What is an NFT?
NFT stands for “Non-fungible token”, a non-interchangeable unit of data stored on a blockchain that can be sold and traded. In comparison, cryptocurrencies can be seen as ‘fungible’: replaceable by another identical item of the same value. The appeal of NFTs lies in the fact that the unit of data that represents their existence on the blockchain can trustlessly (i.e. not rely on any intermediary party) prove the asset’s attributes, scarcity and/or ownership history. Imagine if the Mona Lisa had an unalterable and publicly visible digital record to prove a) it was the original piece, b) the unique identifier keys of each of its previous owners and c) what was used to put it together. That is what NFTs bring to the digital world.
So, what makes an NFT an NFT, instead of just a meaningless bunch of pixels on someone’s computer screen? The answer is smart contracts. We’ve previously gone into detail about smart contracts and their place in the world of blockchain, outlining how you can code a smart contract to automatically execute particular functions when certain requirements are met. In regards to NFTs, smart contracts are used to create digital tokens on a blockchain that represent either digital or physical content, which can then be traded or sold. Using a smart contract, an NFT creator can programmatically designate how many of the particular NFTs will ever exist, the attributes of each, if they work in tandem with any other blockchain functionality and more.
We’re sure you’re all familiar with NFTs being used to trade digital artworks, but the use cases don’t stop there. Artworks, music, gaming, legal documents - the possibilities are almost limitless, as long as there is a need to prove ownership.
In recent years, we’ve heard of music creators being blindsided by poorly executed contracts with their agencies, resulting in their discographies being taken off popular streaming platforms to avoid paying what they see as unnecessary costs. Hypothetically, if these songs and/or albums had been minted to the blockchain as NFTs, the creators would have the ability to determine just how the royalties would work and any payments would be trustlessly sent directly to their accounts, without the need for a third-party to take a cut of any of the profits.
Another example of a benefit of using NFTs is programmatic utility. Using compatible smart contracts, designers can code NFTs to be redeemable for additional items, membership to otherwise blocked groups, tokenized rewards and more. Using gaming NFTs as an example, some blockchain games allow you to participate in their staking programs if your linked wallet holds one of their NFTs. To touch on a more real-world example, there have been some NFTs created that allow their holders to redeem rewards in person. Hypothetically, if you bought an NFT of a 1-of-1 pair of sneakers, you and only you would be able to go in-store and redeem the NFT for the physical pair of sneakers.
Finally, there has been much discussion about the potential to use NFTs in the creation of certain legal documents. Imagine if you could have a tokenized version of the deed to your home - you could prove your ownership at any point, from any location. In the event of selling the property, you could offset the usual amount of paperwork and trustlessly execute an agreement on the blockchain.
If you’ve made your way through this article, and you want to get in on the burgeoning world of NFTs - this is the paragraph for you! Please see below for a list of where you can currently buy and sell NFTs:
- Opensea: A peer-to-peer marketplace, which saw over $5BUSD traded in January 2022.
- LooksRare: A peer-to-peer marketplace that provides rewards for participating in their platform.
- Nifty Gateway: A marketplace that offers NFT drops on a tri-weekly schedule, featuring some of the biggest names in pop culture.
- Rarible: A community-owned NFT marketplace ideal for those just wading into the world of NFTs
- Immutable X: Built as an L2 to the Ethereum blockchain, this NFT marketplace empowers you to trade NFTs without any hefty gas fees.
- SuperRare: Touted as the NFT marketplace for creators, working with creators to curate and consolidate digital content.
- Axie Marketplace: An NFT marketplace designed purely for trading Axies, NFTs used in-game in Axie Infinity.
- Solanart: A curated NFT marketplace existing on the Solana blockchain.
Creating an NFT: In most jurisdictions, creating (minting) an NFT is not in and of itself a taxable event (unless there are gas fees involved in doing so, in which case the disposal of these fees would incur CGT tax). If you are the NFT’s creator, any profit made from selling the NFT will likely be treated as income, as are any royalties accrued through the NFT’s sales.
