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In the midst of the NFT craze of 2021, we hope you didn’t forget to record all your transactions for the purpose of NFT tax. Yes, NFTs are taxable when you mint, sell, buy or exchange them. In this in-depth guide, you will be able to understand NFT taxes for an investor, gamer, and an NFT artist, as well as how to use ZenLedger to record and calculate taxes.
Crypto Tax Basics
Before getting into the specifics of NFT taxes, you would first need to understand the basics of crypto taxes.
The Internal Revenue Service (IRS) considers cryptocurrency (including NFTs) as property so it’s taxed like real estate or stocks. This is because the value of cryptocurrencies such as Bitcoin has increased to a point that 10 BTC can buy you a house.
Capital Gain or Loss
When you buy or sell crypto, it would create a capital gain or loss.
Cashing out your crypto isn’t the only way to trigger a capital gain or loss event. The following actions can also trigger such event:
Cashing out cryptocurrency for USD or other fiat currency
Purchasing goods or services with cryptocurrency
Trading one type of crypto for another such as swapping BTC for ETH
Using tokens to vote on projects, tip creators, or award members of a community
If you earn crypto or NFTs in exchange for work or through rewards from Airdrops or staking, your crypto will be taxed as ordinary income.
If you have a business and receive crypto through selling original NFTs, mining or staking, or selling goods and services, then you would have to report your business income and expenses.
There are also crypto transactions that are non-taxable. These include:
Purchasing cryptocurrency with USD/fiat
Transferring cryptocurrency between wallets and exchanges that you own
Sending or receiving cryptocurrency as a gift, not more than $15,000
Making donations to qualified charities in cryptocurrency
As a recipient of a gift, you won’t be taxed until you sell the crypto. As a sender of a gift, you will be taxed if the value exceeds $15,000.
Now that you have an overview of crypto tax basics, let’s look at NFT taxes.
NFT Tax For Investors
There are many ways for you to acquire and use your NFTs. With each transaction, you’re triggering a capital gain or loss and so your NFTs may be taxable. The following are the various NFT scenarios you may encounter and it’s important to be aware of their tax implications.
1. Buying NFTs
Buying an NFT can create a capital gain depending on how you buy it.
Scenario 1: You already have some crypto readily available in your account and you use that to buy an NFT.
This will trigger a capital gain or loss on the sale of crypto as buying an NFT with crypto is like selling the crypto for USD and using that to buy NFT.
Scenario 2: You buy some crypto just to buy an NFT.
If it is an immediate transaction, there may not be much or any capital gain or loss. Nonetheless, you should still report this transaction on Form 8949.
Scenario 3: You buy an NFT directly with USD.
Congratulations, you’ve experienced a rare non-taxable event! In this case, the amount of USD you paid is your cost basis, and you’ll have a capital gain or loss if and when you sell the NFT.
Scenario 4: You buy an NFT off-chain and then move it to your wallet.
This is similar to purchasing directly with USD so it’s non-taxable. In this case, the cost basis is not recorded on the blockchain but there is still the value that you paid for the asset. You should still record the amount.
2. Reselling NFTs
Just like other cryptocurrencies, NFTs are considered sold when you sell them for USD, use them to buy something, or trade them for other tokens. As such, it would trigger a capital gain or loss event and will be taxable.
What about collectibles? Consider it similar to holding a cryptocurrency. It is non-taxable until you sell it. The long-term gains from selling NFT are subject to a maximum of 28% tax rate. If you’re not sure whether an NFT is a collectible or not, consult an NFT tax professional.
3. Trading NFT for NFT
Without any extra steps in between, trading an NFT for another is akin to swapping BTC to ETH. Therefore, as far as the IRS is concerned, this triggers a capital gain or loss as you are “selling” the first NFT for USD and then using USD to buy the second NFT. This is a taxable event.
4. Fractionalized NFTs
A fractionalized NFT is a small piece of a larger work. As an investor, you can generally treat a fractionalized NFT like any other NFTs for tax purposes. However, in some cases, owning a fractionalized NFT may be considered ownership in a partnership in a pool of funds.
5. Pooling Funds to Buy NFTs
If you pool your money with some friends and purchase an NFT together, you would still need to report it on your taxes. To make things less complicated, it’s best if all parties set up an LLC with its own separate accounts before purchasing NFTs. Reselling or trading the NFTs will create capital gains or losses and it’s much easier to keep track of all that if you properly set up a business.
