January 26, 2022 Skalex

What NFT Traders Need to Know About Taxes

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January 26, 2022

2021 was an absolutely stellar year for crypto, with Bitcoin reaching new all-time highs and on-chain activity skyrocketing. Even by these standards, the NFT sector has seen standout success. From sales of barely $100 million in 2020, the market ballooned to hit $25 billion in 2021.

Many traders may have become caught up in the NFT hype without considering that the taxman may eventually be interested in their activities. After all, they’re such a new asset class; anyone would be forgiven for believing that the tax authorities haven’t yet caught up with the speed of development. Unfortunately, that’s not correct, and it’s likely that NFT creators and traders will need to declare their activities to remain compliant.

So now that tax season has arrived for many, what’s the current tax situation for NFTs, and what do traders need to do?

The exact tax treatment of NFT activities will vary according to the jurisdiction, and given the potential complexities involved with declaring NFTs as a new asset class, it’s worth consulting a professional tax adviser in all cases.

However, there are some general points to consider.

NFT Transactions Are Subject to Definition

Selling an NFT, whether as a creator or selling on the secondary market, is likely to trigger a taxable or reportable event.

However, it may also depend on how your tax authority defines a “sale.” For instance, in the US, any crypto transaction is considered reportable. If you sell an NFT for crypto or trade it for another NFT even without touching fiat, the US IRS requires that you declare it.

In contrast, French law only recognizes a crypto sale when the digital asset is liquidated into fiat currency.

Therefore, it’s worth understanding what kinds of transactions may trigger an obligation. 

NFT’s May Not Be Taxed the Same as Crypto

The way that tax authorities treat cryptocurrencies can already vary depending on the tax rules available for other assets. Effectively, few jurisdictions operate a separate category for taxing crypto, opting instead to classify it in the same way as other taxable assets. 

So in the US, the IRS doesn’t treat crypto as a currency like cash. It applies capital gains tax to cryptocurrency transactions, treating them in the same way as gains from real estate or stocks.

However, most tax experts believe that the IRS is likely to treat NFTs as collectibles, not capital gains. As such, NFT transactions could attract a higher tax rate than crypto transactions.

The good news is that it may still be possible to offset gains against losses, so if there are NFT transactions that didn’t turn a profit, they may turn out to be worthwhile after all.

Freebies Still Count

The crypto world is full of freebies and token giveaways, and NFTs are no different. Many operators, such as exchanges or new projects, have offered NFT giveaways as enticements this year. However, even though they’re free, they’re still likely to attract the same kind of tax treatment as any other crypto or NFT transaction. This includes paying tax on profit if you sell them, where such taxes apply.

Don’t Rely on a Software Provider Just Yet

Over recent years, filing taxes for crypto transactions has become much easier thanks to a proliferation of providers like Koinly and TokenTax. They allow a trader to link their exchange and wallet accounts to automate tax reporting, meaning that even power traders didn’t have to worry too much about keeping records.

Unfortunately, the same infrastructure doesn’t yet exist for the NFT markets, in part because the regulations still aren’t clear. As such, NFT traders will likely need to spend some time manually preparing and filing their NFT trading activities, at least for this tax season.

Don’t Assume You Won’t Get Caught!

Traders shouldn’t assume that they can duck their tax obligations simply because NFTs are a new asset and the rules aren’t particularly clear. Tax authorities have a track record of using the courts to compel crypto operators to disclose details of their customers.

In 2018, a federal district judge ruled that Coinbase had to provide the US IRS with information to investigate account holders who may have failed to meet their tax obligations. As such, there’s every reason to believe that similar action will be taken against NFT platforms like OpenSea, meaning that even retroactive enforcement action is a real possibility.

What Should NFT Traders Be Doing to Prepare for Tax Filing?

At least for this year, traders should resign themselves to the fact that NFT tax rules are likely to remain nebulous and quite possibly not fit for purpose, particularly when it comes to more exotic NFTs linked to real-world assets. However, there are a few things traders can do to make sure they’re prepared to demonstrate compliance with NFT taxes.

1. Keep detailed records of all NFT transactions throughout the year, even if you’re not sure if they’re reportable. Include all acquisitions, both purchases and NFTs acquired in airdrops or giveaways, and all sales, whether you settled the transaction in crypto, fiat, NFTs, or any other asset. Records should include all elements of the transaction, such as gas fees or platform fees, as they may be deductible from the profit declared for tax purposes, depending on your local tax rules.

2. Consult a local tax specialist who can advise you on your jurisdiction’s specific treatment of NFTs and crypto transactions. An adviser may also be able to help plan and optimize your tax position for future years. However, the main issue for 2021 filing is that NFTs are new and uncharted assets, and unless your tax authority is very clear on their treatment, specialist support will help to ensure you remain compliant.

3. Be proactive in filing and declaring to avoid penalties. Precedent shows that when tax authorities have retroactively followed up with non-payment of crypto taxes, ignorance isn’t generally accepted as an excuse.

Murky Waters for Now

It seems likely that the uncertainty surrounding NFT taxes won’t last for long. The tax authorities will be keen to ensure they can reap their share of this growing market. It’s also only a matter of time before crypto tax platforms roll out better support for NFTs, making the reporting burden easier. However, for the 2021 filing season, NFT traders should be prepared for tax regulation to remain decidedly unclear.