From the hype of Bored Ape Yacht club to the depths of crypto winter - NFT losses are estimated at around $25 trillion since it all came crashing down. But there might just be a silver lining in your tax bill. Learn how to use NFT losses to pay less tax with Koinly.
NFT tax loss harvesting
If you've read our Essential NFT Tax Guide for 2023 you'll know that NFTs are a taxable asset. Which means that your NFT can produce both a capital gain or a capital loss. In many cases, NFTs are trading at a loss. This presents a potential opportunity to lower your tax bill, thanks to what's known as 'tax loss harvesting'.
Our dedicated tax loss harvesting guide explains it all, but in brief, tax loss harvesting is a strategy whereby investors realize losses deliberately by disposing of their asset (by selling, swapping or spending it) in order to utilize those losses to offset against gains and reduce their overall tax liability.
In the current market conditions, many investors have decided to cut their losses on held NFTs and recoup at least some of it back in the form of a tax benefit.
But if you haven’t spotted it yet - there’s a key problem with realizing losses on illiquid NFTs, in that for some NFT projects, it’s become extremely difficult to realize your loss by disposing of your asset when no one wants to buy your NFT.
Fortunately, you have options. In Koinly's NFT Tax Loss Harvesting Guide we'll show you how to dispose of your worthless NFTs to reap the tax benefits.
How to dispose of worthless NFTs to realize losses
Follow these steps to dispose of your worthless NFT to realize a loss:
- Figure out which NFT(s) is worthless
- Figure out your disposal options
- Dispose of your NFT by selling, trading, gifting or burning it.
- Offset your losses
Let's look in-depth.
Figure out which NFTs are worthless
Knowing when to cut your losses isn't always easy, while limit and stop orders help managing gains and losses for tokens and coins, this is far less available for NFTs.
With NFTs, it generally all comes down to floor price. A floor price is the lowest price for a given NFT collection. If the floor price has plummeted way below the ATH, it may recover, but it's often a sign the hype train has run out of juice.
You can also look at this in combination with the bid/ask spread to see how liquid the market for your NFT is. In general, the wider the bid/ask spread, the more illiquid the market may be.
It will also depend on your specific circumstances. If you have no gains to offset this year, and think there's still a possibility your NFT may recover some value, hodling might be the right choice for you as you have no urgency to realize your loss. Meanwhile, if you've got gains, realizing your loss ahead of the end of the financial year may be more beneficial for your situation.
Use a crypto portfolio tracker like Koinly to help you keep track of both your realized and unrealized gains and losses.
Figure out your NFT disposal options
To realize your NFT loss, you need to dispose of your NFT from a tax perspective. The normal ways to dispose of a crypto asset include selling, swapping, spending or (depending where you live), gifting it. Of course, for NFTs many of these aren't an option, so you can work through your options to figure out the best disposal route:
- Option 1: Sell or swap your NFT to realize your loss.
- Option 2: Gift your NFT if you live in a country where gifting is a disposal of a capital asset.
- Option 3: Send your NFT to a burn wallet.
Sell or swap your NFT
If your NFT market is still liquid - this is the easiest way to realize your loss, even if you're selling your NFT for effectively nothing.
Another important note here is we recommend listing your NFT on a marketplace, as opposed to making a P2P trade. This is because of what's known as an arm's length transaction in the tax world. An arm's length transaction refers to a transaction in which buyers and sellers act without influencing one another and it's easier to understand with an example.
Let's say you and a friend both have an NFT you wish to dispose of o realize a loss - so you decide to trade NFTs with each other in order to realize your losses. This wouldn't be viewed as an arm's length transaction. Both have motives in their sale and purchase, and they're influenced by each other. In these instances, the experts say this kind of transaction doesn't meet the requirements for an arm's length transaction and as such, you'd not be able to reap the tax benefits.
Gift your NFT - but check where you live
Many tax offices view gifting as a means of disposing of a capital asset - including the ATO in Australia, the CRA in Canada and HMRC in the UK (unless you're gifting to your spouse). If you live in one of these countries, gifting your NFT to a friend, relative, or stranger, counts as a disposal and you'll be able to realize your loss.
Unfortunately, for NFT investors in the US, this isn't the case. Gifts are tax free in the US, under $16,000 a year for 2022. And even if you gift over that amount, you'll still not pay tax unless you're over the lifetime gift allowance of $12.06 million for 2022.
Which is why if you're in the US with an NFT with an illiquid market, you might want to opt for the third choice.
Send your NFTs to a burn wallet
Burn addresses have existed in crypto for some time to manage token supplies and more, but they're relatively new to the NFT market and popping up as a direct result of illiquid NFTs.
One such example of a project that allows you to effectively burn your NFT by disposing of it is Unsellable NFTs. Here's how it works:
- Connect your wallet to Unsellable NFTs.
- Select the NFTs you want to dispose of.
- Verify your collections.
- Sell your NFTs for $0.01 + any gas fees.
- Receive a receipt showing your disposal.
Unsellable NFTs is just one project of many that has popped up to help crypto investors dispose of their worthless NFTs, and you should always do your due diligence researching any projects you'll connect your wallet to.
A word of warning though, some crypto tax experts are concerned that loss harvesting apps will not pass the economic substance test set by the IRS. This common law doctrine denies tax deductions when the related transaction lacks an underlying economic purpose - in other words, if you're using a dedicated app for the purpose of tax loss harvesting, you're not conducting the transaction for a meaningful or substantial economic purpose. As such, there is the potential risk that these losses would not be deductible against gains. A potentially safer alternative is to find a burn wallet to send your NFT to - like the standard ETH burn address.
How to track your NFT losses with Koinly
In even better news, Koinly makes it even easier to track your entire tax liability.
With Koinly, you can track both your realized and unrealized losses and gains, helping you optimize your tax position for the financial year easily and ensuring you pay the least amount of tax possible. You can view your NFTs directly from your Koinly dashboard, making it easy to identify which NFTs you'd like to dispose of for tax loss harvesting purposes.
Sign up and try Koinly free today.
Can I burn an NFT to realize a loss?
Theoretically yes - but note, the IRS hasn't issued any guidance around this yet so it's without precedent currently.
Can I sell an NFT to a friend to realize a loss?
To realize a loss you can utilize, you need to make what's known as an arm's length transaction. This refers to a transaction in which buyers and sellers act without influencing one another. In other words, selling to a friend so you can claim a loss is not an arm's length transaction, while selling to a stranger on OpenSea would be.
Can I claim a rug pulled NFT as a casualty or theft loss?
No. The Tax Cuts and Jobs Act means casualty and theft loss deductions are not allowed, excluding in the instance of a federally-recognized disaster.
What are illiquid NFTs?
It's been a rough year for crypto investors in general, but perhaps for none moreso than NFT investors. As such, many investors are left with illiquid NFTs. These are essentially NFTs that cannot be disposed of easily, as the market demand to sell or swap them is low, or no, volume.
There are many NFT projects where the market is now illiquid – whether that’s due to a rug pull, as in the case of Frosties NFTs, or because the trade volume is so low after the hype that it’s impossible to sell your NFT on.
How many NFT losses can I offset?
As many as you’ve got. For US investors, the IRS says there’s no limit to the number of losses you can offset against your capital gains for the year, however, you do need to offset your losses - particularly from NFTs deemed collectibles - in a particular order.