In our last article on NFTs we noted how the different use cases for various NFTs may affect how they are taxed. NFTs that have a hard utility (such as usable items in gaming) are possibly going to receive different tax treatment than those that do not.
What Are Digital Art NFTs?
Again, we stress that the IRS has not issued any NFT-specific guidance yet. These are simply our best guesses based on other IRS rulings and general accounting principles.
For this first article we’re going to start with art NFTs, since those are a bit more straightforward.
When we say “art NFT”, this isn’t exclusive to digital paintings. This would include:
- Art
- Memes
- Movies/Films
- Music
- Trading Cards
Essentially, these are NFTs that are functioning as collectibles. The NFT shows your ownership of the item, but in practice does not provide you utility beyond that.
In many cases, you could download the same song, look up the meme, “save as” the image, etc. without purchasing the NFT. And you would, in general practice at least, have the same utility as you would actually purchasing the NFT itself on the blockchain.
Again, you are purchasing these NFTs essentially as collector’s items – for bragging rights, rarity, and also hoping that the item goes up in value.
The Taxation of Collectibles
So how are collectibles taxed?
First, we need to look at if you are the original creator of the NFT or if you purchased it. If you created it and sold it, then this is taxed as business income. No further discussion needed. But if you purchased the NFT and then resold it, we need to look more closely at your circumstances.
To do this, we first need to look at your purpose and operations. If you have substantial activity, it is possible that you could be considered a “dealer” for tax purposes. A dealer is someone whose business is the buying and selling of an asset. As an example, think about someone selling tangible collectibles like the owner of an antique shop. They aren’t acting as investors; they’re acquiring inventory to sell at a high volume for profit. Dealer status also exists for securities and real estate.
The IRS has not addressed this status for crypto or NFTs specifically, but it’s not unreasonable to believe that the status could apply to blockchain assets. So depending on your operations, you may be considered a dealer.
But most of us probably aren’t trading with that frequency. So, assuming we have determined that you do not qualify as a dealer, let’s discuss how that would be taxed.
For this step, the first thing we have to look at is how long you’ve owned the collectible for. It may seem like semantics, but in order to even be defined as a “collectible” for tax purposes, the item must have been owned for greater than a year. If the item is held for less than a year before being sold, it is not considered a collectible on your tax return. It is simply a short-term capital gain and is taxed at ordinary income rates.
If the item has been held for greater than a year, the gains are taxed at the lesser of your ordinary income tax rate or 28%. This is much higher than the 0-20% that is available for regular long-term capital gains. This goes back to the Taxpayer Relief Act of 1997 when they dropped the tax rate on most capital gains but left it the same for collectibles. The logic behind this was that collectibles did not stimulate innovation and also were generally owned by the wealthy.
If the collectible is being held as an investment but is sold as a loss, you are able to claim it as a capital loss. But if it was purchased for personal use, you are not able to deduct the loss.
As always, when the IRS does finally provide some guidance, it is almost guaranteed it will vary somewhat from what we are outlining here today. But for now, art NFTs are more analogous with collectibles than anything else and this seems to be a reasonable tax treatment for them.
Any accounting, business, or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.
