Financial advisors advocate for a diverse portfolio, but few could have foreseen the level of variety that many people would embark on in 2021. Investment in NFTs and cryptocurrencies soared nearly as fast as the price of those digital assets. Now, however, some of those newbie investors are in for a reckoning.
It’s tax time—and the Internal Revenue Service is taking a special interest in non-fungible tokens (along with people who bet on Bitcoin). That means collectors could be in for a bigger tax bill than they’re expecting.
While the IRS hasn’t specifically labeled NFTs as collectibles, the working assumption among tax professionals is that they belong in the same category as art, jewelry, or antiques. So, collectors who sell their NFTs could potentially face a higher tax rate on the digital art, as high as 31.8%.
What’s worse? Investors will likely incur taxes on both ends of an NFT deal.
The vast majority of NFT purchases are made with crypto or fiat. That requires the purchase and sale of the digital asset used to acquire the NFT. And if you realized a gain in that cryptocurrency between the time you bought it and the time you used it to purchase the NFT, you’re facing capital gains taxes.
While Bitcoin and other cryptos saw a number of new investors, the NFT world is, broadly speaking, one that’s currently being explored by the same people who saw early promise in crypto. So, there’s a good chance the value of their crypto holdings have increased significantly. And that means the capital gains could be substantial.
The amount you owe will depend on how much you gained (or lost)—and how long you held the tokens. If you’re a long-term investor, it could be anywhere from zero to 20% of your profits. If you bought and held the crypto for less than a year, though, you’ve triggered short-term capital gains, which are taxed as ordinary income. That means you could owe up to 37% of your returns, depending on your income level.
On top of any taxes you face for the purchase of an NFT, you’ll face even more when selling. Just as with cryptocurrencies, your capital gain (or loss) is calculated by subtracting what you paid for the asset from what you got when you sold it.
If you held an NFT even for a short period, odds are you made a profit. Sales hit $6 billion in the third quarter of 2021, compared to just $22 million the year before, according to NonFungible.com.
So why is the definition of NFT as a collectible so important? That’s because collectibles are generally purchased by the wealthy, who face both a 28% tax rate, the top federal tier, as well as a supplemental 3.8% in taxes on investments, which is called the Medicare surtax.
Percentages and tax law are kind of hard to view in the abstract, though. To put things in perspective, here are possible tax implications of some of 2021’s biggest NFT sales at the highest taxation levels:
XCOPY “Right-click and Save As guy”
Sale price: 1,600ETH (about $6,135,536)
Potential capital gains tax: $1.95 million
Sale price: 2,500 ETH (about $10,279,800)
Potential capital gains tax: $3.3 million
Beeple “Everydays: the First 5000 Days”
Sale price: 38,525 ETH (about $69,346,250)
Potential capital gains tax: $21.6 million
Those are, of course, extreme examples. But even something like a “Bored Ape Yacht Club” NFT nets the average seller between $450,00 and $600,000 these days. That would put the top tax bill in the $143,000 to $191,000 range. And a small $700 sale could be facing nearly $223 in taxes, depending on your income levels.