This is the second part of the two-part piece of this article. To read Part 1 of this piece, please click here.

IV. CAPITAL OR ORDINARY ASSETS

Gain or loss is treated as capital or ordinary, depending on whether the taxpayer is an investor or trader (capital), or a creator or dealer (ordinary). Ordinary losses are fully deductible; capital losses are subject to the special loss limitations that apply to capital assets. As a result, some capital losses might not be deductible. In addition, if the taxpayer holds a nonfungible token (NFT) as a personal asset—not for investment, or as part of a trade or business—losses can be permanently denied under rules that prohibit deductions for losses incurred on activities that are not engaged in for profit.[1]

A.  Ordinary Assets

In the hands of creators and dealers, NFTs are ordinary assets. Such taxpayers have ordinary income and loss on their NFT transactions. For creators, an NFT is likely to be an ordinary asset if (a) the creator’s personal efforts produced it and the NFT is “a patent, invention, model, design (whether or not patented), a secret formula or process, a copyright, a literary, musical or artistic composition, a letter or memorandum, or similar property”[2] or (b) if the NFT is a letter, memorandum or similar property created through the taxpayer’s personal efforts or is property that was prepared or produced for the taxpayer.[3]

An NFT is also an ordinary asset in the hands of an NFT dealer because the taxpayer is holding it as inventory or for sale to customers in the ordinary course of business.[4] An NFT dealer receives ordinary income and loss on sales of NFTs.[5]

For a taxpayer who is not a creator or dealer but, instead, uses the NFT in its trade or business, many additional tax issues need to be addressed, including rules under Code § 1231 for property used in the taxpayer’s trade or business. Gains might be capital and losses might be ordinary.[6] A taxpayer carrying on the trade or business of creating and selling NFTs[7] can deduct ordinary and necessary expenses. Those expenses would include the costs of creating the NFT, adding the NFT to a blockchain, and expenses incurred to sell the NFT. The creator’s tax basis is determined by reference to the creator’s costs and expenses in creating the NFT.[8]

B.  Capital Assets

1.  In General

NFTs held by traders, investors, collectors and personal users are treated as capital assets. Short-term capital assets are held for one year or less, while long-term capital assets are held for more than one year. This statement of black letter law, however, does not take into account all of the additional issues that need to be consider in addressing the taxation of NFTs. Some of these rules are mentioned in the remainder of this section.

2.  Collectibles

Collectibles are a unique category of items subject to a special capital gain tax rate. Although the Taxpayer Relief Act of 1997 reduced the maximum capital gain rate to 20%, it left the maximum rate at 28% for collectibles. Collectibles include alcoholic beverages, works of art, rugs, antiques, stamps, certain coins, gems and precious metals.[9] Because each NFT is unique, those that are similar to works of art and other collectibles are likely to be treated as collectibles. Those that are held for the long-term holding period would be subject to the higher 28% capital gain rate. Taxpayers need to be aware of this higher rate so that they properly report and pay their estimated taxes. Short-term capital gains are subject to the same tax rates that generally apply to capital assets, without regard to whether they would be treated as collectibles. Losses on the sale of collectibles are subject to the limitations on losses that generally apply to capital assets.

It seems likely that those NFTs that qualify as works of art and other collectibles will be subject to the 28% maximum rate. Other types of NFTs, however, such as NFTs that represent ownership of actual assets or provide the holder with services or experiences, might not be classified as collectibles and would instead be subject to regular capital gain tax rates.

3.  Personal Use NFTs

Personal use assets are neither held in a trade or business nor held for investment. Such assets include those used by taxpayers in hobbies and for recreational use.

A taxpayer’s intent is determinative as to whether an NFT is a personal use asset. A taxpayer’s NFTs would probably be treated as personal use assets if the activities are too infrequent to rise to the level of investment activities, or the taxpayer does not maintain adequate books and records to support an investment intent.

If a taxpayer wants its NFTs to be taxed as investments, the taxpayer has the burden of proving investment intent. Whether an activity is an investment turns on whether the activity is engaged in for profit, after considering all applicable facts and circumstances.[10] Treas. Reg. § 1.183-2(b) sets out nine factors for determining whether an asset is held for investment, without any one factor being determinative:[11]

1. The manner in which the taxpayer carries out the activity
2. The taxpayer’s expertise or that of the taxpayer’s advisors
3. The time and effort expended to carry on the activity
4. The expectation that the assets used in the activity may appreciate in value
5. Success in carrying on other activities
6. History of income and losses with respect to the activity
7. Amount of occasional profits, if any
8. Financial status of the taxpayer
9. Elements of personal pleasure or recreation.

