nft tax Archives - ARTAEV AT LAW PLLC

Disclaimer: This article is not investment advice, tax advice, or legal advice. It is for informational and promotional purposes only. Do not take any action (including investments) until you have consulted with a professional about your specific situation.

At the end of 2021, Ubisoft announced its plans to add NFTs (Non-fungible Tokens) into Ghost Recon: Breakpoint. Players’ in-game weapons, vehicles, and other rewards will be tradable and sellable on a secondary market, adding a real-world value component to the game. Ubisoft will become the first mainstream videogame developer to incorporate NFTs into its video games, although other A-list developers like SquareEnix are also planning to transcend the virtual and real worlds through blockchain technology.

Ubisoft follows in the wake of some popular Play-to-Earn (P2E) games like the global sensation Axie Infinity. According to a January Business Insider article describing the P2E crypto gaming model, Axie Infinity increased the value of its native AXS cryptocurrency (an Ethereum token) by a staggering 18,000% in 2021. Metaverse platforms that promise fully functional virtual worlds in the near future like Decentraland and Sandbox also saw explosive growth. For example, Decentraland’s native MANA token increased in value by 4000%. The main draw of these virtual worlds is that they allow users all over the world to earn cryptocurrency and NFTs that tradable for mainstream crypto or fiat money. Obviously, the returns and growth potential have captured the attention of many.

However, real world earnings mean real world taxes. As crypto and NFT earnings become more and more mainstream, more tax payers will have to consider the tax implications of cryptocurrency. The IRS considers cryptocurrency to be property, which is subject to capital gains tax similar to stocks or bonds. While the IRS has had guidance on cryptocurrency transactions since 2014, NFTs are a much more recent phenomenon without official guidance. Which then creates a number of questions for P2E players about how their winnings are reported and taxed.

Do I owe taxes on my play-to-earn winnings?

Absolutely. Because play-to-earn games allow users to earn cryptocurrency or NFTs, which then can be exchanged for fiat currency (e.g. U.S. Dollars), these earnings are considered income. In general, real world earnings mean real world taxes; however, the way your earnings are taxed will depend on several different variables.

To understand how the IRS will tax play-to-earn gains, you must first apply a few basics:

Are all P2E earnings the same?

No. Although both cryptocurrency and NFTs exist on the blockchain, they are two very different things and have different tax implications. Non-fungible tokens or NFTs are unique digital-only objects or unique digital versions of real-world objects. This is basically computer code. Mostly associated with collectibles and art, NFTs use blockchain technology like cryptocurrency but can represent almost anything, including virtual real estate, in-game vehicles or weapons, and personalized avatars. In the case of Ubisoft’s Ghost Recon, the “in-game earnings” will be in the form of NFTs. Similarly, the Pokémon-like Axie creatures that players acquire in Axie Infinity are also NFTs. These in-game items are pieces of unique computer code stored on the blockchain. These NFTs can later be exchanged for other NFTs or cryptocurrency.

Cryptocurrency, however, is not a unique collectible, but rather, a virtual currency. The IRS, in its Frequently Asked Questions on Virtual Currency Transactions, defines crypto as a type of virtual currency or “a digital representation of value, other than a representation of the U.S. dollar or a foreign currency (“real currency”), that functions as a unit of account, a store of value, and a medium of exchange.” Play to Earn games like Axie Infinity will commonly use crypto. In fact, Axie Infinity, much like Decentraland (which is more of a general attempt at a metaverse, rather than a stand-alone game), developed its own crypto token (AXS). AXS is tradable and exhcnagable into more mainstream currencies like Bitcoin or Ethereum (which are easily convertible into fiat), giving them value – not only within the game sphere itself – but also within the real world.

How do P2E gamers make money?

To fully understand taxes, it is first important to understand the basics of the P2E economy. Play-to-earn games give players an opportunity to win both cryptocurrency and NFTs by playing a game. Most often, the game will use its own native token as an in-game currency. The in-game currency and NFTs have value on the secondary trading market. To use Axie Infinity as an example, a player can earn value in several different ways:

First, a player acquires NFTs known as SLPs (Smooth Love Potions) through monster battles, player versus player fights, or by completing daily missions and quests. The player can then exchange those potions for cryptocurrency or even cash by selling them on an NFT exchange or DEX.
Second, a player can use SLPs to breed rare magical creatures (NFTs) known as Axie. Depending on the Axie’s traits and characteristics, an Axie NFT can fetch $200 or more on the secondary market.
Third, a player can stake AXS tokens in exchange for a particular return rate. Staking with crypto tokens is akin to holding money in a certificate of deposit (albeit, much riskier).
Finally, the game may award tokens or NFTs via airdrops. Airdrops are giveaways that the game may send its players as part of random promotions or in return for doing specific tasks.