Buying an NFT: In most cases, if you buy an NFT with fiat currency, this won’t be seen as a taxable event. However, when purchasing NFTs from marketplaces, a user will usually do so with a cryptocurrency. In this case, there is a strong likelihood that the purchase of an NFT with cryptocurrency will be seen as a disposal event, and therefore may be taxable.
Selling an NFT: As with any sale of a cryptocurrency, this action will likely be considered a taxable event. There are two main ways selling an NFT might be treated from a tax perspective; a capital gains event or as taxable income. If you bought the NFT and sold it at a profit, any gain accrued will likely be treated as capital gain and therefore liable to CGT taxes.
Trading an NFT: If you’re swapping one NFT for another, this could be seen as a disposal event, similar to swapping one crypto for another. In this case, the swap would be subject to CGT taxes.
The Australian Taxation Office (ATO) recently released guidelines for the Tax treatment of NFTs. The ATO has stated that the tax treatment of NFTs follows the same principles as cryptocurrency. This means that NFTs are treated as Capital Gains Tax (CGT) Assets, and so the following activities will trigger a taxable event:
- Selling NFTs in exchange for cryptocurrency
- Exchanging one NFT for another NFT or fungible cryptocurrency
- Giving an NFT as a gift (unless it is to a tax-deductible gift recipient such as an Australian charity)
It is important to note that creating (minting) an NFT is not in and of itself a taxable event, but disposing of the NFT by selling or trading it will trigger a capital gains tax event. However, if you mint the NFT with an asset that has appreciated or depreciated since first purchased, this may trigger a CGT event on the value of the mint cost. Similar to cryptocurrency taxation, investors that make a loss by disposing of an NFT will trigger a capital loss that can be used to offset capital gains.
The IRS is yet to release any formal guidelines for the tax treatment of NFTs, so there are two options available when considering any NFT transaction activity for tax time: NFTs as property or NFTs as collectibles. These two categorizations have widely different ramifications on the owner’s tax obligations, so it’s best to talk to your local tax professional to decide what best suits your personal situation.
If NFTs are determined by the IRS to be collectibles, then there is a strong likelihood that any related transactions will incur a top 28% tax rate on any profits. If NFTs are instead determined by the IRS to be treated as property like other cryptocurrencies, they will be subject to a maximum 20% tax rate on any profits. Both of these tax rates are also dependent on the owner in question’s income threshold.
As mentioned above, it is best to work with a local tax professional to determine what avenue to take when dealing with your NFT taxes.
In February 2022, the HMRC made headlines for seizing three NFTs as part of their first-ever domestic enforcement action involving tax fraud and NFTs. This mission was supported by statements from both the HMRC and the UK government that they were actively working to put in new guidelines on the taxable treatment of NFTs, but at the time of writing this article, their latest manual outlines:
When you sell a digital asset such as an NFT for a profit, you’ll need to pay capital gains. Depending on how long you’ve held the NFT, you may benefit from a long-term capital gains tax rate. Swapping or gifting (excluding spousal relationships) is also a taxable event when it comes to NFTs, being viewed by HMRC as a disposal of an asset. If you’re the artist or originator of the NFT, you may be subject to paying income tax on any sales. If an NFT transaction appears to fall into a “grey area” tax-wise it may be subject to a series of tests known as ‘The Badges of Trade’ by HMRC. As mentioned in the previous section on the US tax treatment of NFTs, it is best to work with a local tax professional to determine what avenue to take when dealing with your NFT taxes.
As with the other regions discussed in this article, the CRA has yet to issue any specific guidance on NFT taxes. Until such guidance is released, officials advise treating digital assets in (the form of NFTs) in the same way other cryptocurrencies are.