But if you’ve already pooled funds to buy NFTs using personal wallets, you can still report the tax returns accordingly. Here’s how each person might report their NFT taxes:
Let’s say an NFT costs 1 ETH. Alicia sends 0.5 ETH to Ben and he purchases the NFT. Ben should account for the “sale” of 1 ETH that was used to buy the NFT and also have the cost basis for his 0.5 ETH. For the 0.5 ETH that Alicia sent, Ben can use the fair market value as the cost basis. Essentially, when this ETH was sold to buy the NFT, there was no capital gain.
For Alicia, she can report her 0.5 ETH sold to Ben. Depending on the cost basis, she’ll have a capital gain or loss to report.
To avoid further confusion moving forward, both Ben and Alicia should set up an LLC and create a separate business account.
6. Loaning NFTs
It’s now possible for NFTs to be loaned to others or used as collateral for loans. Typically, taking a loan or loaning something out is not a taxable event. However, interest earned is considered taxable income at the fair market value of the interest received. The interest paid by an entity is a spend that can trigger a capital gain or loss. That being said, the tax implications depend on how exactly the NFT lending service is set up.
7. NFT Airdrops
In certain situations, if you own specific NFTs, you may be awarded other tokens via Airdrops. Similar to cryptocurrencies, Airdrops are considered as ordinary income and therefore taxed as such.
8. Burning NFTs Bought
Let’s take the example of NFT artist FVCKRENDER who allowed owners of his BALANCE// NFTs to burn one BALANCE// token in exchange for two FVCK_CRYSTAL// NFTs. How would the transaction be taxed?
Say the BALANCE// token was originally bought for $500. The two new FVCK_CRYSTAL// NFTs that you receive are currently trading at $1,000 apiece. These are the two potential ways you could go about reporting the transaction.
Option 1: Treating it as two separate transactions.
In this case, you would consider the burning of the old token and the receipt of the new ones as two separate transactions. In the first transaction, you sold BALANCE// token for $0, realizing a capital loss of $500. Then, you received two FVCK_CRYSTAL// tokens. You have $2,000 of ordinary income.
Option 2: Treating at as one transaction.
This means you’re selling one BALANCE// token for two FVCK_CRYSTAL// tokens. Since the FVCK_CRYSTAL//s are worth $2,000 and you initially spent $500 for the BALANCE// token, you have a capital gain of $1,500.
Note that these are just examples of one scenario and may defer on a case-by-case basis depending on the facts and situation.
9. Play-to-Earn Games and In-Game NFTs
Now, how about the NFTs that you can earn, buy and trade in play-to-earn games like Axie Infinity, Guild of Guardians, and Aavegotchi? How should you report these transactions?
If you earn tokens within a game that can be traded and sold and have real-world value, then they should be considered taxable as ordinary income.
Spending or Trading Tokens
Spending crypto to buy in-game items, spending in-game tokens for items, and trading in-game tokens are all taxable transactions. This is because each transaction is considered a sale that creates a capital gain or loss.
10. Axie Infinity Scholarships
The play-to-earn game Axie Infinity gained popularity in 2021. Some players have amassed a horde of fantasy creatures called Axie but only a handful can be played at any given time. To not let other Axies go to waste and to earn more in-game tokens, Axie owners (Managers) started loaning out Axies to new players (Scholars).
The Axie Infinity Scholarship has allowed Scholars an easy entry point into the game, as they can play without any upfront costs. Managers and Scholars typically split the rewards based on an agreement between the two individuals.
This is a legal gray area and the IRS has not issued specific tax guidance on the income earned from scholarships. However, the IRS would likely view this arrangement as a business partnership. Ideally, a business entity should be established by all entities before entering into this type of agreement. But in reality, it’s more likely that many players have entered Manager-Scholar relationships without taking this step.
With Axie Infinity Scholarships, the Manager creates an account and gives the Scholar limited access. As the Scholar plays with the Axies, rewards go into this account. The Manager is in charge of distributing rewards to their own wallet and the Scholar’s wallet. At a minimum, both the Manager and Scholar should report the distributed rewards as ordinary income. Income is taxable at the time that you have dominion and control over it.