What (and how) the game pays the player determines the type of taxes that particular player will owe. Is the income in the form on an NFT? Tokens? Staking income? An airdrop?

Are there taxes on tokens?

Whether it is called a token, cryptocurrency, or virtual currency, a native game token is taxed like intangible property and is subject to capital gains tax. The IRS has had a consistent position on this since at least 2014. When you purchase cryptocurrency or tokens with fiat currency (e.g. U.S. Dollars) you do not pay tax on the transaction. So if you buy AXS directly for USD, this is not a taxable transaction. However, if you buy AXS for ETH or BTC or another cryptocurrency, stablecoin, or token, you have incurred capital gains because the IRS considers you to have sold cryptocurrency you have traded – even if the transaction is a direct exchange.

If you earn crypto tokens as a part of a Play-to-Earn game, the value of such crypto is taxable as ordinary income. Likewise, when you sell crypto tokens on an exchange, you are taxed on the gain (if any) just like you would be if you sold a stock or investment real estate. Again, when you exchange one cryptocurrency for another (for example, you buy AXS with stablecoin) the exchange is taxable. Accordingly, it is critical to keep accurate and clear records of every transaction involving cryptocurrency, regardless of gain or loss.

How are NFTs taxed?

The IRS has not issued definitive guidance on how NFTs will be taxed, but most experts agree that NFTs will probably be considered property like cryptocurrency and be subject to capital gains tax. When applying this framework, NFT investing generally involves three different taxable events:

The Purchase of a NFT with Crytpocurrency. Play-to-Earn games often require a buy-in. Axie Infinity, for example, requires players to buy three Axies to start, which currently costs around $1,500. If you “buy-in” with cryptocurrency like ETH, the IRS will consider you having sold the ETH and have earned income equal to the difference between your purchase value and sale value. The acquisition of the NFT itself is not taxable for the buyer – but, is taxable for the seller as income.
The Sale of the NFT in exchange for Crypto. Selling an NFT creates a taxable capital gain or loss equal to the difference between purchase and sale price. Simply put, if you bought an NFT for $1,500 and sold it for $2,000, you incurred a $500 gain. If you bought the NFT for $1,500, but sold it for a $1,000, you have a $500 loss that you can use to reduce your other capital gains or even your ordinary income up to a certain amount.
The Exchange of the Crypto proceeds for U.S. Dollars or other fiat currency. Like the sale and purchase of NFTs, the exchange of a cryptocurrency into USD or other fiat currency will also trigger a taxable capital gain or loss depending on the difference between the original purchase price of the cryptocurrency (or token) and the price at the time of its sale.

Currently, there are no tax exemptions or safe-harbor periods that allow traders avoid capital gains tax on exchange type transactions.

Are NFT investors taxed differently than NFT creators?

Yes. Let’s say you’ve found a way to farm massive amounts of SLP (Smooth Love Potions) in Axie; these are NFTs. The initial creation or the minting of the NFT is not a taxable event. However, the sale of the NFT is taxable. However, in this case, since you are the creator and also the seller, and you technically “did the work” to earn the NFT, the IRS will likely consider the proceeds from your NFT sale ordinary income for tax purposes.

Is staking taxable?

Yes. Sure, my staked sheep in Wolf Game owe a 20% tax to wolves on all sheered WOOL; everyone knows that. But do I also have to pay WOOL taxes to the US government? Yes. Many taxpayers currently consider staking the same as crypto mining income, which means they will owe taxes on the fair market value of the WOOL the moment they receive the WOOL in their wallet – not just when they sell it.

The IRS is currently in litigation regarding this issue. The question being considered is whether the cryptocurrency or token has taxable value at the time of minting ( in my case “shearing”) or whether it should be taxed only upon sale of the WOOL – similar to the way traditional manufacturing companies operate. (For example, factory owners don’t pay income tax on a manufactured table, even though that manufactured table holds value, until the table sells.) This is one of the many unanswered questions in the blockchain sphere that regulators are catching up to answer.

Are Airdrops Taxable?

Yes, generally airdrops are considered ordinary income based on the fair market value of the drop at the time you get it. As with everything else, crypto-related, be sure to keep detailed records of all your crypto transactions to make sure that you account for them properly.

