What do professional athletes, punk artwork and digital kittens have in common? They are all part of the expansion of valuable collectible assets using cryptocurrency and blockchain technology. You can collect digital items for your favorite baseball and basketball players and then sell them in online exchanges. You can also collect and “breed” your own designer CryptoKitties or purchase a digitally created punk portrait using blockchain technology. Investing in valuable collectibles can be both fun and lucrative. There are now thousands of buyers of these new digital collectibles and transactions involve millions of dollars worth of cryptocurrency. The current leader in digital collectibles is NBA Top Shots with an active marketplace where the highest asking prices are hundreds of thousands of dollars. What are the tax consequences of these new assets? Here are some concepts to consider if you have collectible assets, digital or otherwise.
Collectibles Taxed at Highest Capital Gains Rate
Unlike other investments, the IRS doesn’t treat collectible assets very favorably. The tax rate on most net capital gain is no higher than 15 percent for most individuals. Some or all net capital gain may be taxed at 0 percent if your taxable income is less than $80,000. However, a net capital gain tax rate of 20 percent applies to the extent that your taxable income exceeds the thresholds set for the 15 percent capital gain rate (i.e. $441,450 (single) and $496,600 (married filing jointly)). However, in the case of collectibles and some other types of gain, the maximum rate is 28 percent. For taxpayers in higher income tax rate brackets this may still be a lower tax rate, but not necessarily. Therefore, the applicable tax hit on any sale of collectibles should be considered.
Collectibles may be Subject to the Net Investment Tax
Individuals with significant investment income may also be subject to the Net Investment Income Tax (NIIT). This tax applies a 3.8 percent rate to investment income above the statutory threshold (i.e. $200,000 (single) and $250 (married filing jointly)). If an individual buys and sells enough appreciated digital collectibles this could add taxes on top of the already high capital gains rates. Therefore, these threshold limits should be considered when selling any collectible asset held for investment.
Buying Digital Collectibles with Cryptocurrency has Tax Consequences
Because the IRS decided that cryptocurrency is treated as a capital asset, like a stock, instead of as a currency they are taxed whenever they are sold at a profit. This includes using cryptocurrency to purchase your collectible asset. If you use appreciated cryptocurrency to purchase a collectible then you owe capital gains on any profit you realized. For example, If you bought $100 of Ethereum that is now worth $1000 and you use that Etherum to purchase a CryptoKitty you now must pay tax on the $900 of gain. Spending or selling cryptocurrency isn’t treated differently by the IRS. Also, if you received cryptocurrency as payment for your collectible then it will generally be treated as taxable income. The IRS is watching cryptocurrency transactions closely, as shown by asking all individual taxpayers to check a box on the front of the return if they had any cryptocurrency transactions that year. Proper reporting is key.
Donating and Inheriting Digital Collectibles
As digital collectibles increase in value and are held by more taxpayers they may wish to use them in the same way as other more traditional collectibles (i.e. artwork). Taxpayers are allowed charitable contribution deductions so long as the requirements under Internal Revenue Code Section 170 are met. If you receive your Cryptokitty or digital sports collectible as an inheritance then you would receive the benefit of a step-up basis in the property. Essentially, any property acquired by bequest, devise, or inheritance is the fair-market-value of the property at the time of the acquisition. Therefore, if your grandfather purchases a rare CryptoKitten or Digital Sports Collectible for $100 and it is worth $100,000 when he bequests it to you, you only pay tax on amounts above $100,000. There are, of course, various nuanced qualifications found in the Internal Revenue Code for this treatment. However, this basic notion of receiving a stepped-up basis in inherited property remains.
It is encouraging, and even fun, to see how the mainstream use of blockchain technology and cryptocurrency is changing the types of assets involved and how we think about traditional concepts involving the taxation of these assets. It is definitely a brave new world.