?
What are the tax consequences of an NFT?
How is an NFT handled in estate planning?
Do I have to pay taxes if I get an NFT?
Do I have to pay taxes if I sell an NFT?

Non-fungible tokens, or NFTs, are becoming more popular. Yet, many consumers are unaware of what an NFT is, and those who are may be unaware of the tax ramifications of purchasing and selling this digital artwork creation. Continue reading to discover more about NFTs and the tax consequences for artists and art aficionados who want to create, purchase, or sell them.

What exactly is an NFT?

An NFT is a kind of digital asset. An NFT, like bitcoin, is not something you can touch. An NFT is a digital asset that represents a physical thing (typically artwork). An NFT may be linked to real or digital art, a GIF, a digital avatar, a video game skin, a movie, music, tweets, and more.

Selling the NFT directly to a buyer eliminates the need for an intermediary such as an auction house or gallery. Artists may also be paid royalties if the underlying artwork is later sold to someone else.

When you acquire an NFT, you’re getting a one-of-a-kind digital token with its own authentication code. In other words, an NFT transfers ownership of the underlying original artwork to you. Even though a digital artwork is freely accessible online, the NFT provides an art collector or fan with bragging rights as the ultimate owner of the digital depiction.

NFTs are distinct from cryptocurrencies as a digital asset. Bitcoin is fungible, which means it is not one-of-a-kind. The value of one Bitcoin equals the value of another. An NFT, on the other hand, is non-fungible, which means that no two NFTs are similar. As a result, the value of NFTs varies greatly depending on the market value established by collectors.

What are the tax consequences of an NFT?

An artist who sells an NFT might expect the proceeds to be taxed. But what about someone who buys and then sells an NFT whose value has increased?

Various assets are taxed differently on capital gains. The IRS has not issued any explicit guidelines regarding NFT tax consequences at this time. Nonetheless, most tax specialists believe the IRS will consider NFTs similarly to any other collectable. This is bad news for art collectors who participate in the NFT market, since collectibles have a far higher capital gains tax rate than equities or other assets.

Consequently, if you sell an NFT for a profit, you might face a federal tax bill of up to 31.8% (28% maximum capital gains rate plus a 3.8% net investment income surtax). It is far greater than the capital gains tax you would pay if your Bitcoin or other cryptocurrency increased in value. Now, the highest federal capital gains tax rate is 23.8%.

Moreover, if an NFT you own loses value, IRS restrictions may prevent you from deducting a loss on it, unless the NFT was utilized in trade or commerce. If you acquire and hold an NFT, you may depreciate your cost basis in the NFT utilizing the straight-line approach under IRC Section 197.

Moreover, if you use appreciated cryptocurrency to acquire an NFT, you may be required to pay taxes on that bitcoin gain as well. Anybody purchasing and selling NFTs for a living, including artists, may be subject to self-employment tax requirements under IRS regulations. Lastly, selling NFTs may be subject to state income, sales, or use taxes. Legal counsel can assist you in assessing possible tax ramifications.

How is an NFT handled in estate planning?

If you drafted your Last Will and Testament years ago, chances are it excluded digital assets such as NFTs or bitcoin, as well as other digital property such as websites and online content. As the ownership of digital property grows, these assets may be included in an estate plan.

You may devise your NFTs to someone in your Will, just like any other property. If you are not clear about your intentions, your NFTs and other digital assets will transfer to your loved ones in the same way as your other assets would (under the Will or according to state law).

Nonetheless, you should consult with an attorney to develop a digital estate plan that will allow your loved ones to take custody of your assets after your death. This is due to the fact that acquiring access to your NFTs is not as straightforward as going to a bank with a death certificate and court authority to establish a safety deposit box.

Do I have to pay taxes if I get an NFT?

No, if you get an NFT as a gift, the value is not taxable income, and you are not required to submit any papers to prove its receipt (the person giving you the NFT may need to file a gift tax return). If you subsequently decide to sell an NFT that you got as a gift, the transaction will be taxed.

If the value of the NFT rises, your cost basis will match the cost basis of the person who made the gift to you. If the value of the NFT rises but stays below the donor’s cost basis, you will normally not have to pay capital gains taxes on the sale. If the NFT’s value falls, your cost basis will be the lesser of the donor’s cost basis or the NFT’s fair market value at the time you acquired it.

Consult an attorney or a tax specialist for assistance on your duties, as with any gift tax concern.

Do I have to pay taxes if I sell an NFT?

“Sure,” is the quick response. As previously stated, if you generate and sell NFTs, you will owe income taxes as well as perhaps self-employment taxes.

Moreover, purchasing and selling an NFT on the secondary market is subject to capital gains tax. The length of time you held the NFT determines whether the profits you owe are short-term or long-term. If you are liable to the net investment income surtax, your tax rate will be different. But, NFTs are likely to be considered like any other receivable for federal tax reasons.