We live in a world currently flooded with multiple forms of investment options. In the digital era, the investment domain is full of surprises and unexpected advantages. NFTs (Non-fungible tokens) has emerged as one such unique investment choice for many investors. The eccentric functionalities and exclusivity of these tokens make them rather unique and unpredictable. It is why non-fungible tokens are today’s hot topic. As the current digital market is obsessed with NFTs, you might feel lured to know about their financial implications. So before getting all prepped up about fiscal obligations, let us take a look at what exactly is NFT.
What is a non-fungible token?
Assets can be divided into two forms– fungible and non-fungible assets. Fungible assets are swappable like money. These assets can represent almost all forms of real-life objects, for instance, diamonds, land, or even baseball cards. However, non-fungible assets are stored on a digital ledger and are not swappable. This feature is because it has unique metadata and identification codes that distinguish it from other tokens. Each token displays the traits of individual ownership.
These tokens have been a part of the investment world since 2014. But, their popularity spiked in the past few years, akin to cryptocurrency. NFTs could be used to record anything from our birth records to music videos. In other words, these tokens cannot be replicated, as it exists mainly on digital platforms, for example, unique artwork or video. Even social media posts and tweets can take the form of NFTs.
The science behind NFTs- how do they function?
Just like the cryptocurrencies, the non-fungible tokens employ the much eminent blockchain technology. These non-fungible tokens emerge or get minted as representations of intangible and tangible elements. They act as the digital version of physical collector’s items. It is important to note that NFTs come with exclusive ownership. Thus, any given NFT can have a single owner at any given point in time.
Although both NFTs and cryptos have the same kind of programming, these widely differ by how they get treated in the market. For example, cryptocurrencies like Bitcoin or Ethereum are easily exchangeable and tradable as they have equivalent value. In contrast, NFTs are not substitutable for one another as each represents an asset of varying worth.
Accounting for NFT
The legal status of NFT in many countries is that they do not get recognised as a tangible property registry like the Land Registry. As Blockchain does not provide a record of ownership, it becomes an issue when identifying proprietorship in the art market. It happens due to the nature of private keys, which can get relocated off-chain. Apart from this, it is also vital to show accuracy regarding ownership, as cases of art theft and forging payroll are increasing due to the inefficient management of accounting. Moreover, the vastness of digital platforms and the unthinkable freedom to stay anonymous make the process of maintaining transparency and bookkeeping a daunting task.
It is also crucial to understand the realm of rights that NFT grants to the asset holder who does not have access to token codes. The extension of NFT rights, its legal implications, whether you can use it as loan collateral, whether it possesses copyright are also brimming in the digital market. There are buried benefits, such as reselling an art item every time the artist can claim royalty payments. On the other hand, fractionalised ownership will give you the authority to trade shares of artworks on the secondary market.
Taxation compliances for NFT in the UK
In the UK, the NFTs are taxable in many ways. Let’s take an illustration to understand. An NFT can get considered as a taxable asset for capital gains and inheritance tax purposes. However, the present HMRC guidance only states specific measures on bitcoin and has not made any declaration on how tax treatments of NFTs would differ. The token’s location is crucial in the UK context, and according to HMRC, the beneficial owner of fungible assets will get evaluated based on the place of residence. Another critical factor is that it will receive similar treatment like antique piece trading cards or stamps. Hence, we can assume that the same will apply to NFT digital assets. However, the regulations in the case of tangible assets where the location can get identified might vary in the future.
As there is trading happening in NFT, it will fall onto the usual ambit of income tax. Through a series of trade test activities, HMRC will determine the nature of the exchange, and these tests are called the Badges of Trade. If the badges can be associated with these specific activities, those will be regarded as a trade. Thus, based on your profit, income tax will be applied to your NFT. Generally, the income tax rate varies from 10%-37%. Any profits you acquire from NFT trading get accounted for based on Generally Accepted Accounting Practices (GAAP). Additionally, the earned gain will also fall under the self-employment tax at the rate of 15%.
Capital gains tax
NFT gets equal treatment as a fungible asset like bitcoin. Thus, it is bought as an investment and sold for gains, and the conversion amount gets subjected to tax. But, on the other hand, any loss can be adjusted against further capital gains, which contain capital gains tax.
Selling one NFT for another NFT: If you have engaged in trading one NFT or another, it will be equally treated for tax purposes. For example, consider that you bought an NFT for $2,000 of ETH and sold it for a new digital asset worth $3,500 of ETH. It means you will get a taxable gain of $1,500.
Selling an NFT for cryptocurrency
On the other hand, if you bought a $10,000 NFT of ETH and then sold it for $15,000 of ETC, you will incur a $5,000. Such investments in NFTs will get reflected on your balance sheet as an intangible asset. Thus, in the case of reselling, it will come under the Corporation Tax Intangible Asset Regime.
The difference comes when you hold on to the asset for more than one year. Any NFT sold before the one-year threshold will come under short-term capital tax rates similar to your regular income tax rate. Since most cryptocurrencies and NFT platforms do not issue 1099 forms, it is vital to include all your transactions periodically.
Taxation compliances for NFT in the US
In the United States, section 1(h)(4) of the Internal Revenue Code integrated the rules regarding the gains from sales or exchange of collectables or NFTs. As per this rule, 28% of the profit on NFTs is taxable. On the contrary, most nations consider the bottom line as 20%. Additionally, similar to the gains from any sale calculated, the profits from NFT will account for 3.8% of net investment tax and other state taxes.
In contrast, what if the asset is in the hand of the original artist? In that case, NFTs will not get recognised as capital assets. Instead, they will come under ordinary income, which will get taxed at 37% for federal and state taxes.
As NFT does not get exempted in Section 197 of the IRC, a taxpayer can use the straight-line method to amortise them over 15 years, beginning from the month of its purchase. Therefore, if you comply with all the regulations, you will eventually become eligible to receive amortisation deductions in case of potential losses. On the other hand, when you are not engaged in the NFT trade for profit, Section 183(b) allows you to enjoy deductions under certain circumstances. It is determined through Section 1.183-2(a), which applies a rigorous process to decide the profit intention behind the sale. Subsection (b) enlists nine aspects to consider, and the responsibility of proof submission rests on the taxpayer.
Sale or exchange of NFT
The tax implications alter depending on whether you sell or exchange capital or non-capital assets. The creator of the asset often decides these characteristics. Thus, if you consider NFT an asset and use it for trade or business, it will be classified as a non-capital asset. Whereas, if the taxpayer sells or exchanges an asset used in the context of a company and earns an excess amount from it, the transaction will be categorised as a long-term capital gain. Nevertheless, if you experience loss equal or exceed, the law will treat it as ordinary gains and losses.
Manage your NFT treatments with accounting and tax preparation outsourcing services
The distinctive aspects related to NFT purchases and exchanges can lead to increased confusion and hassles. To cope with it, you can seek the assistance of tax preparation outsourcing and outsourced bookkeeping services. They will manage your tax and bookkeeping without much trouble and ensure efficiency to facilitate legal compliance. As you can expect reformations with such diverse digital assets in the coming years, it is vital to keep a closer eye on your tax and accounting management.