NFTs are proof that tax season can always get worse
Since the start of the NFT boom last year, non-fungible tokens – blockchain-bound digital files that can contain, well, anything – have eluded easy definition. After an artist working under the name Beeple sold an NFT artwork for $69 million at auction last March, pieces as varied as concert tickets and images of monkey heads began to appear. exchanged for money that would bring in houses. One thing about NFTs is clear at this point: large amounts of money change hands in confusing, often ridiculous ways.
And that’s before you think about tax season. Existing IRS tax guidelines can be applied to various NFT transaction scenarios, but none were designed with NFTs in mind. This means that tax experts of all stripes are now guessing what assets and transactions to report, and how. They do their best to establish rules of thumb, but all they really have are educated guesses. The Wild West philosophy of non-fungibles is coming back to bite the people who own them, and no one with the power to provide clarity has much incentive to do so.
One such owner is Ryan Roylance, Chicago sales manager and one of NFT’s early collectors. It started with NBA Top Shot, a series of digital trading cards released directly from the basketball league, then moved on to more creator-focused collections, such as Psychedelics Anonymous and Creature World. Since last June, Roylance estimates, he has bought about 100 NFTs and sold about 15.
It was a gas. Only now Roylance has to file his taxes, and he’s well overwhelmed. “I know profits are taxed like capital gains,” he told me in an email. “I know the IRS guidelines say a purchase is a taxable event. And I know I’m completely unprepared for what this bill is going to be.
Roylance’s predicament will be familiar to fellow NFT collectors, a cohort that propelled digital assets from relative obscurity in early 2021 to an estimated $44 billion market by the end of the year. Before April 18, this year’s extended tax deadline, every collector must somehow report their NFT transactions to the IRS under a set of rules the agency never spelled out, but which it applies nonetheless. (The IRS did not respond to requests for comment.) A year ago, IRS Commissioner Chuck Rettig told the Senate Finance Committee that NFTs could become vehicles for tax avoidance. The subtext to collectors: report these goods, otherwise. But as to how to do it, the IRS has been mum.
In charitable terms, the situation is a mess. “It feels like the fox is guarding the chicken coop,” Zac McClure, co-founder and CEO of TokenTax, a tax accounting firm and software provider that caters to cryptocurrency holders, told me. According to McClure, the bloated U.S. tax preparation industry — which he acknowledges is an integral part — is benefiting from ambiguous guidance from the IRS. The less people can understand for themselves, the more they are willing to pay for help. That, McClure says, is not lost on the biggest accounting firms, whose outsized influence over the financial services industry extends to how the tax code is written. McClure suspects that, for them, the confusion over NFTs is a feature of the tax code, not a bug.
Then there’s the IRS itself, the woefully understaffed elephant in the room. “One of the only things politicians can agree on is not to fund the IRS,” McClure told me. The agency has suffered from budget cuts and staffing shortages for more than a decade, and thanks to COVID-related bottlenecks compounding already inefficient processes, it is now mired in a huge backlog. Although this year’s tax season is well underway, the IRS is still working on approximately millions of unprocessed returns left behind by last year.
But even if the IRS had the ability to revise the tax code, NFTs would likely be low on the agency’s priority list. “It’s usually when they want to close something that they act more urgently,” Lawrence Zlatkin, vice president of tax at crypto market Coinbase, told me. If the IRS were absolutely certain that NFTs were being used to create large-scale tax shelters, he said, that would spur faster and more explicit rulemaking. The IRS blamed the unpaid taxes on the crypto world, but it’s unclear whether fraud occurs on the blockchain more than anywhere else. And even the IRS acknowledges that big corporations and the über-rich are behind the lion’s share of tax avoidance schemes, not casual traders in the cryptosphere.
The people who have the power to make life easier for NFT collectors are also usually not the same group of people who own a lot of NFTs. Of the 16% of Americans who say they have ever bought, traded, or used cryptocurrencies, the overwhelming majority are under 50, with the highest concentration among men between the ages of 18 and 29. The seasoned tax lawyers who are able to shape policy tend to be much older. Overall, according to Zlatkin, they seem less enthusiastic about crypto, not to mention adjacent blockchain entities like NFTs.
Whether they are fans or not, tax professionals generally understand that cryptocurrencies such as bitcoin and ether function like any other commodity and should therefore be taxed as such. “Currency” is a concept with which the financial sector knows how to work. But unlike dollars and cents, NFTs are digital tokens that can represent almost anything: art, medical records, legal contracts, and more. They occupy unknown conceptual ground.
Nowadays, NFTs are mainly used as digital representations of artworks. Accordingly, the creation, sale and purchase of an art NFT should mimic the taxation of any tangible work of art, Tony Tuths, tax director of alternative investments at KPMG, told me. For the creator who mints and sells an NFT, the sale would be ordinary taxable income, with the same asterisks (such as state sales tax and self-employment tax) that mainstream artists must deal with each tax season. .
For NFT buyers, things get a little complicated. Under Tuths’ interpretation of the tax code, buyers would have a taxable capital gain or loss on the crypto they used to purchase.. If the currency loses value after the point of sale, they can reverse a loss. But if an NFT buyer made the purchase using the crypto they purchased at less than its current value, the IRS classifies it as an expense. Gain.
Determining how much an NFT is worth is even more complicated. Alex Roytenberg, CPA and co-author of the NFT Tax Guide, told me that the estimated value of an NFT usually depends on a combination of factors: price floors – NFT-speak for the lowest amount that a person could pay for a particular token based on current market activity, plus the scarcity of a given collection and, of course, overall demand.
Tuths says gains and losses on an NFT, while not explicitly defined by the IRS, should be estimated by the fair market value of what was paid in crypto. Roytenberg told me that this figure is determined by the value of the cryptocurrency when it was spent, not its value when you file your tax return. If the buyer later decided to sell the NFT, he would be required to report the sale as a capital gain or loss. As with the sale of any artistic investment, this capital gain or loss would be taxed as a collectible. “An NFT is simply a wrapper,” Tuths said. “The tax will follow the taxation of the actual items, not the digital packaging.”
Such a system would be quite simple, if only the IRS confirmed that it is on board. For now, it’s a pain in the neck, though some collectors are optimistic the confusion will be short-lived.
“Tax worries will hopefully be a one-time thing where I can be better prepared for next year,” Roylance said. Even after struggling to come to terms with the IRS, he has no regrets about plunging five figures deep into the NFT space. He feels at home in his community of fellow collectors and is ready to pay the taxman whatever he owes.