The Income Taxation Of Creators, Investors, Dealers And Collectors Of NFTs

The creative process of individuals, and the medium through which a Creator works, is constantly expanding, including digital assets such as Non-fungible Tokens. NFTs that are created, bought, sold or exchanged are considered property by the IRS, and so these are taxed like art buying, selling or exchanging art.

For the Creator of an NFT   

           For the Creator, the minting of the NFT is not a taxable event, but, where creating the NFT is due to their personal effort (or the effort of someone who is creating the NFT for them) or the NFT is part of the Creator’s trade or business, then the gain from the sale or exchange of the NFT is taxable as ordinary income.

A Creator can receive a percentage of the subsequent sale proceeds. When the Creator receives such a payment on a subsequent sale, that payment is also considered to be ordinary income, much like payments of royalties on copyrights, patents and other intellectual properties. Since those payments are perpetual, those rights cannot be depreciated.

Beyond the Creator: Investor, Hobbyist, Business Collector and Dealer

Once the NFT leaves the hands of the Creator, the owner is categorized as  one of four types of owners:  the Investor, Hobbyist, Business Collector or Dealer, each of which have different tax considerations. Which category a taxpayer falls into would depend on the facts and circumstances of that taxpayer’s case.

Following is a brief introduction to the four categories.

The Investor

An Investor is a person who buys, sells and collects NFTs solely as an investment with the hope the asset will appreciate to enable sale at a profit. For an Investor, generally the NFT investment when sold is taxable as a capital gain unless it falls outside the definition of capital asset. IRC § 1221 defines capital asset to include all assets except inventory for the taxpayer’s trade or business.

   An Investor can be classified as a Dealer or a Hobbyist instead of an Investor based on the facts and circumstances in their case. Sometimes Investors want to be classified as Dealers when they have losses to be able to deduct the loss as ordinary income rather than as a capital loss.

The Hobbyist

An owner of NFTs is presumed to be a Hobbyist. A Hobbyist is a collector who buys NFTs without considering whether it will ever be a profitable investment. Because of the tax disadvantage of being a Hobbyist, the Hobbyist often tries to be classified as an Investor.

The Business Collector

A Business Collector does not buy the NFT for resale but rather for a business purpose such as office display or decorative logo used in the ordinary course of trade or business. Because the useful life of an NFT is not determinable,  it is generally not subject to depreciation (unlike copyrights and other IP interests). Facts and circumstances need to be reviewed in each individual case to determine the categorization of the activity.

The Dealer

The Dealer is one who buys and sells NFTs as a trade or business. NFT Dealers are taxed in the same way as any other retail operation. As such all income including income from the sale of NFT is taxed as ordinary income. Expenses, if ordinary and necessary, are deductible. Dealers sometimes want to be classified as Investors because of the favorable capital gains rates versus being taxed on said gains as ordinary income. Additionally, Dealers can wear the hat of Investor in NFTs as well as Dealer in NFTs keeping the two as separate activities.

Installment Sales

Installment sales are where you sell a highly appreciated asset in return for an installment agreement. In an installment sale, you only pay tax on the gains and the interest as they are paid out to you.  

Trades involving NFTs

   Trades are a common income issue. Trades occur when an owner trades NFTs for other NFTs or Cryptocurrencies. Trades are treated in one of three ways:

1. Recorded on the books as non-taxable. The basis of the new item received is the same as the item given up, plus any  cash or property received to make the values equal (this amount to equalize the value is sometimes called “the boot”). Any such boot received would be reported as income.
2. Recorded as a taxable event. The basis of the new item is its fair market value, or cost.
3. A hybrid method using parts of both methods.

Despite clear law on the recognition of income from the exchange of inventory, trades are still often treated as non-taxable events, with the industry claiming they have always done it this way and/or that fair market value is hard to determine. Irrespective, an adjustment to a taxable event is required.

Charitable Contributions of NFTs

The computation of the amount of a charitable contribution, limitations that affect the amount of the allowable deduction and other aspects of charitable contribution are beyond the scope of this brief introduction. However, there are issues involving charitable contributions of NFT that the private taxable collector should be aware of. In many cases, the owner of an NFT partners with a charity to sell the NFT at auction, with the proceeds going to the charity, and using the net sale price as the value for charitable purposes.

Conclusion

There is currently relatively little case law specifically on the income taxation of the sale, exchange or donation of NFTs. The Treasury treats cryptocurrency as cash for reporting purposes, but the IRS treats transactions involving cryptocurrency, including NFTs, are to be treated as property. Until the rules are clearer, following the rules on the income taxation of art is the best insurance against possible penalties and interest.