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Disclaimer: This article is not investment advice, tax advice, or legal advice. It is for informational and promotional purposes only. Do not take any action (including investments) until you have consulted with a professional about your specific situation.

I have previously written about investing in cryptocurrencies through a self-directed retirement portfolio and about using them in day-to-day business transactions. There is no doubt that crypto and blockchain technology is here to stay. As evidence of this, the U.S. government will increase reporting of and tax enforcement for cryptocurrency transactions, which are currently treated like property for tax purposes, but not the same as stocks or securities. Increasing regulation and taxation certainly indicate how much the technology is being used and adopted across the world.

What about NFTs or non-fungible tokens? There was a lot of buzz in early 2021 about NFTs after Christie’s auctioned off a digital-only artwork for $69 million and suddenly everyone from Nike, to Hasbro, to Cervelo (a racing bike manufacturer) was selling digital-only versions of their collectibles or attaching NFTs to physical world assets. The hype has since subsided, at least from the mainstream media sources. However, spend enough time on the various social media platforms, and NFT proponents (sellers) will be quick to offer “virtual estates,” “one-of-kind avatars,” “priceless digital art,” and various other exotic and futuristic-sounding assets. Often, you will be directed to an auction site where you will have to place bids on the NFT, sometimes even using a native cryptocurrency or token like MANA or SAND.

Suppose you got caught up one night, cashed out your 401k, and bought $100,000 worth of NFTs – a virtual castle in Decentraland, some art tapestries to decorate, and a digital collection of Luka Doncic basketball cards. The next morning at breakfast you have to explain to your spouse – NFTs? WTF did you just buy? Read on.

NFTs as personal or business investments.

Before investing in anything, it is generally a good idea to understand exactly what you are buying. NFTs are digital representations of unique items based on the Ethereum blockchain. When you buy an NFT, you basically just bought computer code. The simplest description of blockchain is that it is a decentralized public ledger or database. Data is entered into a block – in the case of an NFT, it is specific code that signifies the “object” and its owner – and then that data becomes part of the public ledger that is replicated and stored across a vast, decentralized computer network. An NFT can have a real world counterpart, but it does not have to. As will be discussed below, an NFT can be sold together with or separate from the work’s copyright. The “non-fungible” aspect of the token means it is unique and not interchangeable with other items. Traditional fiat currency is inherently fungible because a dollar bill is interchangeable with other dollar bills. Cryptocurrency is also fungible – one Bitcoin is the same as another and has the same value. On the other hand, an original Monet, your grandmother’s jewelry, or even a pair of Nike shoes are all non-fungible because they are unique.

One big difference between NFTs and cryptocurrency is liquidity. One of the reasons why crypto is so popular right now is accessibility. Exchanges like Coinbase make it easy for anyone to buy and sell cryptocurrency right from their phone, while keeping records, and facilitating exchange of almost any cryptocurrency. Whether you want to cash out into fiat dollars to cash out or exchange cryptocurrencies for other cryptocurrencies, you can do it on your phone or computer in a very simple and quick process. NFTs are not as liquid – to sell one you have to find a willing buyer and negotiate a price. For example, OpenSea is a large marketplace for NFTs, allowing listings at auction, fixed price, or declining price settings. The market determines the price of NFTs, meaning supply and demand. In the NFT market, there may be only a couple of willing buyer and sellers, which is quite different from the millions who buy and sell cryptocurrencies every day. Also, tthe Securities and Exchange Commission does not regulate NFTs or most cryptocurrencies at this time. While a company selling stock or bonds on the open market must follow filing and disclosure requirements to ensure a transparent public offering, crypto and NFTs offerors do not. Proceed with caution.

2. What are the legal implications of this “wild west” of NFTs?

NFT investors face two areas of legal issues: copyright law and tax law. Copyright law protects the creator’s rights in computer code, as well as art, music, and other creative works. Tax law is involved whenever you buy, sell, or invest in anything.

A. Copyright.

NFT ownership is not copyright ownership.

When buying or investing in an NFT, it is absolutely essential to understand what it is you are buying – in other word, what “bundle of rights” are you getting in exchange for your cash? In the physical world, when you buy an asset like a painting or a car, you are at least getting the physical thing. In the all-digital world of NFTs, it gets a little bit complex.

