NFTs, or non-fungible tokens, captured the investing world’s fancy in 2021, as high-profile sales of digital art and other digital collectibles such as CryptoPunks soared in popularity and price. In total, $25.5 billion in NFTs were sold last year, according to research platform Dapp Radar, making it the most popular year ever for what many see as a new frontier in digital investments.

With all that speculation, some traders are turning a profit, while creators of NFTs are also realizing income for their virtual designs. But in this fast-emerging market, the IRS has yet to provide clear guidance on some issues surrounding taxes, creating further uncertainty.

So what should investors and creators know as they’re filing taxes and how do they respond? Here are six things that those involved in creating and trading NFTs need to know.

1. Investors and creators don’t owe tax until an NFT sells

If you’re creating NFTs or trading them, you won’t owe tax until the NFT actually sells. In the case of a creator, it’s the same as anyone who produces something, such as a painting. When they sell that painting, they realize revenue on the production but not before. That income will be recognized as ordinary income and taxed as any other pay from work would be.

In the case of NFT trades, traders will owe taxes if they sell an NFT for a profit. But as long as they hold the NFT and don’t sell, they can sit on their unrealized gains without paying taxes.

But the IRS has left it unclear how exactly traders should treat those gains, says Christopher Rogers, senior tax partner at Capital Fund Law Group in New York City.

“Among tax professionals, there are two schools of thought,” he says. “The first is that NFTs should be treated like capital gains. But the more predominant school is that they should be treated like collectibles and subject to a different tax regime.”

If you treat NFTs as capital gains, you’ll owe capital gains taxes on net profits. The silver lining is that if you’ve realized a loss on a trade, you can net that against any gains. In fact, you can realize a net capital loss of up to $3,000 each year and deduct that from your taxable income.

Rogers says that, depending on a filer’s income, this tax treatment is generally more favorable for individuals than treatment as a collectible, where rates could go as high as 28 percent.

2. Even NFT buyers may be creating tax liabilities

If you’re using cryptocurrency such as Ethereum to purchase NFTs, you could be creating a whole separate liability apart from the NFT itself. That’s because any transaction with crypto has the potential to create a tax issue, due to how the IRS has structured the rules about using it.

You’ll create a tax liability if you exchange virtual currency for goods such as NFTs or services that are worth more than what your cost basis is in the cryptocurrency. For example, imagine you purchased Ethereum for $1,000 and then spent it on NFTs worth $3,000, you’ve created a tax liability and you’ll owe tax on that transaction. (You could also create a loss.)

The IRS rules have made it onerous to use cryptocurrency as actual currency, and they extend to any transactions involving crypto, such as the purchase of NFTs.

3. You owe tax on NFT royalties and income, too

Some NFTs have embedded “smart contracts” that pay the original creator a royalty every time the NFT is sold. For example, the creator might sell to Person A, who in six months sells the NFT to Person B. Depending on the NFT, the creator may realize a royalty of a few percent on that second-hand sale by Person A, creating a tax liability for the creator.

Of course, that second-hand sale could also generate a taxable gain or loss for Person A, depending on exactly the cost basis and the sale price of the NFT (see point 1 above) as well as the value received for the cryptocurrency (see point 2 above).

Other newer types of NFTs might represent an interest in an asset and generate income over time. If you receive income from these types of NFTs, you’ll owe tax at ordinary income tax rates, Rogers says. It’s treated just like other regular income.

4. Other IRS rules around NFTs can be murky

The treatment of NFT income is in line with longstanding IRS rules on the issue of income. But what happens when a person is given an NFT? The situation is less clear.

For example, some big corporations have entered into the NFT space, including PepsiCo. In 2021, the soft-drink giant minted NFTs and gave them away free to consumers. Did this promotion create a tax liability for Americans who received the NFT?

Pepsi wasn’t answering that question, and specifically disclaimed any responsibility:

“Participants are responsible for paying any taxes owed as a result of participating … and should consult their tax advisors to determine the tax consequences to them.”

In other circumstances, a giveaway of something valuable can create a liability. If you win a car on a game show, for example, you’ll likely owe taxes on it. But experts say that how the NFT is treated is unclear: Could it be a dividend in circumstances and an interest payment in others?

Also unclear is the NFT’s value and what reference price could be used to create a cost basis. While that game-show giveaway might have a retail price, what’s the “real value” of an NFT? If an NFT entitles the owner to a real physical asset, is that object’s value the NFT’s real value?

Experts — and even PepsiCo — recommend that investors get tax help from a professional. Even so, the IRS rules appear to be unclear.

5. You still owe taxes even if you didn’t get a statement

If you’re trading NFTs and you make a profit, you owe taxes even if your NFT exchange or trading platform didn’t provide you a Form 1099 detailing your gains. Though 1099s are typical in more traditional financial markets and are routinely provided by stock brokers, they’re not yet required for NFTs or crypto exchanges, even though a few players do provide them already.

“Some of the big platforms such as Coinbase might send out 1099 statements, but most trading platforms won’t do so yet,” Rogers says.

You can use Form 8949 to report any sales of NFTs, just as you would if you were reporting trading activities in cryptocurrency.

Some cryptocurrency traders may be convinced that they don’t owe taxes on their gains, but the IRS has been clear that they do and has been tracking down scofflaws. Similarly, if you have a gain from trading NFTs, the lack of a 1099 doesn’t free you from your tax liability.

6. Watch out for sales taxes on NFTs

Many states may start to look closely at taxing NFTs at the point of sale, especially if recent tests in Washington state and Puerto Rico fare well, opening up sales taxes on digital art.

Washington’s state government is looking to draft an excise tax advisory that clarifies its position on the taxability of NFTs. In the interim, the state’s Department of Revenue advised that taxpayers should consider NFT transactions as taxable under the state’s sales and use tax code.

The territory of Puerto Rico has already rolled out a law that treats NFTs as part of digital products that are subject to sales tax. However, the territory’s Treasury Department is working through amendments on the new regulation before the regulations go into full effect.

Though some experts say that sales of NFTs already legally create a tax liability in states that tax digital goods, these states are receiving little, if any, revenue from them. So, states may adopt regulations before too long that offer clearer — and enforceable — guidance on NFT sales.

Bottom line

Even if the IRS hasn’t officially ruled on some aspects of NFTs and other digital art, it doesn’t mean it gets you off the hook for paying taxes on income from selling them or gains from trading them. In the absence of some clearer and more definitive statements from the IRS, those involved in the NFT market should stay alert as rules change and be careful that they’re following them closely.

Learn more: