What is an NFT?
NFT stands for “Non-Fungible Token.” It is a unique digital asset representing ownership of a specific digital item or piece of content. Blockchain technology makes it possible to verify the authenticity of an NFT and keep a transaction history.
NFTs recently started to come into prominence both as a way for digital artists and creators to get fair compensation for their work and as an exciting new investment opportunity. In March 2021, the artist Beeple sold an NFT artwork for $69 million; the future of NFT investing should not be ignored.
NFTs are built on blockchain technology, the same technology that powers cryptocurrencies like Bitcoin and Ethereum. Unlike cryptocurrencies, NFTs are non-fungible, meaning they are not interchangeable. Blockchain is used to verify each unique NFT and its ownership.
Examples of NFTs
NFTs can represent a wide variety of digital items. Some of them include:
- Digital Artwork – This can consist of illustrations, paintings, animations, collages, etc.
- Collectibles – Digital trading cards, NBA top shot moments, and rare items from video games are all examples of NFT collectibles.
- Digital Real Estate—Examples of NFT real estate would be Decentraland and Cryptovoxels, where users can buy and sell digital homes or plots of land.
- Music and Videos – Some musicians are releasing albums or parts of albums as NFTs, giving fans unique access to music, bonus content and experiences.
- Domain Names – Some blockchain-based domain names are sold as NFTs.
How are NFTs Taxed?
Maybe you’ve already ventured into the world of NFT investing, or you’re looking to get started. Either way, you want to know what it all means for your taxes. Do you have to report the money you make from buying and selling NFTs to the IRS? How are your NFT gains taxed? Is there any way to avoid paying capital gains taxes on your appreciated NFT assets? We’ve got you covered–this is your one-stop guide to NFTs and capital gains taxes.
The IRS has determined that NFTs are digital assets, meaning they are taxed like cryptocurrencies. Buying or selling NFTs will subject you to capital gains taxes. If you are a creator selling NFTs, you’ll pay ordinary income tax on your revenue.
Examples of Taxes on NFTs
- Buying an NFT: Most NFTs are bought with cryptocurrency. If you bought BTC for $500,000 and it appreciated to $900,000, and then you traded the BTC for an NFT, you would incur a capital gain of $400,000. You would be taxed on that $400,000 gain.
- Selling an NFT: If you bought an NFT for $1 million in either fiat or cryptocurrency and then sold it for $2 million, you would be taxed on a $1 million capital gain.
- Trading NFTs: When you trade an NFT for another NFT, you will be taxed on how much the worth of your NFT has changed from when you bought it. If you purchased an NFT for $800 and traded it for an NFT worth $1,500, you would incur a capital gain of $700. Even though you didn’t receive any digital or fiat payment, you will still be taxed on that $700.
- Creating and Selling NFTs: If you are a creator, you’ll be taxed on the income you receive from selling your NFTs. If you created and sold $900,000 worth of NFTs over the course of the year, you would report that $900,000 to the IRS as income and owe the appropriate income taxes.
Reporting NFTs on Your Taxes
When you are filing your taxes, you will need to answer yes or no to the following question1:
At any time during 2024, did you:
(a) receive (as a reward, award, or payment for property or services); or
(b) sell, exchange,e or otherwise dispose of a digital asset (or a financial interest in a digital asset)?
If you bought or sold any NFTs during the year, you must answer yes. Answering yes does not necessarily mean that you will owe taxes. However, not reporting NFTs is a form of tax fraud.
You can only check “no” if you didn’t have any cryptocurrency or NFT transactions in that tax year. If you have NFTs but have just held them, you do not have to report them to the IRS. If you move cryptocurrency or NFTs from one wallet to another, you also do not have to report it.
How Do You Avoid Capital Gains Taxes on Your NFT?
Everyone wants to know how to avoid capital gains taxes on cryptocurrency and NFTs, but the truth is that they aren’t any different than any other appreciated asset. You can’t legally wholly avoid paying taxes on your realized gains, but with the right capital gains tax strategy, you can defer and reduce your capital gains taxes, maximizing your returns.
Short-Term vs. Long-Term Gain
Like any other asset, NFTs are taxed differently depending on how long you’ve held them. An asset you’ve held for less than a year is considered a short-term gain and is taxed at the same rate as income tax. Long-term capital gains are given a preferential tax rate of 0%, 15%, or 20%, depending on your tax bracket. So, the simplest first step to reduce your capital gains taxes is to wait to sell your NFT until you’ve had it for at least a year.
Deferred Sales Trust
A Deferred Sales Trust (DST) is a legal tax strategy that allows you to defer paying capital gains taxes by transferring your asset, in this case, your NFT, to an independent, third-party trust before selling. The trust sells the asset on your behalf and then distributes the proceeds back to you in installments over time. After selling, the trust reinvests your profits according to your desires and risk tolerance.
A DST has a few tax advantages:
- You only have to pay capital gains taxes on the installments you receive each year. This spreads your tax burden out over time and leaves you with more money for the trust to invest on your behalf, increasing your returns.
- You can even choose to structure your promissory note to pay out interest only payments, which would keep your capital gains tax in a 100 percent deferral state. In this scenario only ordinary income tax will be owed.
- By delaying the realization of your gains, you may qualify for a lower tax bracket, reducing the taxes you owe overall.
- Your investment options are varied and flexible. The trust can reinvest into cryptocurrency, NFTs, real estate, stocks, or any combination of investment vehicles. This diversification can reduce your risk and increase your returns.
Work with a Professional
Setting up a DST correctly requires the expertise and experience of a qualified Deferred Sales Trust trustee. The IRS constantly updates and changes regulations, especially regarding NFTs. If the trust is not set up correctly and in compliance with all the applicable rules and regulations, the IRS will flag your sale, and you will not only owe all the taxes immediately but may also owe extra fees or penalties.
NFTs are an exciting opportunity for investors. Make the most of your investments by consulting with tax professionals who can help you minimize your taxes, comply with the IRS, and maximize your returns.
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Infographic
Many want to avoid capital gains taxes on cryptocurrency and NFTs, but these assets are treated like any appreciated asset. While you can’t fully evade taxes on gains, strategies exist to help reduce them. Explore this infographic for tips on minimizing capital gains taxes for NFTs.
1https://www.irs.gov/businesses/small-businesses-self-employed/digital-assets