Non-fungible tokens (NFTs) were the hottest digital asset class in 2021. They were so hot, in fact, that the Collins Dictionary named “NFT” its 2021 word of the year.[1] An indication of the explosive growth in NFTs was shown by reports that NFT purchases in 2021 increased by more than 11,000% from 2020, generating sales of close to $25 billion. As I am writing this article, however, 2022’s economic gyrations and market turmoil have taken a huge chunk out of the profits and slowed down interest in the digital asset market. The market for NFTs is reported to have “stabilized” in the first half of 2022.[2] Even with this slowdown, the market value of NFTs sold in 2022 is still reported to be quite robust. In addition to dramatic growth in the past two years, however, the NFT market has experienced dramatic swings; some months report huge sales, others do not.

This article is based on two webcasts I conducted for the NYSSCPA in May and June of 2022. It is structured as follows:

I. The NFT Marketplace

II. Characteristic of NFTs

          A. What is an NFT?

          B. Smart Contracts

          C. Intellectual Property Rights

III. How are NFTs Taxed?

          A. By Analogy

          B. Classification as Property

          C. Barter Transactions

          D. Taxation of NFT Creators

IV. Capital or Ordinary Assets

          A. Ordinary Assets

          B. Capital Assets

                    1. In General

                    2. Collectables

                    3. Personal Use NFTs

V. The Sale or Exchange of an NFT

          A. In General

          B. Capital or Ordinary

          C. Tax Basis and Amortization

          D. Installment Method

          E. Licensing and Royalty Income

          F. Charitable Contributions

VI. State Tax Considerations

I. THE NFT MARKETPLACE

Although the first NFTs were sold in 2014,[3] the NFT market did not really start to gain strength until late 2017. For the next two years, CryptoKitty NFTs basically “congested the Ethereum network.”[4] It was not until July 2020 that the NFT market started to see its extraordinary growth. In 2020, approximately $500 million was spent on NFTs according to NonFungible.com, a website that tracks the NFT market. In the first quarter of 2021 alone, NFT sales grew to over $2 billion.[5] In the 12-month period between November 1, 2020, and November 1, 2021, 5.5 million NFT sales valued at $9.4 billion were reported by the same source. Of the 5.5 million total dollar value of NFT sales, 3.1 million was for “primary market” transactions (transactions representing the first time an NFT was sold) and 2.4 million was for “secondary market” transactions (all subsequent sales of an NFT after its initial sale). Over that same 12-month period, the NFT art market grew over 800%,[6] which included the widely reported March 2021 auction of an NFT created by the artist known as Beeple. It sold for more than US $69.3 million.

II. CHARACTERISTICS OF NFTS

A. What is an NFT?

An NFT is a unique digitized certificate (referred to as a “token”) of data that is recorded, stored, and transferred on a blockchain. It can be a representation of something (a work of art, a photograph, a piece of music, a game or a collectible); it can be an original creation that exists only in digital form; or it can be a single, one-of-a-kind item or one of any number of replicas of the same content. The use case for NFTs continue to expand well beyond the representation of things. In fact, creators are adding physical goods and services as well as virtual goods to their NFT offerings. At the date of this writing, just about anything can be represented in an NFT.

NFTs are typically (although not always) purchased and sold using the native cryptocurrency or digital token used and accepted on the particular blockchain where the NFT is created and transferred. As the market has matured, some NFTs can be purchased with fiat currency (such as the U.S. dollar) and others can be purchased using credit cards. Initially, NFTs were almost exclusively created and transferred on the ethereum blockchain; they were almost exclusively purchased with ether tokens (ETH). The ethereum blockchain is particularly suitable for NFTs because it has functionality for smart contracts, which are discussed in the following section. ETH, the native token of the ethereum blockchain is the primary “fuel” that powers activity conducted on that blockchain.[7] Additional blockchains have been established to offer and transfer NFTs using tokens that are native to those blockchains.[8]

NFTs are typically transferred through online marketplaces, including the popular OpenSea as well as Nifty Gateway, Rarible, SuperRare and MakersPlace. Coinbase has also opened an NFT Marketplace that is now open for beta testing. All NFT platforms host blockchain technology. “Of the $2.8 billion spent on NFT marketplaces in September [2021],” it was reported, “$2.72 billion changed hands on OpenSea, according to data from the crypto websites Dapp Radar and CryptoArt, compiled by the Block.”[9] Although OpenSea provides a general marketplace, many of the newly created NFT marketplaces are more specialized and cater to particular types of NFTs, such as sports memorabilia, visual arts, or games and gamers.

NFTs are typically sold at auction (both online auctions and more recently through traditional auction houses) at a fixed price or through a declining price listing. To get started, an NFT purchaser typically needs a crypto wallet, such as MetaMask, to connect to the NFT platform. With a crypto wallet in place, the participant can acquire and transfer the type of token used to pay for the NFT. Popular tokens used to purchase NFTs include ETH, dai (DAI), and solana (SOL). DAI is a decentralized stablecoin that runs on the ethereum blockchain that attempts to maintain a value of USD $1.00.[10] Unlike centralized stablecoins, DAI is backed by collateral on the maker platform.[11] SOL is the token that is the “gas” or “fuel” used to pay for transactions on the Solana platform.[12] Gas is the amount of a digital token that is needed to perform a certain function on the blockchain network (such as transferring an NFT).

Once an NFT is recorded on a blockchain, its provenance can be tracked, indicating “who owns, previously owned, and created the NFT, as well as which of the many copies is the original.”[13] An NFT’s metadata allows for this tracking. It contains ownership information and all other terms and conditions that apply to that particular token. It is non-fungible because its metadata cannot be duplicated or replicated. In other words, one NFT is not interchangeable with another NFT or with any other asset. Even if multiple replicas have the same content, each NFT’s unique metadata makes that NFT unique.

