NFTs: Why The Next Big Thing In The Digital Economy Is A Cash Cow For The IRS

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  • Source: Forbes
  • 09/20/2021
Sales and trading in nonfungible tokens (or NFTs) have gone from increasing to skyrocketing. They’re new. Their values can be volatile. But for those with U.S. tax obligations they can also be a goldmine for the IRS. Why? Because unlike most other forms of income and assets, NFTs can create multiple taxation events for both those who are creating them and those who are trading them. In a recent interview for Forbes.com Shaun Hunley, a Georgia-based tax attorney and tax consultant for Thomson Reuters, stressed the importance of understanding all of the different ways creating and/or trading in NFTs can result in federal income tax.

NFT Creators

NFTs are considered “self-created intangibles” like many other performances or works of art. What this means is that the creator has no “basis” in what is being sold other than possibly the expenses related to creating it. The IRS, however, has an exception that allows artists to deduct expenses as they go rather than when the artwork is sold. If an NFT creator has deducted their expenses in a tax year prior to the year in which the NFT is sold, the creator has zero basis in the NFT. That means the profit or gain is 100% of the proceeds realized on the sale. Someone who creates an NFT and sells it for $1M has $1M of taxable profit.

Although actual guidance from the IRS is woefully lacking, general tax principles indicate that NFTs are likely to be considered their creator’s inventory (as opposed to capital assets) by the IRS. Whether someone is in the business of creating NFTs or is an artist or celebrity who is simply adding NFTs to their income stream, the sale of an NFT is not only going to be taxed as ordinary income (as opposed to the more favorable capital gains) it is also going to be subject to self-employment taxes. And the tax fun doesn’t end there. While the original NFT is a unique token on the blockchain the artist or creator may retain the copyright to whatever was used to create the NFT itself. For example, NBA Top Shot (one of the hottest NFT markets right now) allows an individual to purchase a unique URL that links to a site where a specific NBA highlight is located. The individual is not purchasing the copyright to the highlight video, the NBA retains that. The individual is purchasing a limited use license (that does not include making and distributing copies of the video). An artist or performing artist may decide to sell multiple NFTs based on the same original artwork or performance, similar to limited edition signed reprints or limited released copies of a live performance. When copyright is retained and copies are being sold the income is considered royalties which must be reported annually on Schedule E and attached to the individual’s Form 1040. Bottom line? NFT creators could be looking at three taxable events when they sell a self-created NFT: income tax on the sale itself, self-employment tax on the sale, and income tax generated by royalties.
 

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