Collectors buying NFTs with cryptocurrency gains could face high tax bills

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Collectors buying NFTs with cryptocurrency gains could face high tax bills

People using crypto to buy NFTs could be in for a tax surprise. CNBC’s Robert Frank reports. For access to live and exclusive video from CNBC subscribe to CNBC PRO: https://cnb.cx/2NGeIvi

The NFT craze may come with a painful tax surprise for buyers and sellers who use cryptocurrencies, according to tax experts.

Sales of NFTs, or non-fungible tokens, have exploded in recent weeks, topping $500 million in 2021, according to NonFungible.com. Along with the sale of the $69 million Beeple NFT titled “Everydays: The First 5,000 Days” at Christie’s last week, and the $3 million NFT sneakers, NFTs of everything from NBA highlight videos to Jack Dorsey tweets have created a vast new market of blockchain-based digital assets to buy and sell.

Yet experts say buyers and sellers aren’t likely aware aware of an Internal Revenue Service tax rule that could come back to haunt them — and cost them a big chunk of their gains. It involves a steep potential tax on anyone who uses their highly valued cryptocurrency to buy NFTs, which experts say is most NFT sales.

“People’s knowledge of this tax in the U.S. is very poor,” said Shehan Chandrasekera, head of tax strategy at CoinTracker, a platform for tracking crypto portfolios and taxes. “I just don’t think people know about it.”

At issue is recent IRS guidance on using cryptocurrencies to buy an asset, including an NFT. As part of its principle known as “disposition of assets,” the IRS states that “if you exchange virtual currency held as a capital asset for other property, including for goods or for another virtual currency, you will recognize a capital gain or loss.”

Chandrasekera said this has major implications for the NFT craze, which is largely being fueled by collectors using bitcoin or ether to buy NFTs. For example, if someone bought a unit of ether for $100 in 2018 and it would worth around $1,700. If they used that ether unit to buy a $1,700 NFT, they might assume they pay no tax on the ether, since they’re simply using it to buy a good or service.

But under the IRS rules, the ether is a capital asset not a currency. So the holder would have to pay tax on the gain of $1,600 as part of the NFT purchase, since the act of exchanging it for another asset counts as a sale or “disposition.” So they would owe the IRS — assuming a top capital gains rate of 20% — a tax of $320. They might also owe state taxes, since many states like New York and California tax capital gains as income. (The rules around additional sales taxes in each state for NFTs are less clear.)

“You’re not spending currency, you’re spending an appreciated asset,” Chandrasekera said. “So just spending it creates a taxable event.”

If the NFT buyer later goes on to sell or “flip” the NFT at a higher price — which has become popular with NBA highlight videos and Beeple works — the seller would also pay a capital gains tax on any gain. And since NFTs are considered collectibles, they are taxed at the higher collectible capital gains rate of 28%.

In other words, both buyers and sellers of NFTs likely face tax bills they didn’t consider when investing in NFTs.

Another problem is inadequate reporting by companies at the center of the NFT boom. The big platforms that buy and sell NFTs, like Flow by Dapper Labs or OpenSea, can report a sale but they aren’t able to report a buyer’s gain on the crypto used for the purchase.

“They don’t know what a buyer originally paid for their Ethereum or bitcoin, they can only report the sale price of the NFT,” said Chandrasekera.

Tax experts say it’s almost impossible to know the total amount owed or unpaid to the IRS from the NFT boom. Some say it’s in the tens of millions, and perhaps hundreds of millions.

Granted, NFT buyers who simply buy bitcoin or ether, and instantly use it to buy an NFT would not face a tax. The tax only applies to those who buy NFTs with crypto that has increased in value since its purchase.

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