NFTs 101: Taxes, Risks, and More

June 9, 2022 Randy Frederick
Nonfungible tokens have become the latest investment craze. Here's what you need to know.

Until recently, nonfungible tokens (NFTs) were written off by many as a virtual fad and a waste of money. After all, why would someone pay $2.9 million to own the very first tweet when anyone with internet access can view it for free?

But when auction house Christie's sold the NFT of Everydays: The First 5000 Days, a collage by the artist Beeple, for $69.3 million in March 2021, it suddenly put this emerging asset class on par with collecting a Picasso (whose heirs have jumped on the digital bandwagon by selling NFTs of the artist's ceramics).

So, what's all the fuss about?

The basics

Like cryptocurrencies, NFTs are stored on a blockchain, which is a digital, publicly available transaction ledger. However, while a single bitcoin can be exchanged for any other bitcoin—just as a $1 bill can be exchanged for any other $1 bill—each NFT is unique (i.e., nonfungible). In that sense, NFTs are more like the Hope Diamond or Picasso's Guernica—a one-of-a-kind work for which there is no substitute.

Indeed, an NFT's inherent scarcity, whether because it's a unique piece of art or a limited-issue collectible, makes it potentially lucrative—but also substantially less liquid than, say, your average stock or bond. As a result, you may need to drop the price or hold on to your NFT if the demand isn't there when you want or need to sell it. Other risks include:

  • Security: Like bitcoin, NFTs require a private key that functions as a password. If your key is lost or stolen, you may never again be able to access your NFT. Other security risks involve replicas that purport to be the original—as with any collectibles marketplace—and fraudulent sites designed to steal private keys and their attendant assets.
  • Taxation: Although the IRS has yet to issue specific guidance, NFTs are generally treated as collectibles. As such, if you sell an NFT you've held on to for less than a year, any short-term gains will be taxed as ordinary income. Any gains on an NFT held for a year or longer will be taxed at a top collectibles rate of 28%—plus a 3.8% net investment income tax if your modified adjusted gross income exceeds $200,000 ($250,000 for married couples).

Where to start

If, after careful consideration, you're still interested in dipping your toe in NFT waters, you'll first need to do three things:

  1. Pick a marketplace: To buy or sell NFTs, you'll need to choose a reputable marketplace. Both Nifty Gateway and OpenSea are popular, although specialty marketplaces also exist, including ArtOfficial if you're a fine-art collector and NBA Top Shot for basketball enthusiasts.
  2. Get a wallet: Shopping through most NFT marketplaces requires a Web3 wallet, such as MetaMask, that can store both cryptocurrencies and NFTs. Some marketplaces, like Nifty Gateway, will store your NFT, but you'll have to pay a fee to transfer it to another wallet should you wish to do so later.
  3. Buy cryptocurrency: Some marketplaces accept payment in so-called fiat currencies, such as the U.S. dollar. However, many marketplaces are built on the Ethereum blockchain and prefer to transact in its native cryptocurrency, ether.

Tread with caution

Although the popularity of NFTs has exploded in the past year, with first-quarter sales topping $11 billion by mid-March 2022—up from $53 million for the fourth quarter of 2020—only time will tell if NFTs will realize their long-term potential or fall tragically short of it. 

Either way, it will be fascinating to see how this new form of digital authentication changes how we invest. (Ernst & Young, for example, is working on NFT-inspired technology that can help collectors track the provenance of fine wines.)

Quantum leap

NFTs experienced exponential growth in 2021.

Beginning in Q3 2017, quarterly NFT trading volume remained under $20 million until jumping to $28.01 million in Q3 2020, then $52.98 million in Q4 2020. It went above $1 billion in Q1 2021 and, as of Q1 2022, has remained above $10 billion since Q3 2021.

DappRadar.com

Sales figures include only on-chain transactions conducted on the 49 NFT marketplaces that DappRadar tracks, excluding LooksRare.

*Q1 2022 data as of 03/25/2022.

For the time being, however, there's a lot to be said for taking a go-slow approach to this new asset class and all the risks it entails. 

In general, those interested in crypto assets like NFTs are wise to limit their exposure to no more than 1% of investable assets.

We can help you build a diverse portfolio.

Closing Market Update

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Quarterly Market Outlook: A Delicate Balance

The Federal Reserve weighs the data while investors wonder: Is the rate-hike cycle over?

Opening Market Update

The market expects the Fed to make no moves on interest rates today, but investors await the central bank's economic projections for the rest of the year and 2024. Crude oil prices and treasury yields eased this morning, giving stocks a premarket tailwind.

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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. 

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed. 

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Digital currencies, such as bitcoin, are highly volatile and not backed by any central bank or government. Digital currencies lack many of the regulations and consumer protections that legal‐tender currencies and regulated securities have. Due to the high level of risk, investors should view Bitcoin as a purely speculative instrument. 

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Investing involves risk, including loss of principal. 

Virtual Currency Derivatives trading involves unique and potentially significant risks. Please read NFA Investor Advisory—Futures on Virtual Currencies Including Bitcoin and CFTC’s Customer Advisory: Understand the Risks of Virtual Currency Trading.

Diversification and asset allocation strategies do not ensure a profit and do not protect against losses in declining markets.

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