NFTs Are Proof That Tax Season Can Always Get Worse

Ever since the NFT boom began last year, non-fungible tokens—the blockchain-linked digital files that can contain, well, anything—have escaped easy definition. After an artist working under the name Beeple sold a piece of NFT artwork for $69 million at auction last March, pieces as varied as concert tickets and pictures of ape heads started trading for sums that would fetch houses. One thing about NFTs is clear at this point: Vast quantities of money are changing hands in confusing, often ridiculous-seeming ways.

And that’s before you think about tax season. The IRS’s existing tax guidelines can be applied to various NFT-transaction scenarios, but none was crafted with NFTs in mind. That means tax experts of all stripes are now second-guessing which assets and transactions to report, and how. They’re doing their best to lay out rules of thumb, but all they really have are educated guesses. The wild-west philosophy of non-fungibles is coming back to bite the people who own them, and nobody with the power to provide clarity has much incentive to do so.

One of those owners is Ryan Roylance, a sales director in Chicago and an early NFT collector. He began with NBA Top Shot, a series of digital trading cards released directly by the basketball league, then graduated to more creator-driven collections, such as Psychedelics Anonymous and Creature World. Since last June, Roylance estimates, he’s bought some 100 NFTs, and sold roughly 15.

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It’s been a gas. Only now, Roylance has to file his taxes, and he’s way out of his depth. “I know that profits are taxed as capital gains,” he told me in an email. “I know that the IRS guidelines say a purchase is a taxable event. And I know I am wildly unprepared for what that bill is going to be.”

Roylance’s predicament will be familiar to fellow NFT collectors, a cohort that propelled the digital assets from relative obscurity at the start of 2021 to an estimated $44 billion market by the year’s end. By April 18, this year’s extended tax deadline, every collector must somehow report their NFT dealings to the IRS according to a set of rules the agency never laid out, but is nonetheless enforcing. (The IRS did not respond to requests for comment.) A year ago, IRS Commissioner Chuck Rettig told the Senate Finance Committee that NFTs might become vehicles for tax evasion. The subtext to collectors: Report those goods, or else. But as for how to do it, the IRS has been mum.

Put charitably, the situation is a mess. “It feels a lot like the fox is guarding the henhouse,” Zac McClure, a co-founder and the CEO of TokenTax, a tax-accounting firm and software provider that caters to cryptocurrency holders, told me. As McClure sees it, America’s bloated tax-prep sector—of which he acknowledges he is very much a part—benefits from ambiguous IRS guidance. The less people can figure out on their own, the more willing they are to pay for help. That, McClure says, is not lost on the biggest accounting firms, whose outsize influence on the financial-services sector extends all the way to how the tax code gets written. McClure suspects that, for them, the confusion over NFTs is a feature of the tax code, not a bug.

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Then there’s the IRS itself, the woefully understaffed elephant in the room. “One of the only things politicians can agree on is to not fund the IRS,” McClure told me. The agency has been suffering budget cuts and personnel shortages for more than a decade, and thanks to COVID-related bottlenecks compounding already inefficient processes, it’s now mired in a massive backlog. Although this year’s tax season is well under way, the IRS is still working through an estimated millions of unprocessed returns left over from last year.

But even if the IRS had the capacity to overhaul the tax code, NFTs would likely be low on the agency’s list of priorities. “It’s usually when they want to shut something down that they’ll act on a more urgent basis,” Lawrence Zlatkin, the vice president of tax at the crypto marketplace Coinbase, told me. If the IRS was absolutely certain that NFTs were being used to create tax shelters on a massive scale, he said, that would spur quicker, more explicit rule-making. The IRS has blamed unpaid taxes on the crypto world, but it’s unclear whether fraud is happening on the blockchain any more than anywhere else. And even the IRS acknowledges that massive corporations and the über-rich drive the lion’s share of tax-evasion schemes, not casual traders in the cryptosphere.

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The people with the power to make life easier for NFT collectors are also not generally the same group of people who own lots of NFTs. Of the 16 percent of Americans who say they have ever bought, traded, or used cryptocurrencies, the overwhelming majority are under the age of 50, with the highest concentration among 18-to-29-year-old men. The seasoned tax lawyers who are in a position to shape policy tend to be significantly older. On the whole, according to Zlatkin, they seem to be less than enthusiastic about crypto, let alone adjacent blockchain entities like NFTs.

Whether or not they’re fans, tax professionals generally understand that cryptocurrencies such as bitcoin and ether function like any other commodity, and should therefore be taxed as such. “Currency” is a concept the financial sector knows how to work with. But unlike dollars and cents, NFTs are digital tokens that can represent almost anything: art, medical records, legal contracts, and so on. They occupy unfamiliar conceptual terrain.

These days, NFTs are mostly used as digital representations of artwork. As a result, the creation, sale, and purchase of an art NFT should mimic the taxation of any tangible artwork, Tony Tuths, the tax principal of alternative investments at KPMG, told me. For the creator who mints and sells an NFT, the sale would be ordinary taxable income, with the same asterisks (such as state sales tax and self-employment tax) that traditional artists have to deal with every tax season.

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For NFT buyers, things get a bit more complicated. In Tuths’s interpretation of the tax code, buyers would have a taxable capital gain or loss on the crypto they used for the purchase. If the currency loses value after the point of sale, they can write off a loss. But if an NFT buyer made the purchase using crypto they bought at a lower cost than its current value, the IRS classifies spending it as a gain.

Figuring out how much an NFT is worth is even more complicated. Alex Roytenberg, a CPA and a co-author of The NFT Tax Guide, told me that an NFT’s estimated worth usually depends on a combination of factors: floor prices—NFT-speak for the lowest amount a person might pay for a particular token based on current market activity—plus the rarity of a given collection and, naturally, overall demand.

Tuths says that the gains and losses on an NFT, while not explicitly laid out by the IRS, should be estimated by the fair market value of what was paid in crypto. Roytenberg told me that this figure is determined by how much the cryptocurrency was worth when it was spent, not its value at the time of tax filing. If, further down the road, the buyer decided to sell the NFT, they would be required to report the sale as a capital gain or loss. As with the sale of any art investment, that capital gain or loss would be taxed as a collectible. “An NFT is simply a wrapper,” Tuths said. “The tax will follow the real-life object taxation, not the digital wrapper.”

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Such a system would be straightforward enough, if only the IRS would confirm that it’s on board. For now, it’s a pain in the neck, though some collectors are optimistic that the confusion will prove short-lived.

“The tax worries will hopefully be a one time thing where I can be better prepared for next year,” Roylance said. Even after struggling to get square with the IRS, he has no regrets about diving five figures deep into the NFT space. He feels at home in his community of fellow collectors, and is prepared to pay the taxman whatever he must.