NFTs are the next big thing in the digital economy for the IRS

NFT purchases and trades have progressed from rising to soaring. They are brand new. Their prices are prone to fluctuation. However, individuals who owe US taxes, maybe a jackpot for the IRS.

What for? Since, unlike many other types of assets and income, NFTs can trigger numerous taxing events for individuals who produce them as well as those who trade them.

NFTs, like many other acts or artistic works, are deemed "self-created intangibles." This indicates that the creator has no “foundation” in the product being sold, other than maybe the costs of making it.

The IRS, on the other hand, makes an exemption for artists, allowing them to subtract expenditures as they go rather than when the piece is sold. If an NFT creator deducted costs in a tax year before the year the NFT is sold, the creator's basis in the NFT is zero. That is, the profit or gain is equal to 100 percent of the sale profits.

Someone who makes an NFT and sells it for $1 million makes a taxable profit of $1 million. Although the IRS has provided no specific advice, basic tax principles imply that NFTs are more likely to be treated as inventories (rather than capital assets) by the IRS.

Whether somebody is in the business of generating NFTs or is an artist or celebrity who is merely supplementing their income with NFTs, the sale of an NFT will be taxed as regular income (rather than the more advantageous capital gains) and will be liable to self-employment taxes. Moreover, the tax hilarity does not stop there.

While the original NFT is a one-of-a-kind token on the blockchain, the artist or inventor may be able to keep the copyright on whatever was used to make the NFT. For instance, NBA Top Shot (currently one of the hottest NFT marketplaces) lets a person acquire a distinct URL that leads to a site that contains a certain NBA highlight.

The NBA controls the copyright to the highlight footage, which the individual does not purchase. The individual (that does not include making and distributing copies of the video) is purchasing a restricted usage license.

An artist or performing artist may opt to offer several NFTs based on the same original work, comparable to small edition replicas or limited live copies. When copyright is kept and copies are sold, the revenue is classified as royalties, and it must be reported on Schedule E and linked to the individual's Form 1040 every year.

What is the bottom line? When selling a self-created NFT, NFT creators may face three taxable events: income tax on the sale, self-employment tax on the sale, and income tax produced by royalties.

However, what if you are not a creator? What if you are only looking to buy NFTs to hold or trade?

Unfortunately, trading NFTs is not as straightforward as trading other financial instruments (like stocks or real estate). NFTs are now only available for purchase using bitcoin (specifically Ethereum). Because cryptocurrency is still treated as property rather than cash by the IRS, merely acquiring NFT triggers a taxable event: the conversion of cryptocurrency for the purchase of the NFT.

The IRS is now focusing on bitcoin transactions, and Hunley (Shaun Hunley, a Georgia-based tax attorney and tax consultant for Thomson Reuters) believes it will take a few years for them to catch up with taxes enforcement of NFT production and trading.

While NFT trading is becoming more popular, it still has a modest volume when compared to bitcoin transactions. In other words, in the short term, IRS enforcement of bitcoin transaction taxes casts a far broader (and more profitable) net. Nonetheless, Hunley believes that the IRS will be able to use the lessons learned in bitcoin taxes and enforcement in the future to apply to NFTs and other developing digital economy technologies.

Cryptocurrency is already being securitized, and the prospect of securitizing NFTs held for investment is always a possibility, but Hunley believes it is unlikely soon. The easiest approach to avoid surprises, according to Hunley, is to notify your tax expert about your cryptocurrencies and NFTs every year and to be honest when answering their inquiries.

Remember that conversations for the purpose of return preparation are not protected, so if you have not been conducting contemporaneous reporting, you should consult an attorney before working with your tax expert to remedy past year reporting and noncompliance.