Under U.S. copyright law, the creator of art, music, movie, or other creative work owns the copyright, which attaches at the moment of creation. Transferring the physical object alone does not necessarily transfer the copyright with it – a written agreement transferring copyright is required to separate the creator from the copyright. In other words, the physical work and the copyright to that work are distinct and separate. NFTs are no different – the fact that the work is digital or consists of computer code does not matter. There is still the ownership of the original work (piece of code) and the copyright to that work. Do not assume that you are buying the copyright to the NFT when you purchase it on an online auction site unless there is a specific agreement to assign the copyright to the buyer.

If you bought an NFT without the copyright, you essentially bought a unique piece of computer code that you cannot display, duplicate, or republish without the original creator’s permission. You need the copyright to reproduce, copy, license, and otherwise do pretty much anything with the NFT. Creating derivative works based on the NFT likewise requires the copyright. In short, know what you are actually buying, as copyright gets particularly complex in the digital world. An attorney may be needed to review the agreements, especially if the transaction involves a substantial sum of money.

B. Tax.

The IRS issued guidance as far back as 2014 that cryptocurrency is taxed like property and subject to capital gains tax. But there has been no guidance on taxing NFTs. Because NFTs and cryptocurrency rely on the same underlying blockchain technology, it is likely that NFTs will also be taxed like property and subject to capital gains tax. That means if you buy an NFT for U.S. Dollars, you do not pay tax on that transaction (unless a state decides to enact a sales tax on digital assets). But when you sell that NFT in exchange for cash or cryptocurrency, or trade it for another NFT, you have a taxable event. Any “gain” will be treated as reportable taxable income.

It can get especially complex if you involve cryptocurrency in the transaction. Some NFTs can only be purchased in exchange for a specific token – for example, virtual real estate in Decentraland can be purchased only for MANA tokens, which are an Ethereum token. The price of the MANA token fluctuates, just like the price of BTC or ETH or DOGE. If you pay cash for MANA, that transaction is not taxable. But then when you exchange MANA for an NFT, you are “selling” the MANA, taking a capital gain or loss, and then acquiring the NFT at the market price, which establishes the NFT’s cost basis for future transactions. When you sell the NFT for cash, you have a capital gain based on the difference between the cost basis and the sale price. But if you trade the NFT for another NFT or for Bitcoin, you again have a double tax event because you are selling “property” (subject to capital gain at the time of exchange) and acquiring “property” (subject to capital gains at the time of subsequent sale or exchange) at the same time. This is why good record keeping is an absolute must and is especially critical if you are engaging in a large number of transactions.

All of this assumes that NFTs will be taxed like cryptocurrency. But it is possible that NFTs will be taxed differently based on what the NFT represents. Will the sale of digital land be treated as a sale of physical real estate? All of a sudden state transfer taxes may come into play. Will the sale of digital art or collectibles be treated the same as physical art of collectibles and subject to special tax rates? There are many unanswered questions at this time, but as the IRS zeroes in on crypto and blockchain assets as sources of tax revenue, there will certainly be regulation and litigation on this subject.

3. Future applications for NFTs beyond collectibles and investments.

One of the most fascinating things about NFTs and blockchain tech in general is unlimited potential. The decentralization and immutability aspects are extremely potent in a number of applications. For example, in the business setting, smart contracts that automatically enforce performance and payment can eliminate many costs and inefficiencies related to international trade. Escrow accounts and associated fees may very well be a thing of the past. If performance under a contract can be reduced to code and automated, costly contract disputes can be avoided.

Blockchain can also be used in software licenses as well as licenses for other intellectual property. Concert or other event tickets are another application. Corporate governance and shareholder meetings can be accomplished through blockchain – for example, a corporation could issue a token for each share and then ask its shareholders to vote by transferring the voting tokens to a specific address. The transparency and security of the blockchain are especially valuable in this context. Some commentators have even suggested blockchain as a way to secure and democratize political elections. With a publicly-verified chain, election fraud would virtually be eliminated and election results would become indisputable.

Whatever the future holds, blockchain is exciting technology. As with all emerging technologies, the law is an a state of flux. Government regulators are playing catch up to address the application of existing law to new tech and to propagate new laws to address emerging problems. If you are investing in NFTs or using blockchain in your business, contact an experienced attorney to answer your questions and ensure that you are being proactive with your regulatory and tax obligations.

Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

2022 is a marquee year for anyone who took got involved in cryptocurrency during the 2021 market boom. The start of the new year means the start of tax preparation season and many individuals and companies are working to understand the tax treatment and implications of digital asset investments. In 2021, the IRS and the Department of Treasury announced increased efforts to track cryptocurrency transactions and enforce the perceived underpayment of tax in the crypto world. However, the government’s guidance has been limited. There are many uncertainties and questions in this evolving area of law. Read on for a summary of the key issues:

Cryptocurrencies Are Taxed As Property Subject to the Capital Gains Tax.

In the ever-changing world of crypto, one thing has stayed the same (since at least 2014): Cryptocurrency is property subject to the capital gains tax. In its FAQ guidelines, the IRS addresses a number of situations (such a hard forks and airdrops) to explain its position on basis and gain/loss calculation. If you received, sold, exchanged, or otherwise disposed of “any financial interest in any virtual currency,” the IRS requires you to disclose this on the first page of the 1040. If you check “yes,” expect to file a 1040 Schedule D (“Capital Gains and Losses”) and an 8949 supplement.

What does this mean in practice?

If you bought cryptocurrency in 2021 for cash and are holding it (or HODLING), there is no transaction subject to capital gains and nothing to report.

If you sold cryptocurrency for cash, traded crypto for another crypto, used crypto to buy an NFT, or paid someone for goods or services using crypto, you have a reportable capital gains transaction. The “gain” is the difference between the initial value (basis) and the sale value. If the period between acquisition and sale is less than a year, the short-term rate applies, which treats the gain as ordinary income. If the period is more than a year, the long-term rate applies and is either 0%, 15%, or 20% depending on your annual income level.

Exchanging crypto for other crypto (for example, you exchange BTC for ETH) is also subject to capital gains tax. The IRS treats the exchange as if you sold BTC for cash and used that cash to buy ETH. That means that any “gain” you realize on the sale of BTC is reportable and taxable, even if you use 100% of your proceeds to buy another cryptocurrency.

If you use crypto to buy an NFT or pay for some other goods or services, the IRS treats the transaction as if you sold the crypto for cash (incurring a capital gain) and then used the cash to buy the NFT or pay for the other goods/services.

IMPORTANT: Stablecoins are cryptocurrency and are also subject to capital gains tax and reporting requirements, even if in practice the capital gain on a stablecoin transaction is zero or even negative.

What if my corporation or LLCs bought, sold, or exchanged virtual currency or digital assets? There is no guidance to suggest that business entities are treated any different. Record and report crypto and other digital asset transactions like you would physical property or assets.

Best practice remains to record all of your cryptocurrency transactions in a spreadsheet or accounting software, including the type of asset, the basis price, the date, and any gain/loss (as well as transaction fees). Alternatively, bigger exchanges like Coinbase make reports available to their customers and integrate with several popular crypto tax reporting platforms.

The IRS Has Not Issued Guidance on Taxing NFTs, Utility Tokens, Security Tokens, or Any Other Types of Digital Assets.

What about NFTs? Or utility tokens that you may have bought and sold as part of a play-to-earn game? Or security tokens (STOs) that becoming a corporate financing alternative for high-tech startups? The IRS has not issued guidance or taken a position on any of these particular instruments. In its FAQ, the IRS defines “virtual currency” as follows:

Virtual currency is a digital representation of value, other than a representation of the U.S. dollar or a foreign currency (“real currency”), that functions as a unit of account, a store of value, and a medium of exchange. Some virtual currencies are convertible, which means that they have an equivalent value in real currency or act as a substitute for real currency. The IRS uses the term “virtual currency” in these FAQs to describe the various types of convertible virtual currency that are used as a medium of exchange, such as digital currency and cryptocurrency. Regardless of the label applied, if a particular asset has the characteristics of virtual currency, it will be treated as virtual currency for Federal income tax purposes.
https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions

Although this definition gives some guidance on the IRS’s position, it is still not clear whether NFTs and non-cryptocurrency tokens are “virtual currency.” For instance, NFTs (non-fungible tokens), represent a wide range of things. They can be art or basketball trading cards, but also can be virtual metaverse real estate or video game magical items. Some commentators have suggested that NFTs will be taxed at the 28% “collectibles” tax rate – but that hypothesis presupposes that all NFTs are “collectibles,” which is simply not true for all NFTs. At the same time, the IRS’s definition of “virtual currency” appears to require the asset to be used as a “medium of exchange,” which is also not true of all NFTs. At this time, the NFT tax analysis is best done on a case-by-case basis, with a careful evaluation of what the NFT represents and how the real-world equivalent would be taxed.

