What is a Non-Fungible Token? A Guide to Understanding NFT's

IMAGE CREDIT: HASHMASKS ARTWORK. IMAGE: HASHMASKS

What is a Non-Fungible Token?

Non-fungible tokens (NFTs) have seen an explosion in popularity over the past few months.

Many people have probably seen the letters “NFT” show up on their timeline and thought to themselves “what the heck is that?” and “how does this benefit me?”.

Well, NFTs are tokens that are generated using blockchain technology to link the non-fungible token with a digital asset that can’t be replicated. The token represents something unique on the blockchain and can be used to digitize assets and data.

OK, But What is Fungibility?

Fungibility refers to a good or asset having the ability to be exchanged with other goods or assets of like kind.

Fungible assets create a simple means of exchange or trade because the fungible nature of the assets implies that they are of equal value.

Money is a prime example. If I lend you a $100 bill, it would be perfectly acceptable for you to pay me back with a different $100 bill, or even make the payment in five $20 bills because the total USD value equates to one another and is mutually substitutable. On the other hand, if I lend you a unique piece of art, and you want to return a different piece by a different artist, this would not be acceptable because these assets have their own unique qualities that can either add or subtract value. In this example, one artist may be more critically acclaimed or may use different styles in the way they complete a piece.

Fungible Tokens vs. Non-Fungible Tokens

When looking at this from a crypto perspective your ETH or BTC has the same value as someone else’s ETH or BTC, as there is a market for the digital assets and it is similar in nature to our fiat example. The individual or entity that previously owned the token or mined the token is irrelevant. 

On the other hand, an NFT is not like BTC or ETH because the NFT is rare and scarce. The NFT is usually indivisible and most importantly, the NFT is unique. This allows the owner of the NFT to certify the authenticity of the token on a permanent basis.

Non-Fungible Tokens are Growing in Popularity

NFTs have seen an explosion in popularity over the last year, creating a new NFT economy.

For example, the NBA, NBPA and Dapper Labs recently came together to create NBA Top Shot. NBA Top Shot is a collectible game that allows Top Shot players to collect their favorite moments and highlights in digital form that they can own forever. Some of the highlights of popular players such as Lebron James and Kevin Durant have sold for more than $50,000.

Additionally, just this past week there was a new ETH project that launched called Hashmasks. The project sold a collection of 16,384 unique digital portraits that were created by over 70 artists around the globe. The founders of the project ended up selling the pieces of art for roughly $9 million. Some of the art pieces were sold for 100 ETH each ($160,000 at the time of writing). Like all NFTs, the collectible art pieces have a market value on the basis of how rare and unique they are, but Hashmasks also have the ability to be named. The Hashmasks project has a native token, The Name Changing Token (NCT), which gives the individual or company holding their Hashmask art a unique name that is visible to the public and is stored permanently.

NFTs are also currently being used in the DeFi space. Armor, a project that is a decentralized brokerage for cover underwritten by Nexus Mutual’s blockchain-based insurance utilizes arNFT. arNFT is a non-fungible token that can be minted and held for a user’s own protection, can be sold by the user on the market, or can be staked by the user to earn fees in both ETH and ARMOR tokens.

The Future of Non-Fungible Tokens

As previously mentioned, NFTs are currently being used in the art and collectible space.

NFTs are very popular in the gaming space as well. In the future, we may see NFTs used for real estate.

With a real property asset-backed NFT, we may see the deeding of property transpire on the blockchain with a completely automated and digitized process. The real property can be tokenized on the blockchain and an NFT could be used to prove that an individual or entity actually owns a parcel of land or a structure. Blockchain technology and NFTs can create a more efficient transfer of ownership with reduced legal disputes.

Taxation of Non-Fungible Tokens

As we discussed last week, pursuant to guidance issued by the IRS (Notice 2014–21), the IRS treats cryptocurrencies (they use the term “virtual currencies”) like Bitcoin, Ethereum, AAVE and UNI as property for tax purposes. This property classification is used for both typical crypto tokens as well as non-fungible tokens.

NFTs are unique and rare, which makes it easier for tracing the NFT to a specific wallet address. The way that the sale of an NFT is treated for tax purposes depends on the nature of activity. NFT tax treatment for the digitized asset will effectively mirror the way that the physical version of the property would be treated for tax purposes.

Using Hashmasks to illustrate an example:

The artists involved in selling the pieces for ETH will have ordinary income at the time of the sale as the artists are in the business of creating and selling art.

The eventual disposition by the purchaser of the Hashmask may have different tax treatments depending on whether the purchaser is deemed a hobbyist, an investor, or a dealer.

Hobbyists (those who buy art without considering whether it will be a profitable investment) will get capital gain treatment on a gain, but losses are not allowed.

Investors (those who buy and sell art with the hope that the asset will appreciate for a profit) will get capital gain and loss treatment.

Dealers (those who buy and sell art as a trade or business) are taxed in the same way as any ordinary business, with income taxed at ordinary income rates.

Most crypto investors will be purchasing NFTs as a means of investment, and upon sale will have capital gain or loss treatment.

Crypto Tax Professionals

At Taxing Cryptocurrency, we have been filing crypto tax returns dating back to 2013. We have reconciled millions of transactions on the blockchain across numerous exchanges and platforms and have filed hundreds of tax returns. The more complex your crypto tax and trading situation gets, the more likely it is that you will need crypto tax advice and guidance. Whether we are assisting our clients with the reconciliation process, or strategizing and implementing our plans for a potential disposition, Taxing Cryptocurrency has the experience and expertise necessary to guide our clients through the complexities that the crypto market imposes on their crypto taxes.