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As with any investment, you should keep a record of when you create, purchase and sell non-fungible tokens (NFTs), and how much was paid or received for it. You should keep similar records on any cryptocurrency you own. You will need to calculate gain or loss when you sell an NFT or cryptocurrency.

All this information should be given to your tax preparer. It is important that you maintain your own records since the level of reporting from the websites handling crypto transactions varies.

If you need a primer on NFTs, click here.

NFTs can be stored in your own name or held in an entity, such as a limited liability company (LLC). [i] The typical benefits of an LLC, such as ease of ownership transfer and possible valuation discounts, would apply if an LLC holds an NFT. The transfer of an LLC interest would not result in a change in the blockchain record since the LLC would still be the owner of record.

Accessing the NFT requires being able to access your digital wallet. This means you need to carefully secure the very long password referred to as a “seed phrase,” which authorizes access to the wallet. If lost, there is no way to recover the seed phrase. Some people keep it in a safe or safe-deposit box or break the seed phrase into sections and store each section in a different location. Others put it on a flash drive or even engrave it on a metal plate that will hopefully survive a weather disaster. [ii]

What Are the Tax Aspects of NFTs?

NFT transactions are taxed like other sales of assets. When an artist sells an NFT she creates, the proceeds will be taxed as ordinary income to the artist. If the purchaser of the NFT later sells it, he will have to recognize a short-term or long-term gain or loss on the sale. There may be challenges in determining current market value. At present, unless particularly unique, the average price of sales of similar NFTs may be the best estimate of value. It is unclear whether the gain on the NFT would be taxed as an intangible asset like a stock (up to 20%) or taxed as an “art collectible” (up to 28%). [iii]

Another tax aspect is the use of cryptocurrency to purchase the NFT. Cryptocurrency is a capital asset, not a form of currency, according to the Internal Revenue Service (IRS). So, if one’s cryptocurrency account has appreciated in value and the person uses some of that cryptocurrency to buy an NFT, the purchaser will also be taxed on the realized gain from the sale of the cryptocurrency. Some cryptocurrency owners may not realize that trading in cryptocurrency is a taxable investment or that they might need to make estimated tax payments if their trades have been profitable.

This is a big concern for the IRS, which expects to see a lot of crypto-tax evasion in 2022. Tax owed on NFT transactions could be in the billions.

What Happens to my NFT When I Die?

You can make a specific bequest of an NFT in your will or let it pass as part of the residue of your estate. NFTs will be part of your taxable estate, but like other estate assets, they are entitled to a step-up in basis. Your personal representative will need to know what NFTs you own, what sites you have accounts on for trading NFTS, where your digital wallet is located and where you keep your seed phrase. [iv]

An NFT can be held in a trust, but it is unlikely the NFT would be considered a prudent investment, given the volatility of NFT values. Any trustee holding an NFT should have authorization from the grantor, the governing instrument, the beneficiaries or per a court order.

What Are Other Concerns about NFTs and Their Future?

When creating an NFT, one needs to be aware to not violate copyright laws.

NFT owners should also follow changes in NFT laws and regulations.

As NFTs increase in volume and value, they are coming under more scrutiny and likely more regulation. For example, at some point, they could be governed by federal securities law or treated as a commodity.

Though most of the publicity about NFTs to date concerns their use in the art and collectible world, there are several other applications for NFTs, such as licensing photography or digital music, recording titles to real estate, and facilitating the ownership and sale by student of digital textbooks. [v] When one considers issues of proof of ownership, certifying authenticity, licensing and property rights, the possibilities of utilizing NFTs seem endless.

If you want to discuss acquiring NFTs, supporting NFT users or how to handle NFTs in your estate plan, please contact Ned T. Himmelrich or Lisa H. R. Hayes.

Ned T. Himmelrich
410-576-4171 • nhimmelrich@gfrlaw.com

Lisa H. R. Hayes
410-576-4070 • lhayes@gfrlaw.com