CONFUSED ABOUT NFTs? ME TOO!!

I know some of you are still trying to wrap your minds around the whole concept of digital currency, Bitcoin wallets, cryptocurrency, crypto currency exchanges, etc. and now come NFTs. 

Non-fungible tokens (NFT) are a special kind of crypto-asset in which each token is unique – as opposed to fungible assets such as Bitcoin and dollar bills, which are all worth exactly the same amount. Because each NFT is unique, the are used to authenticate ownership of digital assets like artwork, recordings, or virtual real estate and  pets. 

In exchange for investing in an NFT, collectors do not receive any physical manifestation of the asset (artwork, recording, etc.). What the investor receives is a crypt-assets called an NFT. 

The word “fungible” is defined as: “(of goods contracted for without an individual specimen being specified) able to replace or be replaced by another identical item; mutually interchangeable.” An item identified as “fungible” is able to be substituted for something of equal value or use. Non-fungible tokens are defined as units of data that represent a unique digital asset that is stored, identified, and verified on the blockchain. 

NFTs are currently being used to sell a wide range of virtual collectible, including: 

• NBA virtual trading cards, 

• Music and video clips from EDM stars like Deadmau5, 

• Video art by Grimes, 

• The original “nyan cat” meme, 

• A tweet by Dallas Mavericks owner and entrepreneur Mark Cuban, or 

• Virtual real estate in a place called Decetraland (an open source 3D virtual world platform. Users may buy virtual plots of land in the platform as NFTs via the MANA cryptocurrency. It was opened to the public in February 2020 and is overseen by the nonprofit Decetraland Foundation.). 

(note from Editor: and if all of this is still Greek to you, know you are not alone! The research I did for this article was enlightening.) 

How does all of this get handled for tax purposes? 

So glad you asked as there is not yet formal guidance from the IRS, however, there are several guidelines you can follow. The tax treatment of intangible assets and virtual currencies are the best guidance available of how NFT transactions are to be handled at present. 

An NFT can be an original creation or a digital version of an existing physical asset. The act of creation is not a taxable event. The sale of the NFT by the creator in all likelihood would be considered ordinary income for tax purposes. However, the basis of an NFT that is a digital version of an existing physical asset raises some questions: Is it a completely separate new asset or is some of the basis in the physical asset appropriately allocated to the NFT offshoot? 

The subsequent sale of the NFT would likely be subject to capital gain tax treatment. If the IRS deems the NFT transaction to be a “collectible” as defined by tax law, the sale could be subject to the higher 28% capital gain rate on the sale of a collectible. It is also possible that a business could be undertaken to deal with NFTs, making the NFT part of inventory and subject to ordinary income tax rates. 

What happens if the NFT is sold at a loss? The investor would be subject to the net capital loss deduction limitations and passive loss rules. The holder of an NFT for personal enjoyment may be denied any loss allowance under the hobby rules. A corporation or pass-through entity may by subject to the applicable loss allowance rules under the Tax Cuts and Jobs Act. 

As more guidance is made available by the IRS in the reporting and tax treatment on the investment in NFTs, we will continue to monitor the situation.