If cryptocurrency was the summer blockbuster, non-fungible tokens (NFTs) are the sequel that somehow found a way to outdo the original.
NFTs are one of the hottest topics on the blockchain right now, as investors have come out in droves to invest in one-of-a-kind art, trading cards, and other electronic assets to the tune of billions of dollars. While the investment may only exist in the ether, the tax liability does not, and now, the U.S. government wants its share of the profits.
It’s a riff on a story we’ve seen play out over the last decade with other digital assets. For years, groups like the Organization for Economic Cooperation and Development (OECD) pushed to develop new tax standards to address the growth of the digital economy. It all started in 2015 with the OECD’s Base Erosion and Profit Shifting Project (BEPS), which put a spotlight on the issue of changing patterns of consumer behavior resulting from an increasingly digital economy. Briefly, BEPS created an agreed upon playbook for tax authorities around the world to implement specific taxes on cross-border and direct-to-consumer digital transactions based on where digital services were consumed, not where the company providing those services was based.
Even before BEPS was fully codified, tax authorities around the world started pointing to BEPS as a green light for aggressive digital tax strategies. The sentiment can be found in the UK Digital Services Act and digital tax proposals from the EU, Italy, Spain, Chile, and a host of others. To-date, most major tech companies have managed to avoid any real financial impact from digital services taxes by either opting out or simply passing the additional cost along to suppliers and customers. And only now, nearly a decade later, global regulation is working its way toward progress on the issue.
That same pattern is now taking shape in the NFT world. Except, now, instead of multinational corporations being on the hook for digital assets, it is investors, a group that runs the gamut from sophisticated institutions to novice investors just looking to get in on the latest trend.
The total number of NFT buyers hit an estimated 260,000 in the third quarter of last year, up from 19,000 during the same period of 2020, and it’s likely that some of those buyers aren’t quite up to speed on how taxes are calculated on any gains their investments may yield. That’s partially because NFTs exist in a grey area that has plagued cryptocurrency investors for years.
NFTs are one-of-a-kind, verifiable assets. But it wouldn’t be a stretch to call them collectibles. In fact, many NFTs are digitized version of common collectibles, like trading cards. Collectibles carry a rate that varies with income, but checks in as high as 28%. That’s quite a bit higher than the 20% top rate that applies to investment returns for stocks, bonds, and cryptocurrencies like bitcoin.
For example, a single taxpayer in the 22% tax bracket — which applied to income between approximately $41,000 and $86,000 last year — would pay a 22% top rate on the long-term appreciation of collectibles. So it makes sense that someone that made $75,000 last year would have their gains on their collectible NFTs taxed at 22%, right? Not so fast.
The IRS hasn’t explicitly said that NFTs are collectibles. And since guidance on burgeoning areas like NFTs from the IRS is usually delivered slowly (the agency took years to issue critical cryptocurrency guidance), there may simply be no way to know if that taxpayer should be taxed at the higher collectible rate, or at a standard capital gains rate.
In time, there may be specific regulation that needs to be written for NFTs, just as the world sought years ago for digital sales tax. In the meantime, this presents a quandary for investors. Do they err on the side of caution and pay the higher rate, or do they take a riskier wait-and-see approach?
One thing is for certain: taxpayers need to stay vigilant and ensure they’re compliant, because the IRS does want its cut of gains from NFTs. The explosion in growth has meant there is plenty the government is owed, and they have millions of reasons to collect.