NFT Gaming Business
Like some Filipinos in Cabanatuan City, people have quit their jobs to play NFT games full-time.
If games like Axie Infinity are a primary source of income, you may have a bona fide business with the ability to write off expenses. If you’re a Manager frequently loaning out Axies, it would be best to create a business entity so you can easily report your NFT tax.
NFT Tax For Creators
Minting NFTs is like creating your own product. And if you sell them, you’re basically running a business. So it’s best that you’ve registered a business entity with a separate business bank account to avoid additional tax responsibilities and protect yourself from liability. The following points will assume that you have a business entity and can claim expenses.
1. Business Tax Basics
When you form an LLC and choose to be taxed as a sole proprietorship or general partnership, then your income and expenses should be reported on Schedule C.
If there are multiple owners of the business, you should also file a separate business tax return to show each owner’s share of the income and expenses. This doesn’t mean any additional tax will be owed. Anything deemed an “ordinary and necessary” business expense can be included on Schedule C.
To find your taxable income, you pool your ordinary income from all sources—wages from a job, self-employment income, etc—and subtract your business expenses.
Keep in mind that self-employment income is subject to FICA taxes. These fund Social Security and Medicare and are roughly 15% of your self-employment income.
2. Minting and Selling NFTs by Yourself
When you sell an original NFT, the proceeds are considered ordinary income. Say you sell an original NFT for 5 ETH. If 1 ETH is worth $2,500 at the time of the transaction, then you have $12,500 of ordinary income to report.
Later, if you sell any of that ETH, you’ll have a capital gain or loss. You can deduct any gas fees required to mint an NFT as business expenses.
3. Minting and Selling NFTs with Others
If you’re collaborating with another artist or a group of people, be sure that each of you has set up a separate LLC with its own business account. That way, each partner will only have to report their own share of the income.
But if you’ve already sold original NFTs with a friend and neither of you have set up an LLC, the following is how you each might report on your tax returns.
Considering you have minted an NFT and sent it to your personal wallet. The NFT is then sold for 1 ETH. You and your friend, Carlos decided to split the proceeds evenly. So you sent 0.5 ETH to Carlos. You should report 1 ETH as ordinary income (business revenue) on Schedule C. The 0.5 ETH that you sent to Carlos can be reported as a business expense. Meanwhile, Carlos can report the 0.5 ETH received from you as ordinary income.
4. Burning NFTs Created
In some cases, you might need to burn an NFT because you made a mistake in the minting process, or you wish to lower the supply and increase the value of the remaining tokens. Since NFTs don’t create taxable income until the creator sells them, burning an unsold NFT wouldn’t create a capital gain or loss. The gas fees used for burning can be considered a deductible business expense.
How to Report NFT Taxes with ZenLedger
Do you feel burdened with the thought of having to dig up all your NFT transactions and calculate the tax returns? If so, it’s worth utilizing ZenLedger to help with your crypto and NFT taxes. With ZenLedger you would only have to follow 3 steps to file your crypto taxes.
1. Connect to your crypto exchanges and wallets
Start by importing your crypto trading history from all years you’ve been trading, and from all exchanges and wallets into ZenLedger. The software will automatically calculate the cost basis, fair market value, and gains/losses on your transaction history.
2. Review your crypto transactions
Easily calculate your capital gains and losses, and view tax liability for every cryptocurrency transaction. ZenLedger provides a resolution center to ensure that you’ve imported your information successfully. You can also review any historical cryptocurrency tax income such as mining, staking, lending, NFTs, or even exchange rewards like airdrops and forks!
3. Download and file your crypto tax forms
After reviewing your reports and ensuring accuracy, the final step is to generate your tax reports and file them.
ZenLedger addresses a key pain point for crypto investors by providing an easy solution for crypto tax preparation and portfolio management. With the ongoing tax reporting debate in Congress and the virtual currency question listed at the top of Form 1040, the current administration and the IRS have made it clear that they are taking crypto tax evasion seriously.
ZenLedger aggregates user transaction information across thousands of exchanges, wallets, and tokens into one simple dashboard, making it easy to calculate tax liability and make financial decisions. ZenLedger helps cryptocurrency investors and tax professionals stay compliant with integration support for over 400+ exchanges, 40+ blockchains, 30+ DeFi protocols, NFTs, and all wallets.
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