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NFTs: An Existential Question

May 11, 2021, 8:00 AM

NFT Tax Haiku

NFT NFT what are thou
the future or just a fad
Taxes follow your dollars

There is a saying by a famous venture capitalist that the next big thing will start out looking like a toy. More specifically this saying means that the next big thing will start out being mocked by people that can’t see what it will evolve into. While the jury is still out on if non-fungible tokens (NFTs) are the next big thing, what is clear is that they arrived out of nowhere, have seen incredible amounts of money flow into purchasing them, and have many people shaking their heads as to why someone would spend $70 million on an NFT of an artwork, or $560,000 for an NFT of a New York Times article on NFTs.

Most of the time tax practitioners don’t have to understand our clients’ motivations when it comes to buying frivolities. For example I don’t have to worry about why my clients spend money on flowers or Lamborghinis any more than why they would want to buy a million dollar NFT. All I need to know is if the expense is ordinary or necessary for the production of income, and what the useful life is. Most of the time that makes life simpler. Unfortunately, this is not one of those times. Beyond the basics, the taxation of NFTs is just a series of unanswered question upon unanswered question.

Those basics are as follows. A user-created NFT is most likely going to be ordinary income. The fees associated with getting the digital rights onto the blockchain, i.e., gas fees, are going to be added to the basis of the NFT. The income realized is the price the NFT sells for in U.S. dollars, even if calculating that figure requires converting from virtual currency to U.S. dollars at the time of the sale, minus the basis.

For the seller an NFT is most likely going to be a capital asset unless the purchaser is in the trade or business of buying NFTs. The buyer will have some virtual currency gains or losses based upon their basis in the virtual currency used to buy the NFT (if required). The basis in the property is the U.S. dollar equivalent of the purchase price plus any fees imposed by the exchange. That basis then determines the gain or loss when the NFT is disposed of.

Picking back up with the unanswered questions, the newness of NFTs, the relative lack of sophistication and fragmentation of the markets that trade in them, combined with the lack of guidance from the IRS makes life more difficult for a tax practitioner. Starting with the private sector, many of the NFT auction websites are opaque when it comes to what the end user is actually purchasing.

A common example of this is that the taxpayer buying an NFT might believe they purchased a digital artwork. The reality is that they might have in fact only purchased an officially licensed image of the artwork that the artist believes represents the one true digital image that has superior rights to all other digital images. If all the taxpayer purchased was a digital representation of the underlying artwork, is that representation by itself art? If so, that opens the door to a larger conversation of What is art? Conceptual artists and art critics have explored these questions for decades and have yet to reach a conclusion so there are bound to be differences of opinions among tax professionals.

Where these existential questions might make a quantifiable difference is if NFTs qualify as collectibles. Tax code Section 408(m)(2)(A) defines a collectible “as any work of art” and imposes a 28% capital gains rate. Section 408(m)(2)(F) provides a backstop that allows the IRS to designate “any other tangible personal property specified by the Secretary for purposes of this subsection” as a collectible. Prior to NFTs this type of logic made sense. It gave the IRS the power to say that investing in baseball cards should be treated consistently with investing in art, because there is no real difference in an art collector’s enjoyment of a Monet and a sports card collector’s enjoyment of a Mantle.

However, with digital-only assets this parity gets turned on its head. Christie’s can sell an NFT as art and the expansive definition of art may result in a 28% tax rate. Comparatively, NBA Topshot can sell an NFT sports highlight as a digital collectible card, and since it is not marketed as art, the max capital gains rate is 20%. Both are NFTs, both are hosted on the blockchain, and both have the potential for investment gains. Yet despite being fundamentally the same they very well may be taxed differently.

What comes next is just as unclear. Just as prior to Notice 2014-21 intelligent people could endlessly debate the merits of Bitcoin being taxed as currency versus being taxed as property, intelligent people can debate if NFTs should be art, collectibles, or something else. The blockchain is the same, but the facts and circumstances have changed to the point where NFTs do not constitute virtual currency, and Notice 2014-21 might be completely inapplicable.

Until Treasury provides some context, we are all left making a judgment call based upon the underlying ownership rights of a particular NFT, the terms of service of an exchange, or how it was marketed. In the end all of this may not matter. Perhaps the only thing that matters is what was the realized sale price, what the taxpayer’s basis in the NFT, and is the character ordinary or capital. If NFTs are just a toy, that is probably all a tax practitioner will ever need to know. If NFTs turn out not to be a toy, tax practitioners will just have to hope that guidance comes sooner rather than later.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

James Creech is a tax attorney in San Francisco.

Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.

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