While much has been written regarding the IRS’s efforts to get its arms around the taxation of cryptocurrencies, Bitcoin, Ethereum and other virtual currencies are not the only digital assets that raise challenges for tax compliance. The exploding popularity of non-fungible tokens (or “NFTs”) has raised questions about how they will be taxed and whether the IRS will pursue enforcement actions against taxpayers who fail to accurately report NFT transactions.
First, some background, in 2014, the IRS provided guidance making clear that virtual currencies would be treated as property for federal income tax purposes. In other words, the “general tax principles that apply to property transactions apply to transactions using virtual currency.”
Last month, the IRS issued additional guidance reflecting its focus on crypto this tax season, reminding taxpayers that the current tax forms ask whether “[a]t any time during 2021, [they] receive[d], [sold], exchange[d], or otherwise dispose[d] of any financial interest in any virtual currency.” The guidance provided a list of eight of the “most common” crypto transactions that would require disclosure:
· The receipt of virtual currency as payment for goods or services provided;
· The receipt or transfer of virtual currency for free (without providing any consideration) that does not qualify as a bona fide gift;
· The receipt of new virtual currency as a result of mining and staking activities;
· The receipt of virtual currency as a result of a hard fork;
· An exchange of virtual currency for property, goods, or services;
· An exchange/trade of virtual currency for another virtual currency;
· A sale of virtual currency; and
· Any other disposition of a financial interest in virtual currency.
None of these categories clearly implicates NFTs and taxpayers active in digital transactions may wonder: how do NFTs fit into the IRS’s emerging framework and how likely is it that that the IRS will be looking into NFT-related transactions?
Like virtual currency, NFTs are blockchain-based digital assets. Cryptocurrency is widely considered “fungible” because it can be easily traded and exchanged (much like non-digital currency). By contrast, each NFT represents a certificate of ownership and authenticity that lives on a blockchain that can be attached to any kind of object, such as an image, song or newspaper article. In the same way that ownership of a car is reflected in the title through a Vehicle Identification Number, each NFT has a record of the unique underlying blockchain code.
Although any digital item can be made into an NFT, the unique nature of each NFT has created a buzz in the world of art investment. According to some reports, investors poured $44 billion into NFTs between January 2020 and December 2021, with approximately 93% of that investment ($41.3 billion) occurring in the last six months of 2021. Even traditional auction houses are participating in this form of digital art collecting—in 2021, Christie’s sold $136 million of NFTs.
Although the IRS has not yet provided guidance to taxpayers, the increased attention (not to mention the billions of dollars of investment) in the space have created speculation about how these digital assets will be treated under the existing tax code and whether the IRS will begin prosecuting those who fail to pay taxes on these transactions.
First, will NFT investments be treated like virtual currency and subjected to the same capital gain/loss tax structure?
For investments in virtual currencies, the IRS requires taxpayers “to determine the fair market value of virtual currency in U.S. dollars as of the date of payment or receipt.” And when cryptocurrency is sold or exchanged at a gain or loss, the taxpayer is subject to the same capital gain/loss treatment that applies to more traditional investment portfolios. If a taxpayer held the cryptocurrency for more than a year, any profit on the sale is taxed at the long-term capital gain rate, while a cryptocurrency that was held for no more than a year would be subject to short-term capital gain treatment and taxed as ordinary income. Any losses from sales of virtual currency may be used to offset a taxpayer’s capital gains and up to $3,000 of ordinary income.
But does the unique nature of each NFT merit a different treatment under the tax code? As part of the Taxpayer Relief Act of 1997, Congress separated net long-term capital gains from the sale of collectibles such as art, antiques, stamps, coins, metals and gems from other types of assets. While lowering the maximum long-term capital gain tax rate for stocks and bonds to 20%, Congress left the top rate for collectibles held more than a year at 28%. Losses on the sales of collectibles are subject to the same limitations on losses that apply to other capital assets.
As a result of this distinction between collectibles and other capital assets, if the IRS concludes that an NFT constitutes a work of “art” and thus qualifies as a “collectible,” the applicable tax rate on long-term gains will be substantially higher than the rate applied to other long-term cryptocurrency investments. Without guidance from the IRS, an unprecedented number of NFT-holding taxpayers are left in the dark. Moreover, because NFTs come in all shapes and sizes, it is possible that the IRS will treat some as collectibles and others as capital assets.
Regardless of the how the IRS decides to tax these digital assets, the increased popularity and investment will almost certainly translate into greater attention from civil auditors and criminal investigators. The IRS is reportedly ready to pounce on those who fail to accurately report gains on the sale of digital assets. In January, Jarod Koopman, Acting Executive Director of Cyber and Forensic Services at the IRS’s Criminal Investigation Division, anticipated “an influx of potential NFT type tax evasion, or other crypto-asset tax evasion cases.”
Last month, the agency appeared to follow up this promise when two defendants were charged in an alleged NFT fraud and money laundering scheme. In connection with the charges, the Special Agent-in-Charge of the IRS’s New York Field Office explained “NFTs represent a new era for financial investments, but the same rules apply to an investment in an NFT or a real estate development. You can’t solicit funds for a business opportunity, abandon that business and abscond with money investors provided you.” The agent further noted that the IRS and the Department of Homeland Security were “closely track[ing]” cryptocurrency transactions in an effort to uncover similar schemes.
Although the charges did not include tax offenses, market participants should view the case as a harbinger for future government enforcement efforts and would almost certainly benefit from regulatory guidance. At a minimum, such guidance would serve as a reminder of the risks associated with transacting in novel assets.
To read more from Jeremy Temkin, please visit www.maglaw.com.
Ariel Cohen, an associate at the firm, assisted in the preparation of this blog post.