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How are Non-Fungible Tokens (NFT) Taxed?

Thanks to OCSC Platinum Sponsor Withum for this valuable information about Non-Fungible Tokens (NFT):

The Age of Non-Fungible Tokens (NFT) is Upon Us

Written by Joshua Horrowitz, Lead How NFTs are taxed

NFTs have been around since the early days of crypto but have become more mainstream starting in 2020. While many people have heard of NFTs, very few can describe them. I will discuss what an NFT is and how the IRS views them for tax purposes.

When most people think of NFTs, they think of virtual art. Common NFTs that have gone mainstream, aka the blue-chip NFTs, are Bored Ape Yacht Club (BAYC), Crypto Punks (Punk), and Smol Brains. However, NFTs are so much more than virtual art. NFTs refer to anything digital that can be tied to the blockchain.

A high-level view of the blockchain is a database of electronic information that is highly secured and is used to verify ownership of anything on it. An NFT needs to be tied to the blockchain since it is the blockchain technology that provides 100% proof of ownership and as the old saying goes, possession is 9/10ths of the law. In this case, owning property on the blockchain is easy to determine who the rightful owner is since the blockchain is secured by thousands of people verifying the data. There are also multiple layers to the blockchain currently in layers 1 and 2. Layer 2 is relatively new and was built on top of layer one to allow for decentralization, transparency, and security while reducing the carbon footprint (the gas fees used per transaction).

Now that you understand better what an NFT is, you may be wondering how to acquire one. Currently, most NFT’s are purchased through an online marketplace such as OpenSeas, LooksRare, and Trove. These online marketplaces sell NFTs using Ether as the currency needed to purchase them. Another common crypto used to buy NFT’s is Solana, which is a layer 2 project that can mint these NFT’s at cheaper gas fees. Ether is a cryptocurrency (crypto) that can be purchased from online central exchanges and is considered one of the major crypto coins along with bitcoin. To put the process in a simple format, you use the currency to purchase crypto on a central exchange and use crypto to buy NFT’s on an online marketplace.

Now let’s discuss the tax ramifications for each of these steps. In IRS Notice 2014-21, the IRS defines crypto as property and not a currency. Therefore, general tax principles applicable to property transactions apply. The IRS has also determined the character of gains associated with crypto is all dependent upon how the taxpayer uses it. Crypto is deemed a capital asset for investment purposes and capital gain rules would apply when the crypto is sold or exchanged. I mention exchanged here since crypto does not qualify for 1031 Like-Kind exchanges as of January 1, 2018, when the Tax Cuts and Jobs Act went into effect. The IRS upheld their ruling in Legal memo 202124008 that crypto no longer applies to Section 1031.

Before we can get to how the NFT itself is taxed, let’s walk through the taxable events that take place beforehand. Using a central exchange, Ether (ETH) is purchased. We will say ETH is valued at $3,000. We buy 3 ETH for $9,020. There is an exchange fee of $20 and we have purchased 3 ETH. The exchange fee is capitalized into the cost and our 3 ETH has a cost basis of...

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