So, Do I Owe US Taxes on My Earnings from Play to Earn Games?

Yes. Real world earnings mean real world taxes. Whether you earn NFTs, native tokens, or Bitcoin, those assets have value and therefore subject to income tax. You, as the taxpayer, are still obligated to report income just like you would be if the game paid you in stock. As always, it is important to consult a crypto tax expert to see how the specifics of your situation apply to current IRS guidelines.

Further reading:

https://artaevatlaw.com/2021/10/05/play-to-earn-games-legal/

Is Playing Video Games for Real Money Legal? It May Depend on the Game.

Ask the Crypto Tax Lawyer: What Are the Tax Implications of Cryptocurrency and NFT Investing?

2022 is a marquee year for anyone who took got involved in cryptocurrency during the 2021 market boom. The start of the new year means the start of tax preparation season and many individuals and companies are working to understand the tax treatment and implications of digital asset investments. In 2021, the IRS and the Department of Treasury announced increased efforts to track cryptocurrency transactions and enforce the perceived underpayment of tax in the crypto world. However, the government’s guidance has been limited. There are many uncertainties and questions in this evolving area of law. Read on for a summary of the key issues:

Cryptocurrencies Are Taxed As Property Subject to the Capital Gains Tax.

In the ever-changing world of crypto, one thing has stayed the same (since at least 2014): Cryptocurrency is property subject to the capital gains tax. In its FAQ guidelines, the IRS addresses a number of situations (such a hard forks and airdrops) to explain its position on basis and gain/loss calculation. If you received, sold, exchanged, or otherwise disposed of “any financial interest in any virtual currency,” the IRS requires you to disclose this on the first page of the 1040. If you check “yes,” expect to file a 1040 Schedule D (“Capital Gains and Losses”) and an 8949 supplement.

What does this mean in practice?

If you bought cryptocurrency in 2021 for cash and are holding it (or HODLING), there is no transaction subject to capital gains and nothing to report.

If you sold cryptocurrency for cash, traded crypto for another crypto, used crypto to buy an NFT, or paid someone for goods or services using crypto, you have a reportable capital gains transaction. The “gain” is the difference between the initial value (basis) and the sale value. If the period between acquisition and sale is less than a year, the short-term rate applies, which treats the gain as ordinary income. If the period is more than a year, the long-term rate applies and is either 0%, 15%, or 20% depending on your annual income level.

Exchanging crypto for other crypto (for example, you exchange BTC for ETH) is also subject to capital gains tax. The IRS treats the exchange as if you sold BTC for cash and used that cash to buy ETH. That means that any “gain” you realize on the sale of BTC is reportable and taxable, even if you use 100% of your proceeds to buy another cryptocurrency.

If you use crypto to buy an NFT or pay for some other goods or services, the IRS treats the transaction as if you sold the crypto for cash (incurring a capital gain) and then used the cash to buy the NFT or pay for the other goods/services.

IMPORTANT: Stablecoins are cryptocurrency and are also subject to capital gains tax and reporting requirements, even if in practice the capital gain on a stablecoin transaction is zero or even negative.

What if my corporation or LLCs bought, sold, or exchanged virtual currency or digital assets? There is no guidance to suggest that business entities are treated any different. Record and report crypto and other digital asset transactions like you would physical property or assets.

Best practice remains to record all of your cryptocurrency transactions in a spreadsheet or accounting software, including the type of asset, the basis price, the date, and any gain/loss (as well as transaction fees). Alternatively, bigger exchanges like Coinbase make reports available to their customers and integrate with several popular crypto tax reporting platforms.

The IRS Has Not Issued Guidance on Taxing NFTs, Utility Tokens, Security Tokens, or Any Other Types of Digital Assets.

What about NFTs? Or utility tokens that you may have bought and sold as part of a play-to-earn game? Or security tokens (STOs) that becoming a corporate financing alternative for high-tech startups? The IRS has not issued guidance or taken a position on any of these particular instruments. In its FAQ, the IRS defines “virtual currency” as follows:

Virtual currency is a digital representation of value, other than a representation of the U.S. dollar or a foreign currency (“real currency”), that functions as a unit of account, a store of value, and a medium of exchange. Some virtual currencies are convertible, which means that they have an equivalent value in real currency or act as a substitute for real currency. The IRS uses the term “virtual currency” in these FAQs to describe the various types of convertible virtual currency that are used as a medium of exchange, such as digital currency and cryptocurrency. Regardless of the label applied, if a particular asset has the characteristics of virtual currency, it will be treated as virtual currency for Federal income tax purposes.
https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions

Although this definition gives some guidance on the IRS’s position, it is still not clear whether NFTs and non-cryptocurrency tokens are “virtual currency.” For instance, NFTs (non-fungible tokens), represent a wide range of things. They can be art or basketball trading cards, but also can be virtual metaverse real estate or video game magical items. Some commentators have suggested that NFTs will be taxed at the 28% “collectibles” tax rate – but that hypothesis presupposes that all NFTs are “collectibles,” which is simply not true for all NFTs. At the same time, the IRS’s definition of “virtual currency” appears to require the asset to be used as a “medium of exchange,” which is also not true of all NFTs. At this time, the NFT tax analysis is best done on a case-by-case basis, with a careful evaluation of what the NFT represents and how the real-world equivalent would be taxed.

Utility tokens are digital tokens that have non-investment uses (or utility) and fall outside of the federal definition of “security.” Play-to-earn video games (like Axie Infinity and its imitators) use native digital tokens for in-game currency and rewards, but the tokens can also be bought and sold on a secondary market. These tokens are more in line with the IRS’s “virtual currency” definition – and while the IRS has not expressly opined that utility tokens are property subject to capital gains tax, they most likely are. In other words, keep records and be prepared to report your sales and exchanges at tax time.

Security tokens (security token offerings are called STOs) are the digital equivalent of traditional corporate financing instruments like SAFE notes or seed round equity. However, the IRS does not consider STOs (or any other tokens) as stock or securities, even if the Securities and Exchange Commission (“SEC”) does. In other words, you sell or buy a security token, you must do so either as a registered security or one that meets an exemption (for example under Regulation A+, D, or S). However, neither the investor nor the selling company gets to claim any sort of tax benefit from the “security” token – because the IRS likely treats it as property and not securities. This means that when you invest in a security token (even one that is registered with the IRS), the tax breaks or advantages that apply to the purchase and sale of stock do not apply.

The Wash Sale Rule Still Does Not Apply to Cryptocurrency, But Might Apply Next Year.

There is a silver lining to the fact that cryptocurrency (or other tokens) are not considered “securities” for the purposes of tax law. The wash sale rule does not apply to crypto and allows for loss harvesting to offset capital gains (and even up to $3,000 of ordinary income.) For example, right now crypto markets are down from their highs and many investors may be showing a loss. If you sell at a loss and buy the asset back immediately, you can claim the “loss” on the sale on your taxes. The wash sale rule – which is applicable to securities – requires a 30 days period before repurchasing the same or substantially the same security.

Congress is aware of and is working on closing this so-called “loophole,” but right now the wash sale rule likely does not apply. It is unclear whether you will be able to claim a loss on 2022 returns if you sell at a loss in 2022, but as of the date of this article, crypto investors can still take advantage of loss harvesting opportunities.

The 2021 Infrastructure Bill Has Not Killed Cryptocurrency.

In the summer and fall of 2021, there was a lot of concern in the cryptocurrency community over certain reporting requirements that Congress wanted to impose on cryptocurrency market participants. Although much of the “hype” was overblown, the main issues were with the new reporting requirements, the definition of “broker,” and how the reporting requirements would affect miners and other participants who are not in the direct sales business.

President Biden signed the Infrastructure Investment and Jobs Act on November 15, 2021, and needless to say, the U.S. cryptocurrency markets are very much alive and functioning. The Act extended the $10,000 cash reporting requirements to “digital assets” transactions, meaning that businesses that receive more than $10,000 in cryptocurrency have to file a Form 8300 with the IRS. The form requires the disclosure of the payor and payee’s name, address, Tax ID, and other information.

The new reporting requirement will not take effect until 2024. By then, expect the IRS and the Treasury Department to develop regulations and provide guidance to market participants, so stay tuned for future developments in this area. It is likely that the scope of the regulations will be limited, as $10,000+ crypto and NFT transactions are much more common than cash transactions, and (unlike cash) also may take place without the parties ever even seeing each other or meeting.

Additional regulation of digital assets in the U.S. is to be expected given their popularity and increasingly prominent role in the economy. However, the U.S. is not about to “outlaw” cryptocurrency, NFTs, token, or any other digital assets. The blockchain tech market is alive and well, but with better defined taxation and regulation may even become more mainstream.

The bottom line is that cryptocurrency markets and derivative digital assets are here to stay. Regulation is constantly evolving and there are many uncertainties for investors and companies working in this emerging market in 2022. Professional legal guidance is always a good idea.

Want to know more? Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.