Non-fungible Tokens, Taxation Questions and More

Change is coming to the fast-moving world of cryptocurrency and investors need to be informed to minimize taxes and diversify their crypto holdings. While taxation of crypto holdings remains unchanged for now, change may be on the horizon.

A proposal by President Biden’s administration to subject cryptocurrency trading the wash sale rule died when the Build Back Better legislation failed to get congressional action in 2021. However, efforts to subject cryptocurrency trading gains to further taxation can be expected to come back.

Cryptocurrency is treated as property, which means returns on investment are generally subject to capital gains taxation. The gain is based on the fair market value (FMV) at the time of disposal. Disposal for tax purposes can mean sale, the use of the currency to purchase services or goods, the exchange from one currency to another currency, or hard forks or air drops. Capital losses may be used to offset capital gains income and up to $3,000 of ordinary income per year. Losses above $3,000 may be carried forward indefinitely. The IRS also publishes Frequently Asked Questions related to crypto transactions.

An Evolving Market – NFTs

As new versions of cryptocurrency are created, the market is evolving and diversifying which provides more opportunities for investors. The loudest buzz today is around NFTs – “non-fungible tokens” – which are non-interchangeable units of data that are often associated with digital files such as photographs, videos, artwork, and audio. Like cryptocurrencies, NFTs are stored on a blockchain; however, they are not traded like cryptocurrency. They are more akin to digital collectibles or digital copyrights. They can be bought and sold and some users are giving them away as part of elaborate marketing campaigns.

The value of an NFT is determined by the marketplace and right now they are such a novelty some NFTs are being traded for millions of dollars. NFTs are being used to represent everything from NBA virtual trading cards to a tweet from Dallas Mavericks owner and entrepreneur Mark Cuban. Eventually, NFTs may be used as digital representations of the deed on your house or other important documents.

NFTs are typically bought with cryptocurrencies (although some can be purchased with fiat currency or credit card). The conversion needed to purchase the NFTs is a taxable event. Currently, there is not a lot of clarity around the taxation of NFTs. While the IRS has addressed the taxation of convertible cryptocurrency being treated as property and not currency, it is reasonable to assume that the IRS may treat NFTs as property, potentially at the 28% collectibles rate. The taxation of NFTs as capital or ordinary also depends on the nature and intent of the user.  Is the taxpayer a dealer, a creator or holding the NFT as an investment?

NFTs create another crypto asset for investors and speculators to include in their portfolios. Whether the value of NFTs turns out to be as volatile as that of cryptocurrency remains to be seen, so investors looking for more predictability in this notoriously unpredictable market may need to be patient.

There may be more predictability in “minting” NFTs than trading them. Individuals create their own NFTs and have them “minted” through several crypto exchanges. This process is not a taxable event; however, selling the minted NFT for crypto or fiat currency is taxable. Crypto entrepreneurs who may not have the capital to trade cryptocurrencies are getting into the market by minting NFTs and selling the minting services as a retail business. The fees they collect are taxed as ordinary income and they may deduct any expenses involved in creating their digital wares.

Another major change in the cryptocurrency market occurred last year when the Securities and Exchange Commission approved the marketing of futures-backed ETFs (exchange-traded funds) for Bitcoin and other large crypto assets. Other countries, such as Canada, have full ETF trading for crypto, but the SEC is only willing to allow futures-backed ETF trading currently. As a result, an individual or institutional investor could go to a fund and invest $1 million in a futures-backed fund. The gains or losses will be tied to the fluctuating value of Bitcoin or another cryptocurrency, but no cryptocurrency will be bought or sold. It’s akin to a stock index fund.

Still in Development

Though it’s been in existence for more than a decade, the cryptocurrency market is still in its infancy. Many businesses and investors are still figuring out how to use it, and the volatility of the market – with wild swings in valuation – have kept many observers on the sidelines. In early fall 2021, the worldwide cryptocurrency market was estimated at $3.1 trillion. But a massive crash in valuations in the late fall pushed it down to about $1.7 trillion.

Those big swings may not inspire a lot of confidence, but investor speculation is not slowing down anytime soon. Issues around taxation and legal definitions will undoubtedly continue. Nonetheless, cryptocurrency’s potential in certain markets is becoming apparent and more mainstream each day.

If you would like to discuss your ventures into cryptocurrency and the potential tax consequences, contact your Adams Brown advisor.