Why the next big thing in the digital economy is a cash cow for the IRS
Non-fungible (or NFT) token sales and trading have gone from an increase to a boom. They are new. Their values can be volatile. But for those with US tax obligations, they can also be a gold mine for the IRS. Why? Because unlike most other forms of income and assets, NFTs can create multiple tax events for both those who create them and those who trade them. In a recent interview for Forbes.com, Shaun Hunley, a Georgia-based tax lawyer and tax consultant for Thomson Reuters, stressed the importance of understanding all of the different ways that creating and / or trading NFTs can result in a tax. federal income.
NFTs are considered “self-created intangibles” like many other performances or works of art. This means that the creator has no “basis” in what is sold other than perhaps the expenses associated with its creation. The IRS, however, has an exception that allows artists to deduct expenses as they arise rather than when the work is sold. If a DTV creator deducted expenses in a tax year prior to the year in which the DTV is sold, the creator has a zero base in the DTV. This means that the profit or gain is 100% of the proceeds made on the sale. Someone who creates an NFT and sells it for $ 1 million has $ 1 million in taxable profits.
While actual IRS guidance is sorely lacking, general tax principles indicate that NFTs are likely to be considered their creator’s inventory (as opposed to fixed assets) by the IRS. Whether someone is in the business of creating DTV or whether it is an artist or celebrity who is just adding DTV to their income stream, selling DTV will not just be taxed as ordinary income (as opposed to more beneficial capital gains) it will also be subject to self-employment tax. And the tax fun doesn’t stop there. Although the original NFT is a unique token on the blockchain, the artist or creator can retain the copyright to anything that was used to create the NFT itself. For example, NBA Top Shot (one of the hottest NFT marketplaces right now) allows an individual to purchase a unique URL that links to a site where an NBA highlight is located. The individual does not buy the copyright to the highlight video, the NBA keeps it. The individual purchases a limited use license (which does not include the creation and distribution of copies of the video). An artist or entertainer may decide to sell multiple NFTs based on the same original work or performance, similar to limited edition signed reprints or limited copies of a live performance. When the copyright is retained and the copies are sold, the income is considered a royalty that must be reported annually on Schedule E and attached to the individual’s Form 1040. Results? NFT creators might consider three taxable events when selling a self-created NFT: the income tax on the sale itself, the self-employment tax on the sale, and the income tax generated. by royalties.
NFT Traders and Investors
But what if you are not a creator? What if you just bought NFTs to hold or trade? Unfortunately, trading NFT is not as straightforward as trading other capital assets (like stocks or real estate). Currently, NFTs must be purchased with a cryptocurrency (especially ethereum). Because IRS still treats cryptocurrency as property rather than currency, the simple purchase of an NFT creates a taxable event: the conversion of cryptocurrency for the purchase of the NFT. Depending on the taxpayer’s basis in the cryptocurrency traded (what was paid for the crypto), the buyer could realize a taxable gain or loss on the conversion. Additionally, gains could be taxed as ordinary income (rather than at long-term capital gains rates) if the crypto’s holding period is not long enough to qualify for the more preferential tax treatment. The gain on crypto conversion may be subject to additional Net Investment Income Tax (NIIT) of 3.8% if the taxpayer’s income is high enough. The taxpayer will also be subject to capital gains tax on the sale of TVN if he decides to sell it. But unlike cryptocurrency, NFTs are considered collectibles subject to a 28% tax on gains on their sale (plus NIIT if applicable).
Take the example of a taxpayer who used ethereum purchased for $ 10,000 to purchase an DTV worth $ 100,000. The taxpayer has a gain of $ 90,000 on the ethereum conversion. Depending on how long the ethereum is held, the taxpayer will pay either ordinary income tax or capital gains tax on that $ 90,000. Five years later, the NFT is worth $ 500,000. The taxpayer decides to sell it. The sale of the asset (the NFT) generates a capital gain of $ 400,000 (due to the five-year holding period) but, as the NFTs are considered collectibles, the $ 400,000 is subject to at a flat rate tax of 28% as opposed to the lower amount (and income-based) on capital gains rates (0%, 15% or 20%). Finally, unless there are offsetting losses elsewhere on the tax return, such a large transaction will almost always result in an NIIT as well.
Compliance and enforcement
Right now, the IRS is heavily focused on cryptocurrency transactions and, according to Hunley, it could take them a few more years to catch up on the tax enforcement of creating and trading. NFT. NFT trading, although growing, remains low in volume compared to cryptocurrency transactions. In other words, the IRS’s imposition of taxation of cryptocurrency transactions creates a much wider (and more lucrative) net in the short term. Nonetheless, Hunley believes that the IRS can apply the lessons it has learned in the taxation and application of cryptocurrencies to NFTs and other emerging digital economy technologies going forward.
Tax specialists in the digital economy have asked for more advice for cryptocurrency and NFTs. The IRS has been slow to respond. At present, Hunley suggests that practitioners in the field rely on general tax principles and best practices, such as documenting the guidance upon which to decide how to report the transaction in an income tax return. customer. Hunley notes that “the assessment in particular can be sticky.” Taxpayers who invest in NFTs should track all of their cryptocurrency transactions, keep a record of the purchase price of their NFTs, and keep a record of the sale price or fair market value of NFTs for reporting purposes. Like any other asset, NFTs can lose value and a trader can realize a loss. Losses realized on the decline in value of personal assets, however, are not deductible on a tax return. Asked about “an apocalyptic blockchain-ending event that renders all NFTs worthless,” Hunley said that while such an event is extremely unlikely, if it did occur, the associated losses would most likely result in personal losses. non-deductible (similar to losses in non-disaster areas) than deductible capital losses (which are limited, but at least available). Again, however, in the absence of specific guidance from the IRS on these matters, most practitioners should rely on their knowledge of basic tax principles and do their best to apply them to the specific facts and circumstances of the case. customer.
Taxpayers who trade cryptocurrencies and / or NFTs should also be aware of the potential for creating reporting requirements for foreign accounts and possibly foreign source income. The penalties for non-reporting, even accidental, are heavy, and those for voluntary non-reporting are worse. And, as with cryptocurrency, the IRS prioritizes the enforcement of foreign accounts and tax returns.
Finally, securitization of the cryptocurrency is already underway and the possibility of securitization of NFTs held for investment purposes is still a possibility although according to Hunley likely not in the immediate future. Hunley reminds readers that the best way to avoid surprises is to talk to your tax professional about your cryptocurrency and NFTs every year and be honest when answering their questions. Remember, however, that communications for tax preparation purposes are not privileged. Therefore, if you have not made contemporaneous returns, it may be best to consult a lawyer before working with your tax professional to correct the previous year’s returns and non-compliance.