If you’re selling an NFT you’ve personally created, it will likely be subject to income tax. If you purchased an NFT from someone else and then sell it for either a profit or a loss, the transaction will be subject to Capital Gains Tax. Similarly, if you buy an NFT with crypto, it will also be subject to CGT tax. If you purchase the NFT with fiat currency, this will likely not be subject to taxes.
In the CryptoTaxCalculator platform, we have numerous categorization options designed specifically for NFT activity.
If you’re an NFT creator, you can categorize any minting transactions as ‘Mint’ and any royalties earned as ‘Royalties’. If you’re a general NFT trader, then any buys, sells and/or trades will be automatically categorized as such.
We also recognize transactions from large NFT marketplaces so you can quickly identify that one particular NFT you bought off of Opensea 11 months ago - how good!
Example 1: Selling an NFT
Bob bought a Bored Ape in April 2021 for 0.08ETH ($190 USD at the time).
He watched the hype build around the NFT project and decided to sell when his Bored Ape was worth 20 ETH ($50,000 USD at the time) in December 2021.
Bob’s cost basis would be $190 USD. Upon selling his Bored Ape, he made $49,810 USD in profit. In most countries, this profit will have Capital Gains Tax applied.
Bob imports his MetaMask wallet address that held his Bored Ape into CryptoTaxCalculator. Both the purchase and the sale of the NFT are tracked and categorized as a ‘buy’ and ‘sell’ in-app so that the correct values are carried over to the final report for the 2021 financial year.
Example 2: Minting an NFT
Bob isn’t just into the hottest NFT projects, he likes to get in at the grassroots level as well. He spots an NFT project that looks promising and decides to mint one of their NFTs on release day for 0.05 ETH. Once Bob imports his MetaMask wallet address that he minted this particular NFT on, CryptoTaxCalculator will categorize the outgoing ETH as a ‘sell’ and the incoming NFT as a ‘mint’ (a term which is generally not recognized by tax authorities, so the app will apply the same taxable characteristics as a ‘buy’). As buys aren’t usually a taxable event in most tax jurisdictions, this mint value of 0.05 ETH will be tracked for any future cost basis queries.
Example 3: NFT Royalties
Bob also happens to create his own NFTs. The beauty of the blockchain means that NFT creators like Bob can reap the rewards of their efforts automatically. With NFT Marketplaces like OpenSea and Rarible giving creators the option of plugging a royalty fee into their NFT listings, any payments can be provided automatically to the creator upon secondary sales.
CryptoTaxCalculator recognizes the importance of tracking NFT royalties for tax purposes, and as such, has a categorization option purely for this purpose. Any transactions which are deemed royalties from secondary NFT sales can be categorized as such so that they can be appropriately segmented.
After Bob has imported his MetaMask wallet address into CryptoTaxCalculator, the algorithm will automatically apply the ‘Royalties’ categorization to any secondary sales linked to the specific NFT tokens.
Example 4: Buying an NFT
For the majority of NFT Marketplaces, you’ll be purchasing NFTs with a cryptocurrency. In most tax jurisdictions, transacting crypto in exchange for another cryptocurrency token (or an NFT) is seen as a disposal event, and would likely be considered taxable.
Let’s say Bob has his eye on a CryptoPunk after selling his Bored Ape, so he buys CryptoPunk 9393 for 200 ETH in July 2021. The ETH he uses to buy this CryptoPunk was obtained in January 2021 at a price of $3000 USD for 1 ETH. This means that his cost basis was $600,000 USD. The value of ETH when he bought the CryptoPunk was $3500 USD for 1 ETH, meaning the fiat value was $700,000 USD at the time of purchase. This means that to calculate his capital gains, Bob would need to subtract $700,000 - $600,000. Bob would then likely have to pay Capital Gains Tax on this remaining $100,000 USD.
CryptoTaxCalculator will track all buys, sells, and cost bases for all of your crypto transactions. This means that when buying an NFT, you won’t have to manually calculate the taxable amounts like Bob would’ve had to in the example above.
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