Investor Guide to NFTs and its Tax Implications

Getting started with NFT investments

NFTs or Non-Fungible Tokens are all the rage today, as evidenced by their popularity within the modern trend currents sweeping through the digital ocean. According to the author, speaker, and social entrepreneur Gary Vaynerchuk, NFTs are the “holy grail for humans, it’s just that we’re fortunate humans that are here when it’s being invented.” Coming from an individual who continues to inspire entrepreneurs through his talks and has also judged digital ventures before on their commercial viability, this quote holds a lot of weight.

In essence, NFTs have been defined as the bedrock upon which the vast vision of the digital economy of the future is being built today and thus, the movement has a lot of hardcore followers. The fundamental attraction around the NFT comes from the potential for creators to earn thousands and even millions of dollars doing what they do best. At the same time on the other side, the investor side, things are a bit more speculative and uncertain.

To dip your toes into the NFT craze, as an investor you need to know what you are getting into. This is what we will be covering in this particular article.

How to buy NFTs?

NFTs are sold in dedicated marketplaces, good examples of which include Open Sea and Raible. They can be purchased via two main modes of transacting, namely through digital auctions and fixed price purchases. No two NFTs are created the same (which is where the term non-fungible derives its meaning from) and hence, price fluctuations tend to be enormous and unpredictable. Unlike stocks and commodities, NFTs are mostly subjective and sentiment-based niche products and so, their prices tend to be much more volatile.

To buy an NFT or partake in one of these digital auctions, you will need to complete the following two steps:

First, open a Crypto wallet on any NFT marketplace of your choice so that you can store and trade in cryptocurrency. Some good examples of Crypto wallets include Metamask, Enjin, Trust Wallet, and Math Wallet, which are just a few among many others. It is best to go for a wallet that is cross-chain compliant, which is a fancy way of saying that it should be compatible with trading in many cryptocurrencies. At the moment, the most popular crypto for NFTs is Ethereum.

Second, create an account on one of the NFT marketplaces, the best one at the moment being Open Sea. This is a fairly simple process, similar to creating an account on most normal websites. However, a core prerequisite while creating an account on these platforms would be to fund your digital wallet with a basic amount of relevant cryptocurrency in that marketplace. For example, on Open Sea, you might be asked to populate your wallet with 0.006 Ethereum to get started, an amount that will vary based on the current market price of Ethereum. In any case, funding your digital wallet would mean registering and buying some crypto on any of the crypto stock exchange platforms out there, like Coinbase and WazirX.

How to choose which NFTs to buy?

In order to know which NFT to buy, it is important to know about the various types of NFTs that exist in the digital world at large. Here are the core types:

• Art: these are single or collection-based digital art pieces that are visual in nature and represent something of aesthetic value for a specific community or for the general populace.
• Music: these are songs or albums or related musical paraphernalia that are collectibles or products which come with a level of rarity or value not accessible to the general consume
• Access: these are tickets or passes for physical/virtual events, entry into special Discord servers, access to special video lessons or courses, and any other form of interactive experience
• Game Objects: these are special items that can be used within games that are not normally accessible within the narrative/storyline that is readily available to the normal player
• Redeemable: these are digital objects or tokens that can be redeemed for a physical item, such as the Rebirth NFT Collection which allowed the owner of digital art pieces to redeem them for actual whiskey bottles
• Identity: These are digital representations of a core part of one’s identity, such as viewing preferences, credentials, records or one’s entire social graph/connections and several other aspects that contribute to one’s personality in the digital space
• Web 2 Databases: these are, generally speaking, any form of stored information that one places within the existing web spaces of today, which in their NFT form can be transferred from one platform to another without loss, corruption, or privacy compromise

With so many choices available on these platforms and marketplaces, investors are bound to feel overwhelmed. However, there are certain tips to keep in mind when searching for an ideal NFT to put your hard-earned crypto into. The fundamental rule, in this case, is that “there are no rules”. It is virtually impossible to predict which NFT will increase in value and which one will crash, contrary to the stock market that most investors are privy to.

