What is a Non-Fungible Token or NFT and what are the IRS and California tax issues associated with Non-Fungible Tokens or NFTs which might apply to you? NFTs are unique tokens based in and recorded within a blockchain that are essentially like artwork or one-of-a-kind media tokens or other form of digital content. You may find it easier to conceptualize a Non-Fungible Token like you would title to a parcel of property. The property itself is a unique verifiable area of land and the title to that property is your legal proof of ownership. Like title to a property, an NFT is a digital form of legal certification of ownership associated with a specific asset – whether it physically exists or is a digital property.
The conceptual purpose behind an NFT is the creation of a “token” or visual digital icon which facilitates the legally verifiable process of purchasing, selling or trading the associated physical or digital asset. Each NFT has a unique digital signature which differentiates that item from any other individual property. This data based signature is then placed on a blockchain where transactions occur.
How Are NFT Transactions Taxed by the IRS and the State of California?
What are the IRS and California tax issues associated with Non-Fungible Tokens or NFTs in a purchase, sale or trade? US and California taxpayers have the responsibility to report appropriate financial gains and losses each year on their tax returns. Generally speaking, California regards an NFT transaction in the same light as a transaction consisting of personal property.
There is presently no California sales or use tax related to the sale of an NFT. The California Revenue and Tax Code does not apply to assets (such as software) which are transferred in a digital form, and the sale of the NFT is a digital transaction on a blockchain.
It is important to be cautious when combining an NFT with other products, services, access or assets within a transaction as the action of bundling could make the value of the NFT within the transaction a taxable event.
The purchase price generally becomes the financial “basis” of the NFT going forward. Selling an NFT at either a profit or a loss triggers a taxable event. If the NFT asset is sold for more than its basis (what one paid for the NFT) the transaction creates a short or long-term capital gain.
Essentially, if the asset was held for more than a year the taxable consequence is a long-term capital gain. If the NFT was bought and sold in less than the period of a year the taxable consequence is a short-term capital gain. Short term capital gains are taxed at a higher rate than long-term capital gains. The amount of earned income for that tax year will have an impact on the tax rate for any capital gain. Generally speaking, the higher the income the higher the capital gain tax rate.
Therefore, the sale of an NFT would create less of a net capital gains tax in a year when the taxpayer has less actual earned income. “Harvesting” is a strategy to consider in years where there are substantial other capital gains. Harvesting an NFT for a loss (selling it for less than the original purchase price) may be an effective strategy to generate the type of loss which might offset part of the taxpayer’s capital gains.
If the NFT transaction results in a loss the IRS allows a capital loss from an NFT transaction to offset other capital gains or up to $3,000 of earned income.
It is important to consider the location and/or status of both the buyer and the seller. If the income from an NFT can be California “sourced” (referring to the location of the NFT transaction) it will be taxed in California as income. It is important to note that it is not uncommon for California’s income tax on NFTs to actually be higher than the associated federal tax. If the transaction involved cryptocurrency (for example, using cryptocurrency to purchase the NFT) there could also be resulting cryptocurrency tax issues.
Trades of equal value may or may not generate a taxable event. For example, trading cryptocurrency from your portfolio for an NFT of equal value may seem to be a net-zero transaction from a tax point of view. However, the transaction of the cryptocurrency in this example would generate a taxable event (capital gain or loss) if the basis of that cryptocurrency asset (i.e. the purchase price) is less or more than the trade value of the NFT.
Looking Into the Future: The IRS Proposal to Tax Some Non-Fungible Tokens as Collectibles
The IRS intents to implement a “look-through analysis” to establish whether or not the NFT in a given transaction is to be considered as a “collectible.” How will the specific NFT asset or its associated rights be classified going forward? If the asset or right associated with the NFT represents a “collectible” under US tax code, the NFT transaction would be taxed at the same tax rate established for collectibles.
Presently, the federal tax code defines a collectible as “tangible personal property such as any work of art; rug or antique; metal or gem; stamp or coin; or alcoholic beverage.”
Collectibles are taxed at a higher rate than the capital gains rates on other types of financial transactions. For example, in the current tax year the highest long-term capital gains tax rate on a collectible is 28%, while for most other transactions the highest long-term capital gains tax would be 20%.
We are watching the IRS for future guidance on the analysis which is to be applied to specific NFT transactions.
IRS and California tax issues associated with Non-Fungible Tokens or NFTs in a purchase, sale or trade should be carefully considered prior to the execution of any crypto or NFT transaction. Many cryptocurrency and NFT investors consider these assets to be outside of the awareness of the IRS or the State of California and therefore “non-taxable.” This is simply a fictional myth at this point in time.
How will the IRS know about your crypto or NFT transactions? The IRS has gained access to detailed information regarding transactions on blockchains worldwide. The IRS works with external expert contractors to analyze and extract information from blockchain transactions and associate them with specific US taxpayers. In addition, many exchanges issue 1099 forms to transaction participants or require verification of identity in order to conduct transactions or derivative trades.
“Under the Penalty of Perjury”
Finally, US taxpayers must genuinely and carefully consider a phrase just above the location of your signature on the Form 1040 which states: “Under penalty of perjury, I declare that I have examined this return and accompanying schedules and statements, and to the best of my knowledge and belief, they are true, correct and complete.
The 2022 Form 1040 held a specific box near the top of the form entitled “Digital Assets” which asked: “At any time during 2022, did you: (a) receive (as a reward, award, or payment for property or services); or (b) sell, exchange, gift or otherwise dispose of a digital asset (or a financial interest in a digital ass)?”
The failure to answer this question honestly and accurately exposes the taxpayer to criminal charges for perjury, as well as tax evasion [not to mention the cost of the result audit(s) and payment of restitution of unpaid taxes, penalties, fees and interest].
NFT transactions, like cryptocurrency transactions, carry potential IRS and California tax consequences.
We invite you to download our Allen Barron Crypto Reporting Guide which is an informative PDF while you listen to ABCast Podcast Episode 13 – Cryptocurrency and NFT Services and we hope you enjoy learning more about the important issues associated with crypto and NFTs from an accounting and tax perspective. You may face genuine risk of an IRS or California tax audit, as well as substantial financial penalties and interest as well as criminal exposure for perjury which can result in jail time. We invite you to meet with Janathan Allen and the experienced team at Allen Barron by contacting Allen Barron, or call 866-631-3470 to schedule a free consultation.
Read a Transcript of Episode 13 – Cryptocurrency and NFT Services
