Non-fungible tokens (NFTs), first introduced in 2014, have exploded in popularity over the last two years in part because of the concurrent rise of cryptocurrency. These “one of a kind” digital assets can be bought and sold, but they do not have a tangible form that makes them unique. For Texas businesses and individuals interested in investing in this new type of asset, there are many considerations to make. One of the most important is the tax risks and advantages associated with this new world of property ownership. Even after 2021’s demand surge for NFTs fizzles out and returns to normal, there will still be plenty of opportunities for taxpayers and investors to cash in. Before diving in, it’s important to understand what NFTs are, how they can be used for investing, and the tax implications. To help clients, prospects, and others, Calvetti Ferguson has provided a summary of the key details below.
NFTs: the Basics
Unlike stocks and cryptocurrencies, which are interchangeable, NFTs are unique pieces of digital property. A brief list of NFT examples include:
- Artwork (in file formats like .JPG or .GIF),
- Digital collectible,
- Legal documents,
- Domain name, and
- Event admission ticket.
Once created, an NFT is secured on the blockchain with a digital certificate. They are typically bought and sold using cryptocurrency, mostly on the Ethereum blockchain. NFTs are secure in that ownership and record of transactions can’t be modified, though that’s not to say fraud can’t ever happen. No two NFTs are the same.
Some of the advantages include access to a wider audience for buying and selling, an opportunity to expand one’s investment portfolio, and the inherent security of blockchain. However, an NFT’s value is subjective and can easily change over time. And since the Ethereum blockchain is the only main avenue to buy and sell NFTs, users have experienced slow handling speeds and higher transaction costs. Another drawback for investors is that if a password or other credential to verify the asset is lost or forgotten, it’s impossible to reset or recover, and the asset would be worthless.
Currently, NFTs are most often associated with digital artwork and other creative assets and collectibles. Future uses for NFTs are expected to include event admission – a sports team in Ukraine is already experimenting with this – limited edition tangible merchandise, NFT-backed loans, gaming, and even proving ownership of items like cars or real estate. NFT creators can also begin to incorporate royalties into smart contracts. Since it’s powered by blockchain, NFTs are a decentralized system of asset ownership.
Still, decentralized does not mean deregulated.
How are NFTs Regulated?
NFTs are only lightly regulated because they are produced in such a way as to only have one owner at a time, they avoid the SEC purview of securities, ownership of which is designed to be spread out among multiple investors. If enough NFTs are made to be split up between multiple owners, it’s more likely the SEC would step in to regulate it. However, some NFTs are already offering revenue distributions to current holders.
In the future, they could be classified as either a commodity or a security, though it is important to note that as of this writing, the SEC views NFTs as neither. This article from Jones Day further explores the nuances and legal implications of both.
NFTs could at some point also fall under the jurisdiction of the Financial Crimes Enforcement Network (FinCEN) and/or the Office of Foreign Assets Controls (OFAC), and at least two states (Louisiana and New York) currently have tax laws governing cryptocurrency business activities – though now these laws do not extend to NFTs.
Investment Implications for NFTs
It’s important to note that an NFT’s value is two-fold: the asset itself and the smart contract that gives the owner verifiable rights to the asset. They can be a risky asset because the value can widely fluctuate. Their appeal is widespread, though. In 2020, NFT investments grew 299 percent. The first and second quarters of 2021 saw NFT trade volume exceed $500 million and $700 million, respectively.
The frenzied nature of NFT sales in 2020 and 2021 is, by all accounts, unsustainable. Many feel that NFTs are here to stay and point to an established technological infrastructure and increased commercial interest. In the investment world, there are almost limitless possibilities for token-based trade on a global scale.
Investors who can more easily spot market trends in media such as digital art or music could cash in on smart buys. As with any investment portfolio, diversification is key. If NFTs are part of an investment strategy, there should probably also be other types of cryptocurrencies involved to balance out the risk.
How is a NFT Taxed?
The IRS views NFTs as collectibles, which means they’re taxed as alternative investments just like artwork, a rare coin collection, or an autographed jersey from a sports star. As such, NFTs are subject to capital gains when sold. For collectibles, this rate is 28 percent if sold as a gain. High earners will also have to pay an additional 3.8 percent net investment income tax on the sale. And as mentioned above, state sales tax may come into play as well.
NFT investors need to report transactions to the IRS using Form 8949 (Sales and Other Dispositions of Capital Assets) and Schedule D (Capital Gains and Losses). Organizations would record NFT transactions at cost as an intangible asset in the financial statements. Selling or exchanging the NFT would depend on whether it’s classified as a capital or noncapital asset.
Because NFTs aren’t heavily regulated now, investors won’t automatically receive a 1099 for an NFT transaction. That doesn’t mean the IRS isn’t paying attention or will at some point.
Investors will need to maintain their own documentation in case an inquiry occurs down the road. Records like the cost basis and fair market value of the cryptocurrency used to purchase the NFT are essential to calculate capital gains or losses.
This valuation can be challenging. Value is almost purely subjective and largely psychological in nature; it’s based on whatever the market will pay for it in addition to other factors like scarcity and access. Further, valuation considerations change throughout the NFT’s lifetime; it’s different, for example, when an investor buys an NFT directly from the creator versus when it is later sold repeatedly.
Some NFTs may also have a life cycle that could affect their value. Current guidance is scarce, but taxpayers could consider using a 15-year straight-line amortization schedule.
NFTs, like other assets, can be donated to charity and deducted at their fair market value, though there are additional considerations regarding capital gains.
The investment opportunities in Non-Fungible Tokens continue to attract the attention of many Texas businesses and individuals. Since it is such a new form of investment, it is important to be aware of the potential tax issues and advantages which may arise from a transaction. If you have questions about the information outlined above or need assistance with a cryptocurrency tax issue, Calvetti Ferguson can help.