From digital art to in-game digital assets, the recent emergence and rising popularity of non-fungible tokens (NFTs) is leaving individuals with a plethora of tax questions. This article is intended to provide some clarity for those looking to invest in this evolving asset class.
What is an NFT?
An NFT is a one-of-a-kind digital token that represents ownership of a unique digital item that can be bought and sold on the blockchain. Unlike fungible digital assets, such as Bitcoin or Ethereum, NFTs cannot be substituted with another identical token, creating digital scarcity. A Bitcoin can be substituted for another Bitcoin and the rights associated with both are identical. In most cases, the rights or traits associated with each NFT (represented in a “smart contract”) are what make these tokens unique. For example, NFTs include digital authenticity of artwork, digital ownership of a collectible or tradable card, and exclusive access to a real-life or virtual experience.
How Are Individuals Interacting with NFTs?
As described above, NFTs may represent digital art or other digital assets held for investment. However, NFTs are also popular in the gaming world. NFTs used in play-to-earn (p2e) games may be purchased or rented to earn rewards within the game, further unlocking additional features of the game, such as experiences or digital goods. A popular p2e blockchain game, Axie Infinity, allows players to breed or purchase “Axies,” which are magical creatures used for battling other players in the game. Each Axie is a unique NFT that may be used in the game, or the Axie token (the native token within the Axie Infinity ecosystem) may be sold on a digital asset exchange.
How Can an Investor Purchase an NFT?
For those looking to enter the NFT market, there are multiple online platforms where these assets are available. Secondary marketplaces such as OpenSea and Rarible allow individuals to become creators, sellers and purchasers of NFTs on the Ethereum blockchain, meaning investors must own ether (ETH) in a compatible wallet to transact. The large majority of NFTs exist on the Ethereum blockchain; however, NFTs also exist on other blockchains, such as Solana and Tezos. A digital asset wallet allows individuals access to their assets on the blockchain and creates and holds the private key required to authorize transfers on the blockchain. NFT purchasers commonly use Metamask as their digital asset wallet.
U.S. Tax Considerations for Acquiring and Disposing of NFTs
Acquiring an NFT
Generally, the initial purchase of the NFT requires the purchaser to exchange their ETH for the NFT. Depending on the purchaser’s holding period and basis in the ETH, this may result in taxable income. For example, if the purchaser acquired two ETH in November 2021 for $8,500 and transferred them both to purchase an NFT in December 2021 when the fair market value was $9,000, the purchase would result in $500 of taxable income. This is the difference between the purchaser’s basis in their ETH and the fair market value of the NFT they received. If the ETH was held for investment and not as a trade or business asset, the purchaser should recognize short-term capital gain. That gain is taxable at ordinary income rates, with the highest rate currently at 37%.
If the user receives the NFT as a reward in a play-to-earn game, they should recognize ordinary income based on the determined fair market value at the time of receipt. Generally, the NFTs earned within these games are tradable on NFT marketplaces that may provide insight on the fair market value based on recent activity within the collection.
Transferring or Selling NFTs
There is no like-kind exchange treatment to defer gain recognition when selling an NFT. Any sale of an NFT, which should be considered property for U.S. tax purposes, results in gain or loss recognition. Most typically, NFTs are purchased and sold as capital assets, subjecting them to capital gains tax treatment. In some cases, the NFT may be considered a collectible (such as a representation of valuable artwork, trading card, autograph, etc.) and will be subject to the 28% collectible gains rate if held for more than a year. If held for less than a year, it would be subject to the short-term ordinary rates, regardless of collectible status.
If an NFT becomes worthless, the owner may dispose of it by transferring the asset to a “black-hole” wallet to recognize the loss. A black-hole wallet is one with no private key, meaning the assets held within the wallet are unable to be recovered or transferred. This action effectively abandons the worthless NFT, allowing for loss recognition.
Needless to say, possessing a one-of-a-kind digital token can be an exciting opportunity for many investors. But as with any evolving asset class, it will be important to keep a close watch on the simultaneously emerging tax guidance.
Contact Matt Rager at firstname.lastname@example.org, Cynthia Pedersen at email@example.com, Jamie Gasiorowski at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances, and current law.