NFTs: How to Treat Capital Gains and Why Puerto Rico May Be a Crypto Utopia
- Posted: May 12, 2022
- Posted by: Travis Lynk
- Last Reviewed: July 1, 2022
Since 2020, non-fungible tokens (NFTs) have become mainstream in the world of trade and finance. High-profile sales of digital art and other digital collectibles such as CryptoPunks have broadened the horizons of digital investments. Nevertheless, while NFT traders are turning large profits, very few have considered the tax implications of such transactions. Here are a few things to keep in mind regarding how to treat taxes on NFTs.
What Are NFTs?
NFTs are digital representations of assets stored on a blockchain, like Ethereum. Each NFT contains a unique identification code and additional information that sets it apart from other NFTs. A particular NFT, therefore, has a unique value and cannot be duplicated or exchanged freely with another. This quality makes NFTs different from fungible tokens like cryptocurrencies, which are all identical to each other and may be used as a means of commercial transactions.
An innovation in the world of financial infrastructure, NFTs simplify sophisticated methods of trading and intricate loan systems for different asset types, from artwork to real estate, by “tokenizing” real-world tangible assets. Being able to securely hold the ownership rights of physical assets without the need of intermediate agents, they drastically improve market efficiency. It is no wonder that there has been a boom in the number of NFT investors since 2020. However, a key factor that is easy to overlook and yet cannot be escaped is taxes.
When Are NFTs Taxed?
Since NFTs are digital versions of assets, a capital gain or loss occurs every time you sell an NFT. The U.S. Internal Revenue Service (IRS) and the Puerto Rico Treasury Department taxes every transaction involving NFTs in accordance with their respective rules and regulations. There are three possible taxable events that may transpire when investing in NFTs:
- When you buy an NFT using a form of cryptocurrency such as ether (ETH), you will incur a capital gain or loss and this transaction will be classified as a taxable event. The taxation in this case will be on the price appreciation or depreciation of the ETH over the time you possessed it.
- You will also trigger a capital gain or loss taxable event if you sell an NFT for ETH. Then, you will owe taxes on the price appreciation or depreciation of your ETH between the time you bought and sold the NFT.
- Lastly, if you convert your NFT to U.S. dollars, this new taxable event will cause you to pay taxes on the price appreciation or depreciation of ETH from the time the NFT was bought to the time it was sold.
While there are multiple ways in which NFT investors are taxed on their capital gains or losses, NFT creators have to play by different rules. The creation of an NFT requires the creator to pay no tax at all, except for that which will need to be paid for receiving ETH once the NFT is sold.
How Are Capital Gains on NFTs Treated?
There is no strict consensus yet as to how capital gains on NFTs should be treated. The IRS has not formally decided the asset class for NFTs, and, consequently, they could receive various forms of tax treatment. If NFTs were to have the same status as cryptocurrency, then they would be considered property. On the other hand, they could be regarded as collectibles and receive a different kind of treatment in terms of tax.
The capital gains incurred due to the buying and selling of NFTs can be of two types:
- Short-Term Capital Gain occurs when an NFT is sold after a holding period of less than a year. This sort of transaction will be subject to short-term capital gains tax rates, which are the same as ordinary income tax rates. In this case, it does not matter if the NFT is viewed as property or a collectible, and the tax rate depends entirely on your specific tax bracket, ranging from 10% to 37%.
- Long-Term Capital Gain is a result of selling an asset which has been held for more than a year. The long-term capital gains tax rates differ depending on how the NFT is viewed. If it is considered property, then the rates vary from 0% to 20%, depending on your income; if it is regarded as a collectible, then you will have to pay a significantly higher rate of 28%.
Why is Puerto Rico a Blessing for Crypto Investors?
Puerto Rico may be considered paradise not only by lovers of nature but also by taxpayers. The Investor Resident Individual Tax Incentive, a part of the Act 60 program, offers U.S. citizens who have become a bona fide resident of Puerto Rico multiple tax benefits. This is a possibility because Puerto Rican residents are not taxed by the Federal Government but, instead, by the Puerto Rico Treasury Department.
According to the Act, individuals enjoy a 100% tax exemption on all short-term and long-term capital gains due to NFT sales made after the individual has become a bona fide resident of Puerto Rico. In case of pre-existing capital gains, the individual has to pay a tax rate of only 15% if the gain is realized within 10 years of establishing residency, and a rate of 5% if realized after 10 years.
The bottom line is that the rules and regulations pertaining to the tax treatment of capital gains on NFTs are still murky. However, permanently moving to Puerto Rico has enabled U.S. citizens to profit in this new and promising crypto market through the various tax benefits that the territory has to offer. If you are an investor in blockchain technology, then Puerto Rico is your tax utopia.
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