If an activity produces a profit during three or more years out of a five-year period, the taxpayer is presumed to be in the activity for profit, unless the IRS proves otherwise.[12]

Under Code § 212, a taxpayer with a personal use NFT cannot deduct investment expenses because the taxpayer’s expenses are not incurred for the production or collection of income. A taxpayer can, however, deduct certain expenses to the extent that gross income from these personal activities exceeds the tax deductions otherwise allowable to the taxpayer without regard to whether the activities were engaged in for profit.[13]

Personal use assets are treated the same as other capital assets, with a few important differences:

• Gains are taxable as capital gains at the same rates as other capital assets.
• Expenses attributable to personal use NFTs cannot be deducted except for those allowed under Code § 183.
• Losses are not deductible (since tax changes in 2017).
• If a personal use NFT becomes worthless, losses are not deductible under Code § 165(c).

V.  THE SALE OR EXCHANGE OF AN NFT

A.  In General

Because NFTs are recorded and transferred on a blockchain, NFTs are typically purchased using cryptocurrency, not fiat currency. When a taxpayer purchases an NFT using cryptocurrency to make the purchase, both the seller and the buyer have engaged in a taxable barter transaction. The NFT (property) is acquired using other property (cryptocurrency).

Gain or loss is taxable when it is realized or sustained in the amount by which the value of the cash or property received on the sale or exchange is more (or less) than the amount of the taxpayer’s adjusted tax basis.[14]

A buyer who holds appreciated cryptocurrency can avoid paying tax on the purchase of an NFT if the buyer does not use the appreciated cryptocurrency to make the purchase. Rather, the buyer can acquire the required amount of cryptocurrency in the market and deliver the newly acquired cryptocurrency in payment for the NFT. There would not be any appreciation in the newly acquired cryptocurrency so the taxpayer would not have any gain or loss on the NFT purchase.

B.  Capital or Ordinary

Sellers have ordinary or capital gain or loss, depending on whether the NFT is an ordinary or capital asset in the taxpayer’s hands, as discussed above.

C.  Tax Basis and Amortization

Rules for computing the amount of gain or loss are contained in Code § 1001 and the regulations issued under that section. Although NFTs are intangible assets, the tax rules that allow for the amortization of the tax basis in certain intangible assets do not apply to creators of intangible assets.[15] This is because Code § 197(c)(2) allows certain taxpayers—other than creators—to amortize tax basis on an intangible asset that was (1) acquired by the taxpayer and which is used in the taxpayer’s trade or business or (2) is an investment activity described in Code § 212.[16] If an amortizable NFT becomes worthless, a deduction might be available.[17] Only those holders of NFTs used in a trade or business or held for investment can amortize the NFT’s tax basis, as long as they did not create the NFT.

D.  Installment Method

In an installment sale, the seller receives at least one payment in a tax year after the year in which the sale occurs.[18] Reporting income on the installment method might be available to certain NFT sellers, allowing them to recognize income as payments are received. Code § 453 and the regulations issued under that section set out the rules that must be met for a transaction to qualify for the installment method. The seller cannot be a dealer and the NFTs cannot be inventory for tax purposes.

E.  Licensing and Royalty Income

As of the date of this writing, the copyright and intellectual property ownership rights associated with an NFT are often retained by the creator, and coded into the NFT’s metadata. As a result, an NFT purchaser does not obtain the copyright or other intellectual property associated with an NFT unless those rights were explicitly transferred as part of the NFT purchase. Upon subsequent sales, license and royalty payments may be due to the creator or subsequent license holders. If so, these requirements would be reflected in the NFTs metadata. This additional revenue would be taxed as ordinary income.[19]

F.  Charitable Contributions

Because each NFT is unique and its value is only set by a willing buyer and a willing seller, it can be difficult—if not impossible—to value it. This makes it impossible for many people looking to make charitable donations to meet all of the necessary tax requirements. To overcome this valuation problem, creators that want to support charities are, instead, partnering with their favorite charities to auction off NFTs, where some or all of the proceeds benefit the charity.

VI. STATE TAX CONSIDERATIONS
Buyers and sellers of NFTs need to consider possible state and local taxation on their NFT transactions. Purchases and sales might trigger state income tax, sales tax, and use tax. As a result, taxpayers need to be aware that different tax rules might apply to capital transactions and those generating ordinary income and loss. Some states, for example, tax capital gains as ordinary income, while others do not; some states exclude intangible personal property from their sourcing rules, while others do not.