Being the most important digital asset today, non-fungible tokens (NFTs) have revolutionized the world of arts and investing. But what exactly are they, and how are they treated for tax purposes? This article provides an overview of “need-to-know” information regarding these exciting – and potentially risky – assets.
NFTs, or non-fungible tokens, are now the most important digital assets registered and transferred on the blockchain. It’s so hot that Collins Dictionary He called “NFT” the word of the year for 2021. Compared to last year, purchases of NFTs are up 11,000%, with final 2021 numbers not yet available.
The massive interest in NFTs shows a “unique artistic collision between art, technology, and commerce” that “has cut through the hype of Covid to become ubiquitous” (Allison Flood, “NFT Beats Cheugy to be Collins Dictionary’s Word of the Year,” November 24, 2021). Take, for example, the widely reported auction in March 2021 of an NFT auction of 5,000 individual pieces of digital art created by the artist known as Beeple. It sold for more than $69.3 million USD.
The first NFTs were reported sold in 2014 (Andrew Steinwold, “What is a Non-Foldable Token (NFT)?” October 7, 2019, Medium), but the NFT market didn’t really begin to take off until late 2017 when CryptoKitties NFTs “overcrowded The Ethereum network” (Joon Ian Wong, “The Ethereum network is swarming as people rush to buy cartoon cats on the blockchain,” Quartz, December 4, 2017). For the next couple of years, CryptoKitties were basically the only popular NFTs.
But in July 2020, the NFT market started to grow. Nearly $500 million was spent on NFTs in 2020, according to NonFungible.com, a website that tracks the NFT market. In the first quarter of 2021, NFT sales grew to over $2 billion (Robin Barber, NFT Statistics, Facts & Trends in 2021, Cloudwards, June 29, 2021). From November 1, 2020 to November 1, 2021, 5.5 million NFT sales worth $9.4 billion were reported – again according to NonFungible.com – with 3.1 million transactions “in the primary market” ( i.e. transactions representing the first time a particular NFT has been sold) and 2.4 million “secondary market” transactions (all subsequent sales of an NFT after its initial sale). Over the same time period, the NFT art market has grown by more than 800% (www.businessinsider.com.au/nft-art-market).
Like its significant growth, the NFT market has experienced dramatic fluctuations. Some months have huge sales and other months don’t. In May 2021, for example, the total value of NFTs sold was less than half of that sold the previous month (Market Insider May 18, 2021).
Interestingly, the creators of NFTs add physical goods as well as virtual goods and services to their NFT offerings. The tax and regulatory issues with these types of products can be very complex, and such products are beyond the scope of this article.
What is NFT?
Each NFT is a unique digital certificate (referred to as a token) which is a digital unit of data stored on the blockchain. It can be a representation of something (artwork, photograph, piece of music, toy or collectible), or it can be an original creation that exists only in digital form. NFTs are usually bought and sold using the type of cryptocurrency or digital tokens (collectively referred to as tokens) used or accepted on the specific blockchain. Initially, NFTs were created almost exclusively on the Ethereum blockchain and purchased using Ether (ETH) tokens. (Ether is the original token of the Ethereum blockchain, which has functionality for smart contracts. ETH serves as the primary “fuel” that powers all activity on the [the ethereum blockchain](“About Ethereum,” CoinDesk)).
Recently, an additional blockchain is being created to implement native NFTs for those blockchains (TW Lounge, “Choosing the Right Blockchain for Your NFT, Medium, 2020).
Once an NFT is created on the blockchain, all of its subsequent sales are tracked and recorded. The metadata of each token allows such tracking as it contains information regarding ownership and all other terms and conditions applicable to that token. Each token is not replaceable because its metadata cannot be duplicated or copied. In other words, an NFT cannot be exchanged for another NFT or with any other asset. Even if multiple replicas are created using the same content, each NFT has unique metadata. Once an NFT is registered on the blockchain, its source can be traced back, indicating “who previously owned, owned and created the NFT, as well as the many original copies” (Matthieu Nadini et. al., “Mapping” The NFT Revolution: Market Trends, Trade Networks, Visual Features, Scientific Reports, Vol. 11, 20902 (2021)).
The NFT cannot be broken down into smaller units or used in the same way as a convertible cryptocurrency such as Bitcoin (BTC) or Ethereum. (Convertible cryptocurrency has a value equivalent to real currency or serves as a substitute for real currency. In this article, the term cryptocurrency is used for “virtual currency,” “tokens,” and “digital assets.”) One NFT cannot be exchanged for another value, and the value of an NFT , if any, depends only on what someone is willing to pay the seller to buy.
NFTs are marketed through online marketplaces, including the popular OpenSea as well as Nifty Gateway, Rarible, SuperRare, and MakersPlace. Scott Nofer recently reported, “Of the $2.8 billion spent on NFT Markets in September , $2.72 billion has changed hands on OpenSea, according to data from crypto sites Dapp Radar and CryptoArt, compiled by The Blck.” On October 12, 2021, Coinbase announced that it was creating its own NFT marketplace. (“What does Coinbase’s entry into the NFT market mean?” For the Open Sea,” Quartz, October 14, 2021). Blockchain technology is hosted by all NFT platforms. Although OpenSea provides a general market, many other NFT markets are more specialized and cater to certain types of NFT, such as sports, visual arts or games .