Utility tokens are digital tokens that have non-investment uses (or utility) and fall outside of the federal definition of “security.” Play-to-earn video games (like Axie Infinity and its imitators) use native digital tokens for in-game currency and rewards, but the tokens can also be bought and sold on a secondary market. These tokens are more in line with the IRS’s “virtual currency” definition – and while the IRS has not expressly opined that utility tokens are property subject to capital gains tax, they most likely are. In other words, keep records and be prepared to report your sales and exchanges at tax time.

Security tokens (security token offerings are called STOs) are the digital equivalent of traditional corporate financing instruments like SAFE notes or seed round equity. However, the IRS does not consider STOs (or any other tokens) as stock or securities, even if the Securities and Exchange Commission (“SEC”) does. In other words, you sell or buy a security token, you must do so either as a registered security or one that meets an exemption (for example under Regulation A+, D, or S). However, neither the investor nor the selling company gets to claim any sort of tax benefit from the “security” token – because the IRS likely treats it as property and not securities. This means that when you invest in a security token (even one that is registered with the IRS), the tax breaks or advantages that apply to the purchase and sale of stock do not apply.

The Wash Sale Rule Still Does Not Apply to Cryptocurrency, But Might Apply Next Year.

There is a silver lining to the fact that cryptocurrency (or other tokens) are not considered “securities” for the purposes of tax law. The wash sale rule does not apply to crypto and allows for loss harvesting to offset capital gains (and even up to $3,000 of ordinary income.) For example, right now crypto markets are down from their highs and many investors may be showing a loss. If you sell at a loss and buy the asset back immediately, you can claim the “loss” on the sale on your taxes. The wash sale rule – which is applicable to securities – requires a 30 days period before repurchasing the same or substantially the same security.

Congress is aware of and is working on closing this so-called “loophole,” but right now the wash sale rule likely does not apply. It is unclear whether you will be able to claim a loss on 2022 returns if you sell at a loss in 2022, but as of the date of this article, crypto investors can still take advantage of loss harvesting opportunities.

The 2021 Infrastructure Bill Has Not Killed Cryptocurrency.

In the summer and fall of 2021, there was a lot of concern in the cryptocurrency community over certain reporting requirements that Congress wanted to impose on cryptocurrency market participants. Although much of the “hype” was overblown, the main issues were with the new reporting requirements, the definition of “broker,” and how the reporting requirements would affect miners and other participants who are not in the direct sales business.

President Biden signed the Infrastructure Investment and Jobs Act on November 15, 2021, and needless to say, the U.S. cryptocurrency markets are very much alive and functioning. The Act extended the $10,000 cash reporting requirements to “digital assets” transactions, meaning that businesses that receive more than $10,000 in cryptocurrency have to file a Form 8300 with the IRS. The form requires the disclosure of the payor and payee’s name, address, Tax ID, and other information.

The new reporting requirement will not take effect until 2024. By then, expect the IRS and the Treasury Department to develop regulations and provide guidance to market participants, so stay tuned for future developments in this area. It is likely that the scope of the regulations will be limited, as $10,000+ crypto and NFT transactions are much more common than cash transactions, and (unlike cash) also may take place without the parties ever even seeing each other or meeting.

Additional regulation of digital assets in the U.S. is to be expected given their popularity and increasingly prominent role in the economy. However, the U.S. is not about to “outlaw” cryptocurrency, NFTs, token, or any other digital assets. The blockchain tech market is alive and well, but with better defined taxation and regulation may even become more mainstream.

The bottom line is that cryptocurrency markets and derivative digital assets are here to stay. Regulation is constantly evolving and there are many uncertainties for investors and companies working in this emerging market in 2022. Professional legal guidance is always a good idea.

Want to know more? Contact Dan Artaev by email or call or text to set up your initial consultation.