Non-fungible tokens (NFTs) are the latest crypto craze to dominate the headlines; although these tokens are nothing new to the blockchain industry. In 2015, CryptoKitties took the industry by storm when people spent millions purchasing digital images of cartoon cats. Whether it’s digital art, music, videos, or items created in video games, NFTs offer a unique value over other cryptocurrencies – that is, NFTs provide a digital proof-of-ownership of the work that cannot be copied or reproduced. Fungible tokens like Bitcoin are exactly the same, so that when you trade one bitcoin for another bitcoin, you receive exactly the same type of cryptocurrency that you traded to begin with. But with NFTs, each digital representation is authentic and therefore, the value of a single NFT can roil up and down depending on the market demand for it.
Last week Beeple’s digital collage was offered as a single lot sale by Christie’s Auction House and sold for over $69M. Earlier this week, a NFT image of Cristiano Ronaldo sold for almost $300K. NFTs are used in games too – like Decentraland, where users can create content and monetize content they create in a virtual world.
What does all this mean from an income tax perspective?
In order to explain, remember that the IRS treats virtual currency as ‘property’ for tax purposes and NFTs are virtual currency. When cryptocurrency is disposed of taxpayers are supposed to calculate gains and losses. NFTs can be bought and sold via online marketplaces and exchanges where buyers and sellers use fiat and other crypto to transact. So, when a NFT is sold for fiat or exchanged for other cryptocurrency like Bitcoin the taxpayer is required to calculate gains and losses and report the details on their annual income tax return. Similarly, the marketplace or exchange should issue the taxpayer and file Form 1099 with the IRS and states.
But since the Treasury and IRS have not issued 1099 requirements for virtual currency transactions, most exchanges don’t report at all; and those that do usually issue a Form that can’t be used. So make sure that you track the details – for every transaction – when you acquired NFTs, how much you acquired them for, when you sold them and for how much. You will need this information to help the IRS understand how you arrived at your gain and loss calculations reported on your annual return.
Are NFTs prohibited for IRA investments?
Some investors have sought to maximize gains and limit tax exposure by funneling investments of self-directed IRA assets to NFTs. But the tax issues are unclear here too. IRC 408 makes it clear that investments in collectibles are not allowed for tax purposes. The definition in 408(m) indicates that ‘any form of artwork’ is a collectible. Does that include intangible digital artwork assets? This is a crucial issue for IRA custodians and account holders because if the investment in NFTs is disqualified, all transactions would be treated as ‘distributions’ from the IRA and subject to tax withholding and Form 1099-R reporting.