Checked “YES” to the Crypto Question on Form 1040? Have NFTs? Get Ready….  

It’s been no secret that the Internal Revenue Service (IRS) has cracked down on crypto.  With many more taxpayers investing in cryptocurrencies the agency has targeted crypto investors who are often not complying with the US tax rules (many unknowingly).

IRS “John Doe” subpoena activity of crypto exchanges has been successful with the biggies such as Coinbase and Kraken.  The John Doe summons is a very powerful IRS weapon against possible tax evaders whose specific identities are not known to the IRS.  It employs a very simple concept – put a name and get details on a currently anonymous person by forcing the place where they are hiding to provide it. Unlike the traditional summons used routinely by the IRS in its tax investigations which must identify the taxpayer whose conduct is in question, the John Doe summons generally directs the recipient (say, Coinbase or Kraken) to produce records identifying “all US persons” who conducted specified transactions.  The agency has been generally obtaining information on clients with more than US$20,000 in crypto activity.

Crypto “YES” or “NO”?

The current tax filing season required taxpayers to answer YES or NO to a question about cryptocurrency. The question appears right on the front page of Form 1040: “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” We are learning that the IRS has held up returns that answered “yes” to check if the taxpayer has actually reported any income from virtual currency transactions. So, with regard to these taxpayers, further questions may be forthcoming from the IRS.  As an aside here, I must admit that my blog piece has used the words cryptocurrency and virtual currency interchangeably.  They are not the same thing and a good primer is here.

What might happen if a taxpayer checks the ‘No’ box, but in fact has virtual currency transactions?  The history we now have from so-called FBAR enforcement indicates the IRS may be aggressive and take the position that the taxpayer “willfully” failed to disclose their interests and impose harsher penalties.

Essentially, the IRS position is that a taxpayer is charged with knowledge of the information on a tax return by virtue of signing it under penalties of perjury.  Under this IRS view (if taken by the agency with respect to crypto), since the taxpayer filed his income tax returns but did not fully and properly report his cryptocurrency, he has made a “willful” violation. Thankfully, this position is not automatically accepted by the courts.  After all, if the IRS view were to be accepted, it would render the distinction between “willful” and “nonwillful” penalties meaningless. Taxpayers are always required to sign their tax returns under penalty of perjury, but this does not mean that a violation was always willful if something was omitted or incorrectly reported.

NFT — You Say What?

Taxpayers trading regularly in cryptocurrency find it difficult to meet the tax recordkeeping and reporting requirements since the rules are currently very uncertain and complicated.  Current IRS guidance is sorely lacking and does not address many of the tax issues that are involved in the myriad crypto transactions that arise in the real world.  Take for example the latest blockchain craze in non-fungible tokens, or NFTs. What are these things? You may have read that a “digital-only” Beeple artwork sold at Christie’s for US$69 million.  The winning bidder got a NFT – not a sculpture, a painting, lithograph or any other physical asset. So, what is a NFT?

These are newer blockchain-created digital assets that have an indefinite life, are transferable and are being used to digitize a vast array of intellectual property including music, text (even “tweets”), artwork, images and all types of audio recordings.  Ownership and transfers of NFTs are registered online through the same type of blockchain technology utilized with some of the more familiar cryptocurrency assets, such as Bitcoin or Ethereum.

Here are some basics that may help in understanding the concept:  A fungible asset in the world of economics is something with units that can be readily interchanged. Money is a fungible asset.  You can exchange a $20 dollar bill for two $10 dollar bills and the money will retain the same value. Fungible items are interchangeable because they are identical to each other for practical purposes. Other examples aside from dollar bills or pound notes include bitcoins, commodities, common shares, or options. If an item is non-fungible, it has such unique characteristics that it cannot be interchanged with something else. A car, diamond, a painting or a sculpture are non-fungible since each is “one-of-a-kind” and each has unique qualities.

A NFT is a “one-of-a-kind” asset in the digital world. The NFT can be bought and sold in just the same way as any other kind of property, but the NFT has no tangible form of its own.  There is no sculpture, painting, manuscript or other tangible item involved. The NFT is a digital token akin to a certificate of ownership for a virtual asset or a physical asset. Right now, most NFTs are bought with Ethereum, but other cryptocurrencies are also beginning to develop NFT capacity.  A common misconception is that NFTs are a type of cryptocurrency. They do have similarities since they both have a stored digital record on a blockchain. The similarities, however, end there.  Each NFT has a unique value and cannot be exchanged for another of equal value.

If a taxpayer is involved with NFTs, it generally means the taxpayer has been receiving, sending, or selling a cryptocurrency.  If so, make sure the “Yes” box is properly checked on the virtual currency question on the Form 1040!

NFT – Some Nifty Tax Issues

Numerous creators are selling their NFTs in marketplaces such as SuperRare and NiftyGateway.  The IRS has not issued tax guidance to date with regard to NFTs, but without question, US tax issues arise for both those who create and sell NFTs as well as for those who buy and sell NFTs as investments.

Let’s look at the NFT creator selling on say, SuperRare.  If the creator sells that NFT for Ethereum, he will have ordinary income in the value of the Ethereum on the sale date. The income earned on the sale will be subject to US income tax.  It could be treated as “self-employment” income, much like earnings of any other artist and thus, subject additionally to “self-employment” taxes.  If the activity rises to the level of a trade or business, deductions of ordinary and necessary business expenses might be available to offset income.

An investor in NFTs will also have US income tax issues.  Most NFT investors make their purchases with cryptocurrency.  Purchasing an NFT using crypto will be treated as a taxable exchange of property and will trigger a taxable event.  The NFT investor will be viewed as disposing of a cryptocurrency, which is treated as property by the IRS pursuant to IRS Notice 2014-21.   If the NFT is later sold by the investor, how should it be taxed? The NFT is being viewed as the digital answer to “collectibles”.  If the NFT is sold, is it to be treated as a “collectible” subject to the higher 28% capital gains tax rate?

Is the NFT an “intangible”?  This would be important, for example, to the nonresident alien individual (NRA) who wishes to gift a US-situs NFT and not pay US gift tax on the transaction. A NRA is potentially subject to US gift tax only if the transfer is one of tangible property (gifts of intangible property are exempt), and, the transfer occurs within the US.  You can learn more about the US gift tax rules as applied to NRAs at my blog post here.

The IRS certainly has its work cut out just to keep pace with the rapid growth of technology.  Let’s hope we get more guidance soon.

Posted July 7, 2021

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