What is an NFT?
An NFT is a digital asset. Like cryptocurrency, an NFT is not something you can touch. An NFT is a digital asset representing an object (typically artwork). You can create, buy, or sell an NFT tied to tangible or digital art, a GIF, a digital avatar, a video game skin, a video, music, tweets, and more.
For an artist, selling the NFT directly to a buyer avoids the middleman like an auction house or gallery. Artists can also receive royalties if the underlying artwork is sold to someone new in the future.
When you purchase an NFT, you buy a unique, one-of-a-kind digital token that comes with its own authentication code. In other words, an NFT gives you ownership rights in the underlying original artwork. Even if a digital artwork is available online, easily viewed by anyone, the NFT gives an art collector or enthusiast bragging rights as the ultimate owner of the digital representation.
As a unique digital asset, NFTs differ from cryptocurrency. Cryptocurrency is fungible, meaning that it is not unique. The value of one Bitcoin is equal to the value of another Bitcoin. In comparison, an NFT is non-fungible, meaning that no two NFTs are alike. This leads to the value of NFTs varying widely, depending on the value set by collectors in the market.
What are the tax implications of an NFT?
An artist who sells an NFT can expect the sales to be taxable income. But what about someone who buys and later sells an NFT that has appreciated in value?
Different assets have different capital gains tax treatments. NFT tax implications are still unclear at present as the IRS has not made any specific rules. Most tax professionals, however, expect the IRS to treat NFTs like any other collectible. That is unwelcome news for art enthusiasts engaged in the NFT marketplace, because collectibles come with a significantly higher capital gains tax rate than stocks or other investments.
So, if you sell an NFT at a profit, the gain could be taxed at a federal rate of up to 31.8% (28% top capital gains rate plus a 3.8% net investment income surtax). That is quite a bit higher than the capital gains you pay if your Bitcoin or other cryptocurrency appreciates in value. The top federal capital gains tax rate is 23.8% today.
In addition, if an NFT you own becomes worthless, IRS rules may preclude you from taking a loss on it, unless the NFT was used in trade or business. If you buy an NFT and hold it, you may amortize your cost basis in the NFT under IRC Section 197, using the straight-line method for depreciation.
In addition, if you use appreciated cryptocurrency to purchase an NFT, you may owe taxes on that crypto gain as well. Anyone buying and selling NFTs as a business, including artists, may need to be mindful of self-employment tax obligations under IRS rules. Finally, selling NFTs could trigger state income, sales, or use taxes. Legal help can help you assess potential tax consequences.
How is an NFT handled for estate planning purposes?
If you created your Last Will and Testament years ago, odds are that it did not include digital assets like NFTs or cryptocurrency or even other digital property like websites and online content. As ownership of digital property continues to grow, these assets may appear in an estate plan.
You can leave your NFTs to someone in your Will, just as you could devise any other property. If you are not specific about your intent, your NFTs and other digital assets will pass to your loved ones like your other assets (under the Will or according to state law).
Still, you may consider working with an attorney to create a digital estate plan designed to help your loved ones take possession of those assets after your death. That's because gaining access to your NFTs is not as simple as going to the bank with a death certificate and court authorization to open a safety deposit box.
If I was given an NFT, do I owe taxes?
No. If you receive an NFT as a gift, the value is not considered taxable income, nor will you have to file any forms documenting its receipt (the person giving you the NFT may need to file a gift tax return). If you decide to later sell an NFT that you received as a gift, the sale will be a taxable event.
If the value of the NFT increases, your cost basis will be equal to the cost basis of the person who gave you the gift. In the event the value of the NFT increases but remains below the donor's cost basis, then you will generally not owe capital gains taxes on the sale. If the value of the NFT decreases, your cost basis will be the lower of the donor's cost basis or the NFT's fair market value when you received it.
As with any gift tax question, consult an attorney or tax professional for advice about your obligations.
If I sell an NFT, do I owe taxes?
The short answer is "Yes." As described in more detail above, if you create and sell NFTs, you will owe income taxes and, potentially, self-employment taxes.
Additionally, buying and selling an NFT on the secondary market comes with capital gains tax implications. Whether the gains you owe are short-term or long-term will depend on how long you held the NFT. Your tax rate will depend on whether you are subject to the net investment income surtax. But it is likely that NFTs will be treated like any other collectible for federal tax purposes.
The good news for artists and art enthusiasts is that it appears that NFTs and other types of digital assets are here to stay. Understanding the potential tax consequences of buying, selling, gifting, or devising your NFTs can help ensure you make the right decision. Reach out to a Rocket Lawyer network attorney for affordable legal advice about your NFT transactions, or how those may impact your future tax filings.
This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.