So, how do you choose which NFTs to buy and which ones to avoid? Here are some tips for the budding NFT investor:

• Do your research: before investing in an NFT, make sure you put in the needed research into your choice. Some of the core things to study about a specific NFT include its floor price, the number of potential buyers (or a number of bidders), the community around the NFT, and the official website and social media platforms associated with the creator of the NFT. Using external tools, such as the Rarity Tool and Dune Analytics to identify how rare an NFT is and how it has performed since its publishing day.
• Get social: NFTs is a social phenomenon and are largely driven by communities associated with the creator/creation. This could be a fan club associated with a musician, a gaming community, or even a community of investors interested in collecting digital works of modern art. In any case, joining associated online forums of these communities and learning what they are buying and selling can help you get in on trends and avoid putting your capital into non-viable NFTs.
• Keep an eye on the crypto-market: if the NFT you are interested in is tied to a token or coin, make sure you keep a vigilant watch on the behavior of the coin on crypto marketplaces and exchange platforms. Websites like CoinMarketCap and CoinGecko are especially good options for such observational research. Some of the core parameters to keep in mind when observing the token/coin behavior include trading volume, market capitalization, ATH (All-Time High), and ATL (All Time Low).

Some risks of NFT investments

The NFT landscape can be explained using the metaphor of the Wild West, where anyone has the opportunity to take a shot and everyone feels they have an equal chance. This sort of a set comes with a variety of very serious risks, which are as follows:

• Anyone can create an NFT, which means that there are tons of really bad investments out there waiting for newbie investors with their jaws open like traps. The problem is merely escalated by the sheer ease with which websites and other promotional material can be developed by individuals today, making it important to not fall for the marketing hype.
• There are no set mechanisms to aid in the pricing of NFTs and hence, volatility is extremely high in this investment landscape. For instance, NFTs that was initially priced at a few dollars soared to thousands in value overnight, specifically because a major investor or a newly formed community took a lot of interest in the same.
• NFTs suffer from illiquidity as it is not easy to cash out on unique digital art pieces. A lot of these NFTs are not utility-based and tend to be extremely niche in terms of their value and contextual importance. In many cases, these unique items tend to be very hit-or-miss in terms of their selling potential, and hence, finding the right buyer can become a painful task, especially if a large investment has been made.
• Frauds and manipulation are more common in the NFT space than you might think. One type of fraud prevalent in this industry is known as wash trading, where an investor ramps up the price of an NFT by creating multiple accounts and trading with themselves. Moreover, being digital assets, storing NFTs in your computer or device makes them vulnerable to all types of threats that tend to afflict digital technologies, from malware to hackers.

Tax Implications for NFT Investors

Similar to cryptocurrencies in general, NFTs are at the moment taxed as per capital gains tax rates in the US. There are three main situations that trigger tax events within the investment cycle around NFTs, which are as follows:

1. Purchasing an NFT using Ethereum

If you purchase an NFT on any marketplace using appreciated Ethereum, this would be counted as a capital gain and you would be expected to pay capital gain taxes on the same. The capital gain tax rate on this purchase would depend on how long you were holding the Ethereum before making the purchase, resulting in either short or long-term capital gains tax rate.

On the other hand, if you purchase the NFT using depreciated Ethereum, you have the chance to offset other capital gains owing to the capital loss incurred, thereby decreasing your tax liability.

2. Trading one NFT for another one

If you purchase a higher-priced NFT with a previously purchased lower-priced NFT, you will have to pay capital gains tax on the amount difference. For instance, if your previously purchased NFT priced at $5500 is exchanged for an NFT priced at $8000, you will have to pay taxes on the capital gain incurred, which in this case would be $2500.

3. Selling an NFT in return for crypto

If you make a profitable sale of your NFT, your profit obtained in the relevant cryptocurrency will be subject to capital gains tax rates. Similar to the above scenario, the amount difference between the initial value of the NFT and the additional amount of cryptocurrency it was sold for will be the capital gain upon which the tax rate would be applicable.