An NFT cannot be divided into smaller units or used in the same way as fungible convertible cryptocurrency such as bitcoin (BTC) or ETH.[14] This means that one NFT cannot be exchanged for another, and its value, if any, is based solely on what a willing buyer is willing to pay a willing seller.

B. Smart Contracts

As a smart contract, an NFT’s embedded metadata allows relevant information to be visible and stored on the blockchain in a transparent and immutable way. It verifies ownership; transferability (and if so, under what circumstances); links to other digital assets; license fees; royalties; and any other payment rights and obligations. Upon transfer, an NFT’s metadata assures that required 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 made to the seller and transferred to the NFT’s original creator and other subsequent owners if any of the intellectual property rights were allocated to subsequent owners in addition to the creator.

C. Intellectual Property Rights

NFT purchasers receive the rights granted to them in the terms and conditions stored in the NFT’s metadata. Creators often retain ownership of the content that underlies an NFT. The artist Beeple, for example, retained his copyright to the art underlying the NFT mentioned earlier in this article. As a result, Beeple has the right (if he decides to do so) to create and sell countless other NFTs and other types of artwork from the content included in the NFT he sold in March 2021.

Many legal and regulatory issues are currently unanswered with respect to copyrights, intellectual property rights, token ownership rights, content, ownership rights, and authentication. Because of this lack of regulatory guidance, NFTs are “vulnerable to copyright theft, unauthorized replication and fraud, and storage failure.” In addition, “protocol risks like hacking, platform risks related to governance, and high gas fees, affect NFTs.”[15]

III. HOW ARE NFTs TAXED?

A. By Analogy

Currently we have no specific guidance from the U.S. government as to how NFTs are taxed. In fact, NFTs are not mentioned in any of the IRS’s cryptocurrency tax pronouncements. This means that taxpayers must look to general tax principles to determine, by analogy, how NFTs are likely to be taxed.

The tax treatment of a purchase or a sale of an NFT turns on a number of factors, including whether the seller created the NFT; whether the seller is a dealer, trader, investor, collector, or personal user; how long the seller has held the NFT; whether the NFT has appreciated in the seller’s hands; which type of property is used to purchase the NFT; and, if the buyer used appreciated property to buy the NFT, how long the buyer held the appreciated property.

Our first points of reference are Notice 2014-21[16] and the 2019 Frequently Asked Questions (FAQs) that were the IRS’s first attempts to address convertible cryptocurrency taxation.[17] Convertible cryptocurrency (e.g., BTC, ETH) has an equivalent value in fiat currency, can be purchased for or exchanged into fiat currency, and can be used to buy goods and services.

B. Classification as Property

According to the IRS, convertible cryptocurrency is property, not currency. As a result, the general tax principles that apply to property transactions apply to convertible cryptocurrency transactions. Although the IRS does not address the tax character of nonconvertible cryptocurrencies or NFTs, it is likely that other cryptocurrencies and digital tokens (including NFTs) are property for tax purposes. It stands to reason that if convertible cryptocurrency is not treated as currency for tax purposes, other digital assets including NFTs will not be treated as currency.

C. Barter Transactions

Because NFTs are likely to be property, exchanging one cryptocurrency or token for another is taxable as a barter transaction. Both the NFT buyer and the NFT seller—not just the seller —have taxable transactions when the buyer pays for the NFT with property such as cryptocurrency or a digital token. (Gain is taxable if the fair market value of the cryptocurrency used to buy the NFT is greater than the taxpayer’s tax basis in that cryptocurrency.) The seller has taxable gain (or loss) equal to the difference between the seller’s tax basis and the value of the property received in payment for the NFT. (Losses are not deductible in certain situations. If the NFT is a personal transaction, loss on disposing of it might not be deductible.)

On the other hand, if the NFT is purchased with US dollars, the seller has a taxable sale but the buyer does not. (The tax laws do not treat U.S. currency as appreciated or depreciated property in the hands of U.S. taxpayers.) The seller’s gain (loss) is the difference between the NFT’s adjusted tax basis and the amount of currency used to purchase it. If the buyer uses appreciated property to buy the NFT (that is, the fair market value in the property used to buy the NFT is greater than the buyer’s tax basis), the buyer has taxable gain equal to the amount of this appreciation. The buyer’s tax basis in that property is what is relevant for tax purposes.

D. Taxation of NFT Creators

People who create NFTs are referred to as creators; when they initially record an NFT on the blockchain, this is often referred to as “minting.” Creators include artists, musicians, celebrities, influencers, athletes, sports fans, collectors and authors, among many others.

The tax treatment of NFT creators should be fairly straightforward. Creating an NFT should not be taxable to the creator because creation does not represent the sale or exchange of property.[18] The creator does have a taxable event, however, when selling or exchanging the NFT for fiat currency, cryptocurrency, a digital token, another NFT, or any other type of property if the property differs materially from the NFT. Buyers typically pay an agreed-upon amount in cryptocurrency or the digital token that is native to the blockchain where the NFT is recorded. (Some NFTs are purchased using fiat currency or with a credit card.) The value, if any, of an NFT is only what a willing buyer will pay a willing seller. When a buyer pays for an NFT using property, rather than real currency such as the US dollar, the transaction is treated as a barter transaction. The buyer and the seller both have a taxable event.

Whether the sale of an NFT triggers ordinary or capital gain or loss turns on whether the NFT is an ordinary or capital asset in the creator’s hands. There are two possible ways in which an NFT could be treated as an ordinary asset for the creator. These issues are discussed in the following section.

Part two of this piece will be featured in the September TaxStringer.