Ever since the Cryptocurrency boom and bitcoin's emergence, people have been trying to find similar avenues for investments. Recently, you may have noticed the NFTs have been in the headlines consistently for the past few months. That might pique your interest and convince you that it's the right time to invest in an NFT.
However, before you make that decision, it's essential to ensure that you understand NFTs completely. Investing in NFTs may have entirely different consequences on your taxes and accounting.
What Is An NFT?
Many people are familiar with the term NFT by now. However, not many know the true definition of the word. Let's begin with what NFT stands for; it refers to a non-fungible token.
It's understandable that the term non-fungible token doesn't immediately clear things up. It's a digital token that's a form of cryptocurrency similar to Bitcoin. However, unlike a regular coin in a blockchain, an NFT is unique and can't be traded.
What makes them more special than a regular crypto coin is that they store much additional information. The ability to store extra details is what elevates NFT above common cryptocurrency. They can store just about anything. Recently, Twitter put an autographed tweet up for sale as an NFT.
How Do They Work?
An NFT works in essentially the same manner as a regular coin that's a part of the blockchain. However, what sets them apart is the ability to store extra information. That gives NFTs the ability to take the form of art, music, video, digital rights like loyalty and free digital collectibles, and anything else that you could imagine. The easiest way to understand how NFTs function is that they function similarly to art.
Each single NFT has value and can be bought and sold just like traditional pieces of art. The estimated free value of the NFT depends on the nature of the market and the level of demand. Factors like rarity can help increase the value of an NFT significantly.
Even though every NFT is unique, it's possible for copies of an original NFT to exist. It functions the same way as art does in real life. There are copies of NFTs available as well.
These function as a proper and valid part of the blockchain, but they won't have the same value as the original. It's safe from hackers and scammers because NFTs only receive value because they're a part of the blockchain.
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Where Do You Buy NFTs?
NFTs are available on several different platforms. Most people tend to choose the platform depending on what they want to buy. If you're looking for digital cards, the best bet is to visit a website like digitaltradingcards.com.
There are a few requirements that are necessary to help facilitate your purchases on digital NFT marketplaces. You're going to need a wallet that works with the platform, and along with that, you'll need to fill the wallet with the necessary amount of cryptocurrency. This cryptocurrency will cover the total transaction price, including any associated costs such as gas fees, which are usage-based fees required to process transactions on the blockchain.
However, as NFT pieces are starting to become more popular, they're starting to hit the mainstream auction houses as well. Beeple's Everyday – The first 5000 days at Christie's recently sold for an eye-watering $69.3 million.
The immense level of popularity and surging profit has seen multiple mainstream brands jump onto the NFT train. Every single day something new seems to enters the NFT market. It's an entirely new way to buy digital art and even digital real estate.
It's completely transforming the way the world views digital assets and even real-life assets. Even video games are starting to include NFTs as ways to purchase digital assets inside a video game.
As NFTs surge in property and all kinds of people are looking to make investments, it's essential to understand the tax implications. Many people are completely unaware and don't consider the potential tax implications that may arise while using high-value cryptocurrency to purchase NFTs.
Experts believe that the main issue is that a majority of people are entirely unaware of the tax on using high-value cryptocurrency to purchase an NFT. Let's take a look at the potential taxes investors can expect to pay after purchasing.
Recent IRS Guidelines
The main issue that potential investors face is the recent IRS guidelines on using cryptocurrencies to buy assets. These guidelines also include NFT, which are considered indefinite-lived, intangible assets. According to the IRS, the guidelines for NFT transactions center around the disposition of assets principle.
The principle implies that when you give virtual currency, which is held as a capital asset for another property, you'll experience a capital gain or a loss. That capital gain is then liable to taxation.
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When people are using cryptocurrency to make purchases online, they simply assume that they'll have to pay no tax because they're using it to purchase a good or service, which is understandable!
Under the IRS rules, the issue arises because cryptocurrencies and ether aren't currency but function as assets. So essentially, while making a purchase, they're engaging in the exchange of assets, which will lead to them experiencing a capital gain or loss.
Take, for example, a top capital gains rate of 20%. In that scenario, if someone purchases an asset worth $1600 transaction price using cryptocurrency or ether that's appreciated in value since they purchase, they'll be liable to pay $320 in taxes.
On top of that, they can potentially owe even more taxes depending on the state. Several states include New York, and California has additional taxes on capital gains in income. However, the rules around the purchase of intangible assets are unclear.
According to experts, it's nearly impossible to calculate the total amount of taxes owed to the IRS due to the NFT transaction booms. Some estimates indicate that it's worth tens of millions, or perhaps over a hundred million.
The IRS has recently made additional efforts to get taxpayers to report any potential income they may earn from cryptocurrency. They're sending out increasing amounts of notices to individuals that fail to report their crypto earnings in their bookkeeping.
How Do the Taxes Work For Creators?
The taxes aren't just applicable to the investors, but they apply to the sellers as well. However, sellers will only have to report their sales as ordinary income as part of their revenue streams. For creators in the business of creating NFTs, they can deduct business-related expenses to help reduce the tax bill they encounter.
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Accounting Guidelines for Investors
It's important to understand how these purchases work for investors, so you understand all NFT accounting needs and what goes in the balance sheet before making any purchases. Those who actively trade bitcoin are advantageous because the taxes work similarly to those on crypto trading.
The purchase and sale of NFT using cryptocurrency create taxable events for the investors. It's the profit from their activities that is ultimately subject to the capital gains tax.
An investor that purchases ether when it's valued at 1 ETH for ($200) is looking to make a purchase in the NFT market. The value of 1 ETH in January 2021 was around $2,000. If he were to make an NFT purchase using that 1 ETH, it would enter the bookkeeping records as a long-term capital gain of $1800! The accounting treatment for long-term capital gains falls under the 0%, 15%, or 20% tax bracket, depending on the investor's income.
In the case that the investor would then further sell the NFT down the line for $8,000, it would represent a capital gain of $6,000! It falls under the category of a short-term capital gain and is taxed under the ordinary income tax bracket.
High Income Earners Will Pay More Taxes
NFTs, due to their nature, could potentially fall under the category of "collectibles." That puts high-income earners in a disadvantageous situation when it comes to long-term NFT capital gains.
High-income earners are classified as single filers with a taxable income greater than $441,450 and married filers with a taxable income greater than $496,000. Those that earn more than the set limits are subject to a 28% tax rate on collectible gains.
Who's Exempt from The Tax
There are certain conditions where you're exempt from paying the tax on crypto-related purchases. If you purchase the cryptocurrency to then immediately spend on an NFT and it doesn't appreciate in value, you're not creating a taxable event.
In that event, cryptocurrency is treated as regular currency and not an appreciating asset. The principle of asset disposition doesn't apply.
International investors are also exempt from paying the taxes depending on the tax laws in their country. Many countries don't have additional taxes on capital gains, which puts them in an advantageous position.
Conclusion
The NFT boom means that an increasing number of people are looking to invest in digital assets. Their versatile nature means that they're available for all kinds of price points. From digital real estate to sports highlights, there's some form of NFT out there for everyone.
However, it's important for potential investors to consider the potential tax implications that can arise during NFT purchases.
The IRS is potentially looking to collect millions of dollars in unpaid taxes because of the NFT boom. For future investors, it's always better to be safe than sorry!