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November 29, 2022


NFTs in your portfolio? If you are profiting, the IRS is not far behind.

The IRS does not view NFTs as vehicles for hidden or untaxable financial activities.

Bitcoin, Ethereum, Chainlink, Cardano, Stellar and other cryptocurrencies are assets that exist only digitally on the Internet, but the IRS views them as property for taxation purposes. We have written previously about IRS taxation of gain from virtual currencies and as we explained, the agency has historically been concerned about cryptocurrencies that are readily convertible to cash or cash-equivalent units.

Specifically, the IRS defines virtual currency for these purposes as that which has an “equivalent value in real currency, or that acts as a substitute for real currency.” Transactions involving virtual currencies that have crypto-to-cash convertibility are subject to the federal tax rules that apply to gains from those involving property and may come up in the wage or investment context as well as from other transactions.

New(er) kid on the block: NFTs

This IRS policy, however, only applies to fungible (identical in value and interchangeable) cryptocurrency, but the agency has not ruled out taxing other digital assets as they develop. A new kind of virtual token has evolved, the nonfungible token (NFT). In other words, these are unique and not interchangeable with other NFTs. NFTs can represent, for example, unique physical assets like real estate or artwork, or potentially intellectual property interests like those in licenses or written creative works.

Ethereum defines an NFT as a token “used to identify something or someone in a unique way … [like] collectible items, access keys, lottery tickets, numbered seats for concerts and sports matches, etc.”

ZenLedger explains that because an NFT is a “digital representation of a physical asset … the taxation of the asset will mirror that of [the physical asset] rather than of cryptocurrencies.” For example, if the NFT represents a piece of real estate, the tax rules relating to real estate transactions would apply.

Should you be concerned?

Failure to properly report taxable gain involving virtual currency may result in unpaid taxes, interest, penalties and in extreme cases, criminal prosecution.

The IRS is serious about the taxability of all kinds if virtual currency and has sent letters to taxpayers who have potentially unreported crypto income, urging compliance. The agency is using specialized data analytics to help uncover taxpayers who have failed to properly report it. The criminal investigation wing of the IRS has also ramped up its efforts.

This area of tax law is extremely complex and continually evolving. People who have owned or used NFTs or traditional cryptocurrencies without considering potential tax liability can speak to an experienced lawyer to understand their legal obligations such as potentially filing amended or late tax returns. Or, anyone already facing investigation, audit, collection or other enforcement actions related to unreported crypto-related taxable gain should also seek immediate guidance about how to respond and potential legal remedies. A tax lawyer can also negotiate with the agency on a client’s behalf and represent them in a dispute.

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