Taken from article originally published 27th September 2023

In a relatively short span of time, Non-Fungible Tokens (NFTs) have transitioned from an obscure concept to an common feature among sections of the investment and collector realms.

For those unacquainted, an NFT stands for Non-Fungible Token. To provide more context, a Non-Fungible Token signifies digital ownership of an asset, encompassing items like photos, videos, or other forms of digital media.

Consider this analogy: when an online image goes viral, undergoing numerous shares and edits, the NFT holder retains ownership of the original image. Much like the Mona Lisa, which exists online but resides primarily at the Louvre in Paris, the Louvre could be seen as the possessor of the Mona Lisa's NFT.

It's crucial to understand that an NFT represents ownership of the digital asset itself, not intellectual property rights. Crafting an NFT is feasible, yet not necessarily valuable.

NFTs gained traction in 2020 and swiftly experienced a boom, resulting in widespread online trading. Evaluating their suitability as investments, particularly concerning taxes, is of paramount importance.

The abrupt emergence of NFTs caught the Internal Revenue Service (IRS) off-guard, much like the sudden ascent of cryptocurrencies. Given that NFTs surged in popularity during the height of the pandemic in 2020, the IRS could be pardoned for its initial delay.

Since then, investors, collectors, and enthusiasts dealing with NFTs have been navigating a lack of comprehensive tax guidance. Some individuals treat NFT gains conservatively as ordinary income (subject to higher tax rates), while others neglect to report this income altogether.

Thankfully, the IRS has now (almost) come to a determination regarding the tax treatment of NFTs, aligning it with how other collectibles such as art, antiques, stamps, and coins are treated. The IRS statement reads:

"A nonfungible token (NFT) is a unique digital identifier that is recorded using distributed ledger technology and may be used to certify authenticity and ownership of an associated right or asset."

To elaborate, NFTs are governed by distributed ledger technology, like blockchain, which records, shares, and synchronizes transactions across multiple nodes. While NFTs and fungible tokens (e.g., cryptocurrencies) can both establish ownership on distributed ledgers, each serves a distinct purpose, as outlined in Revenue Ruling 2019-24.

Tax Code Section 408(m)(2) outlines collectibles for specific purposes. Acquiring a collectible within an individual retirement account (IRA) or a qualified plan's individually-directed account is regarded as a distribution from the account equivalent to the collectible's cost. Collectibles often don't receive the favorable capital gains tax treatment that other capital assets do.

Until further guidance is provided, the IRS intends to ascertain NFTs' treatment by utilizing a "look-through analysis." Under this approach, NFTs are classified as collectibles if their associated rights or assets fall under the tax code's collectible definition. For instance, a gem qualifies as a collectible under section 408(m); consequently, an NFT certifying gem ownership would be deemed a collectible.

While IRS guidance on NFTs is enlightening, it presents a challenge for NFT holders.

Capital gains from collectible sales (held over 1 year) are subject to a higher tax rate, specifically 28%. This rate surpasses the 15-20% range applicable to ordinary long-term capital gains. For many taxpayers, the 28% rate might exceed their ordinary tax bracket.

Though this guidance is preliminary and open for public input, it seems probable that this higher tax rate will be applicable to NFT transactions.

In essence, if an NFT is sold for more than its purchase price, the 28% rate applies to the gains.

In some instances, selling an NFT within a year of purchase might be beneficial if your US tax bracket is lower than 28%. This categorizes the sale as a short-term capital gain, thus subjecting it to your ordinary income tax rate rather than the 28% long-term rate.

For NFT purchasers, meticulous record-keeping of purchase costs and related expenses is vital. Upon NFT sale, these records determine your basis (the reference point for capital gain/loss calculations) and prevent taxation on the entire sale amount.

US citizens in New Zealand or countries without comprehensive capital gains tax systems should anticipate no foreign tax credit (to offset local tax) against US liability on NFT gains.

When contemplating investment avenues, seeking professional advice beforehand is crucial. Steer clear of tax pitfalls with expert guidance.