Taxation Of Non-Fungible Tokens

• Published date: 22 July 2022
• Subject Matter: Tax, Technology, Income Tax, Tax Authorities, Fin Tech
• Law Firm: BakerHostetler
• Author: Mr Nicholas C. Mowbray

Part Four in our series discusses U.S. federal income tax issues relating to Non-Fungible Tokens (NFTs) and provides an overview of how NFTs may be treated for U.S. federal income tax purposes

IRS GUIDANCE

1. Notice 2014-21

At the time of this publication, the U.S. government has only passed legislation addressing tax reporting requirements for "brokers" of "digital assets."¹ There is therefore no legislative guidance regarding the taxation of NFTs. Likewise, the IRS has not addressed NFTs in any of its limited cryptocurrency guidance. Notwithstanding, Notice 2014-21,² which is the IRS' first attempt to address the taxation of convertible cryptocurrencies, serves as a point of reference.

Notice 2014-21 applies to "virtual currencies," which are defined as "a digital representation of value that functions as a medium of exchange, a unit of account, and/ or a store of value." It further provides that a convertible cryptocurrency is treated as property - not cash or currency - for tax purposes. Thus, general tax principles that apply to property apply to convertible cryptocurrency. While Notice 2014-21 does not specifically address nonconvertible cryptocurrencies or NFTs, it is most likely that NFTs are also treated as property for tax purposes.

2. Purchasing NFTs with Cryptocurrency vs. US Dollars

An initial point of consideration regarding the taxation of an NFT is whether it was purchased with a cryptocurrency. The use of cryptocurrency to purchase an NFT results in taxable transactions for both the buyer and the seller. This is because the NFT buyer is buying property (i.e., the NFT) with other property (i.e., cryptocurrency). The buyer's gain would be taxable if the fair market value of the cryptocurrency used to buy the NFT is greater than the buyer's tax basis in the cryptocurrency. If, on the other hand, the NFT is sold for cash, the seller has a taxable transaction, but the buyer does not. The amount of taxable gain or loss for the seller is the difference between their adjusted tax basis in the NFT and the amount received for the NFT.

CAPITAL VS. ORDINARY TREATMENT

Gain or loss on an NFT transaction is treated as capital or ordinary, depending on whether the taxpayer is an investor or trader (capital) or a dealer or creator (ordinary). Whether the holder of an NFT is an investor, trader, dealer, or creator is a mixed question of fact and law.

1. Investors and Traders

Investors are typically taxpayers who profit solely from price fluctuations and...