- Sales of NFTs, or nonfungible tokens, have exploded in recent weeks, but many buyers and sellers aren't likely aware of tax rules governing these transactions.
- Those who use cryptocurrency to buy NFTs could face capital gains taxes.
- The IRS states that "if you exchange virtual currency held as a capital asset for other property, including for goods or for another virtual currency, you will recognize a capital gain or loss."
The NFT craze may come with a painful tax surprise for buyers and sellers who use cryptocurrencies, according to tax experts.
Sales of NFTs, or nonfungible tokens, have exploded in recent weeks, topping $500 million in 2021, according to NonFungible.com. Along with the sale of the $69 million Beeple NFT titled "Everydays: The First 5,000 Days" at Christie's last week, and the $3 million NFT sneakers, NFTs of everything from NBA highlight videos to Jack Dorsey tweets have created a vast new market of blockchain-based digital assets to buy and sell.
Yet experts say buyers and sellers aren't likely aware of an Internal Revenue Service tax rule that could come back to haunt them — and cost them a big chunk of their gains. It involves a steep potential tax on anyone who uses their highly valued cryptocurrency to buy NFTs, which experts say is most NFT sales.
"People's knowledge of this tax in the U.S. is very poor," said Shehan Chandrasekera, head of tax strategy at CoinTracker, a platform for tracking crypto portfolios and taxes. "I just don't think people know about it."
At issue is recent IRS guidance on using cryptocurrencies to buy an asset, including an NFT. As part of its principle known as "disposition of assets," the IRS states that "if you exchange virtual currency held as a capital asset for other property, including for goods or for another virtual currency, you will recognize a capital gain or loss."
Chandrasekera said this has major implications for the NFT craze, which is largely being fueled by collectors using bitcoin or ether to buy NFTs. For example, if someone purchased a unit of ether for $100 in 2018, it's now would worth around $1,700. If they used that ether unit to buy a $1,700 NFT, they might assume they pay no tax on the ether, since they're simply using it to buy a good or service.
But under the IRS rules, the ether is a capital asset not a currency. So the holder would have to pay tax on the gain of $1,600 as part of the NFT purchase, since the act of exchanging it for another asset counts as a sale or "disposition." So they would owe the IRS — assuming a top capital gains rate of 20% — a tax of $320. They might also owe state taxes, since many states like New York and California tax capital gains as income. (The rules around additional sales taxes in each state for NFTs are less clear.)
"You're not spending currency, you're spending an appreciated asset," Chandrasekera said. "So just spending it creates a taxable event."
If the NFT buyer later goes on to sell or "flip" the NFT at a higher price — which has become popular with NBA highlight videos and Beeple works — the seller would also pay a capital gains tax on any gain. And since NFTs are considered collectibles, they are taxed at the higher collectible capital gains rate of 28%.
In other words, both buyers and sellers of NFTs likely face tax bills they didn't consider when investing in NFTs.
Another problem is inadequate reporting by companies at the center of the NFT boom. The big platforms that buy and sell NFTs, like Flow by Dapper Labs or OpenSea, can report a sale but they aren't able to report a buyer's gain on the crypto used for the purchase.
"They don't know what a buyer originally paid for their ethereum or bitcoin, they can only report the sale price of the NFT," said Chandrasekera.
Tax experts say it's almost impossible to know the total amount owed or unpaid to the IRS from the NFT boom. Some say it's in the tens of millions, and perhaps hundreds of millions.
Granted, NFT buyers who simply purchase bitcoin or ether, and instantly use it to buy an NFT would not face a tax. The tax only applies to those who buy NFTs with crypto that has increased in value since its purchase.
What's more, the rules don't apply to overseas investors in NFTs. The buyer of the $69 million Beeple NFT that sold at Christie's last week, for instance, goes by the pseudonym Metakovan and is based in Singapore. Tax experts say that since Singapore doesn't have a capital gains tax that would apply, Metakovan would not have owed tax on the appreciated ether he used to purchase the piece. If he had been a U.S. citizen, he could have owed more than $10 million in capital gains taxes as part of the purchase.
The IRS, however, will get its share of the Beeple purchase. The artist who created and sold the work, Mike Winkelmann, who also goes by Beeple, will owe federal and state ordinary income taxes on the proceeds since he is an artist by profession. Depending on the fees paid to Christie's and MakersPlace, he could owe tens of millions in dollars in taxes, experts say.
When told that he could face such a significant tax bill, Winkelmann said to CNBC: "Holy s---, that's a lot of taxes."