An NFT participant needs a crypto wallet, such as MetaMask, to connect to the NFT platform. Once the participant obtains a crypto wallet, he or she can transfer the type of token required to purchase the NFT and can keep the NFT in the wallet. Common tokens used to purchase NFTs include ETH, dai (DAI), and solana (SOL). Dai is a decentralized stablecoin that runs on the Ethereum blockchain and is trying to maintain the value of $1.00. Unlike centralized stablecoins, Dai is backed by guarantees on the manufacturer’s platform. (“Dai (DAI) Price and Charts and News,” Coinbase.) Sol is a token that represents the “gas” that drives transactions on the Solana decentralized computing platform. (Solana Price (SOL) charts, Coinbase.) The term “Gas” refers to the amount of token required to perform a particular function on the blockchain network. NFTs are usually sold at auction (both online auctions and more recently through traditional auction houses), at a fixed price, or through a declining list price.
As a “smart contract,” the metadata embedded in each NFT allows relevant information to be visible and stored on the blockchain in a transparent and immutable manner. Metadata verifies ownership, portability (and if so, under what circumstances), and is associated with other digital assets, licensing fees, royalties, and any other payment obligations. Upon transfer, the NFT metadata ensures that the requested payments are accepted and confirmed, the correct payment amount is transferred to the seller, and any license fee or royalty amount is deducted from the payment paid to the seller and transferred to the NFT originator or owner of the intellectual property.
intellectual property rights
Several legal and regulatory issues regarding NFTs are currently unanswered. However, a number of open-ended questions “touch on copyright, intellectual property rights, and token ownership versus content ownership and authentication.” Due to the current lack of regulatory guidance, NFTs are “prone to copyright theft, unauthorized copying, fraud, and storage failures,” as well as “protocol risks such as hacking, platform risks related to governance, and high gas fees arising from the Ethereum network.” (Matthew Fox, “Market NFT is now worth more than $7 billion, but legal issues facing the nascent sector could hinder its growth, says JP Morgan,” Business Insider, November 19, 2021.)
Because NFT buyers only receive the rights granted to them as stated in the NFT metadata, creators can – and often do – retain their ownership of the content that forms the basis of the NFT. Artist Beeple, for example, has retained his copyright for the art underlying the NFT mentioned at the beginning of this article. As a result, Beeple can create and sell countless NFTs and other types of artwork from the same content.
How are NFTs taxed?
As of this writing, there are no specific guidelines from the US government on how to tax NFTs. In fact, NFTs are not mentioned in any of the IRS crypto tax announcements. Therefore, one must look to general taxation principles to determine, by analogy, how NFTs are likely to be taxed.
The first reference point is the 2014-21 Notice (2014-16 IRB 938) and 2019 Frequently Asked Questions (FAQs) which were the IRS’s first attempts to deal with exchangeable Cryptocurrency Taxes (IRS, “FAQ, 2019,” last updated March 2021). Convertible cryptocurrency has a value equivalent to real currency, can be purchased or exchanged for real currency, and can be used to purchase goods and services. For example, BTC and ETH are convertible cryptocurrencies. The IRS treats convertible cryptocurrencies as a property, not a currency. As a result, the general tax principles that apply to real estate transactions apply to convertible virtual currency. While Notice 2014-21 does not deal with non-transferable cryptocurrencies or NFTs, it is possible that many other cryptocurrencies and tokens are property for tax purposes.
Since NFTs are property and not real currency, such transactions are taxed as barter transactions. Both a buyer of an NFT and a seller of an NFT—not just the seller—are subject to taxable treatment when a buyer pays for an NFT with “ownership” such as a cryptocurrency or digital token. (The gain will be taxable if the fair market value of the cryptocurrency used to purchase the NFT is greater than the taxpayer’s tax base in that cryptocurrency.) The seller receives a taxable gain (or loss) equal to the difference between the seller’s tax base and the value of the property received in the payment NFT. (Losses are not deductible in certain situations. If the NFT is a personal transaction, the loss on disposal may not be deductible.)
On the other hand, if an NFT is purchased with a physical currency such as US dollars, then the seller has a taxable sale but the buyer does not. The seller’s gain (loss) is the difference between the adjusted tax base of the NFT and the amount of currency used to purchase it. If the purchaser uses property destined to purchase an NFT (that is, the fair market value of the property used to purchase the NFT is greater than the purchaser’s tax base), the purchaser has a taxable gain equal to the amount of that appreciation. The buyer’s tax basis for that property is appropriate for tax purposes.
Profit or loss is treated as capital or ordinary, depending on whether the taxpayer is an investor or a trader (capital), an innovator or a trader (ordinary). Ordinary losses are fully deductible; Capital losses are subject to special loss restrictions that apply to capital assets. As a result, some capital losses may not be deductible. In addition, if the taxpayer holds the NFT as a personal asset, and not as an investment (or as part of a trade or business), losses can be permanently denied under the rules prohibiting deductions for losses incurred on non-profit activities (Code § 183).