While crypto assets continue to demonstrate significant levels of volatility, there are several issues that tax practitioners ought to know about and understand. Specifically – and following what was a tumultuous tax season for 2020 – the tax status and treatment of crypto assets still have quite a bit of ambiguity and uncertainty associated with them. In 2020, alone, an entire new set of blockchain and crypto-related business models – specifically decentralized finance (DeFi) and non-fungible tokens (NFTs) – burst on the scene. On top of generating quite a bit of excitement and headline news stories, these new crypto-related business models have also generated a slew of tax questions.
As exhausting as crypto taxes might have been in the past, the continued differentiation of crypto asset applications means that there are new questions coming over the horizon. This is especially true for clients who may have only entered the crypto space during 2020 and inadvertently become involved with these new topics. As tax planning for tax year 2021 and quarterly filings kick into high gear, let’s dig into a few of the items that might be coming across your desk.
What are DeFi and NFTs?
DeFi is an attempt to replicate banking products and services, such as lending, borrowing, and earning interest, without the need for traditional financial institutions. Because numerous organizations have sprung up to provide such services, it’s not terribly radical to assume that some of your clients might have funds at entities such as BlockFi, Compound, and other firms.
NFTs are an interesting combination of digital collectibles and the ability to monetize and, now, license intellectual property. Doing a deep dive on NFTs would be an entire article, or series of articles, but summarizing it as intellectual property monetization makes sense for tax planning purposes.
Here are a few of the tax considerations involved with DeFi and NFTs:
DeFi is ordinary income. While there is currently no crypto-specific authoritative guidance related to DeFi, the general consensus has been that any DeFi-related earnings, coins, or tokens are going to be treated as ordinary income. There is an array of terms used to describe DeFi operations, including simply earning interest denominated in crypto assets, liquidity mining, block rewards, staking rewards, yield farming, and providing liquidity for mining pools. However, if your client is involved in these types of operations, there is a tax liability associated with them.
Earned versus receipt. A question that is being hotly debated right now among practitioners is when exactly a taxpayer has taxable income, and by extension, a tax obligation. This is especially pertinent for taxpayers who have received block rewards or staking rewards, or have been airdropped coins or tokens. The crux of the unresolved argument is whether the taxpayer has an obligation, even if these rewards or airdropped coins/tokens are locked up for a certain period.
Who owes for NFTs? At first glance, the question around who owes the taxes for NFTs should be relatively straightforward. Assuming an individual mints or creates the NFT and sells it to another individual, the selling price should serve as the basis for computing tax obligations. The NFT tax conversation, however, does not stop there. In recognition of the fact that simply treating NFTs as collectibles might not create a robust and sustainable marketplace, a new item has recently emerged: license rights.
If a taxpayer purchases an NFT, he or she owns the rights to this unique token, but not necessarily the underlying asset. Thus, this token might come with licensing rights. Dapper Labs was the first to create and market such an option, but other organizations have also recently caught up. The takeaway: If a client purchased an NFT, they may also have taxable income, depending on whether that NFT came with a licensing option and whether that option has been exercised.
Be proactive with your tax planning
The 2020 tax season was a grueling one, and tax planning for 2021 obligations does not look like it will be any smoother or simpler. That said, it is also worth keeping an eye on, and asking proactive questions about, whether clients have invested or become affiliated with crypto assets during 2021.
With the new and innovative use cases that have come onto the scene during the last year, including DeFi and NFTs, it is doubly important to make sure that all bases are covered. Crypto tax planning has always been a complicated matter, and it is shaping up to become even more complex moving forward. As always, clients will seek out practitioners and firms that are proactive, educated, and well informed to advise on these emerging issues.