2021 was the year for Non-Fungible Tokens (NFT). Trading volume increased to $24.9 billion, up from $94.9 million the year before. Hundreds of thousands of crypto enthusiasts become multimillionaires in a couple of months as a result of the hype.
However, new worldwide tax reporting requirements might soon apply to crypto, NFT, and decentralized finance (DeFi). This has gotten some people concerned that the Organization for Economic Cooperation and Development’s (OECD) rigid framework would stifle a fast-growing sector. The international group proposed in March that information on crypto-assets be shared with foreign tax authorities.
While platforms and wallets like Opensea, Metamask, and Phantom make NFT trading simple and accessible, they fail to provide tax clarity at the time of transaction.
How is an NFT taxed?
There might be up to three taxable events while investing in non-fungibles
1.Paying with crypto: A capital gain/loss taxable event would occur if an NFT was acquired using a cryptocurrency, such as ether (ETH). This transaction is viewed by the US Internal Revenue Service as users selling their ETH for fiat and then using the money to acquire the NFT. Users will be taxed on the increase in value between the time they purchased their ETH and when they “sold” it to buy the NFT.
2. Selling for crypto: A new capital gain/loss taxable event would be triggered if an NFT was sold for crypto, or swapped for another non-fungible. The IRS sees this event as investors selling their NFT for fiat and then repurchasing ETH or another NFT with fiat, similar to the previous instance. Investors will be taxed on the increase in the price of ETH from the time they originally purchased the NFT to the time they sell it.
A noteworthy point is that there exists the possibility users may sell their non-fungible for less ETH than what they paid to acquire it. They would still owe taxes because the price of ETH may have risen since they acquired the NFT.
3.Converting to fiat: Investors will be taxed on the price appreciation between when they got their ETH revenues to the current market price at the time of fiat conversion when converting ETH proceeds from sales.
NFT creators pay a different tax rate than NFT investors. While the creation of the NFT is not a taxable event, the sale of an NFT in exchange for cryptocurrency or other compensation is. If an NFT creator sells a digital collectible for ETH, the money received will be taxed as regular income. In this case, if the creators do not convert the ETH to USD right away, a fresh capital gains holding period begins for the ETH received.
In regards to the gas fee paid, the fee is added to the cost of transactions in the same way that a commission fee is added to the cost of buying and selling securities.
The transaction cost, or cost basis, of a collectible acquired for 1 ETH with a gas fee of 0.05 ETH is 1.05. When selling the NFT, investors should regard the purchase price to be 1.05 ETH rather than 1.
What about airdrops and rug pulls?
The IRS provides very little guidance in the instance of a collectible obtained through an airdrop. According to the previous precedent, when assets are entered on the ledger and/or enter a wallet, they will be taxed as ordinary income (i.e., short-term capital gains rates). So, if investors don’t file a claim, they won’t have ownership over the asset and, as a result, won’t be taxed. When investors sell the airdrop, however, capital gains tax rates will apply.
Furthermore, the IRS does not consider rug pulls to be thefts or frauds, thus there is no formal law that benefits NFT proprietors.
A cautionary reminder that selling NFTs at a loss to associates or friends to reap tax losses might be considered tax fraud.