Understand NFT Tax Laws, Inheritance, and Access Before You Invest

From floppy disks and hard drives to the cloud, how we store our precious data has significantly changed over the years. Our investments have gotten a similar upgrade, and in some cases, our digital portfolios are far more valuable than our physical estates. If you’re considering a digital investment in non-fungible tokens, it’s vital that you fully understand your NFT tax liability—during and after your lifetime.

[TABLE OF CONTENTS]

• What Exactly Is an NFT?
• What Products Can Be Sold as NFTs?
• Where Is an NFT Stored?
• Is There a Password for NFTs?
• Where Should I Keep My Seed Phrase?
• How to Calculate NFT Taxes
• Can I Include an NFT in My Will or Trust?
• Let Us Guide You Through the Nuances of Your Digital Assets

What Exactly Is an NFT?

The technical definition, according to Merriam Webster, of a non-fungible token (NFT) is a “unique digital identifier that can not be copied, substituted, or subdivided, recorded in a blockchain, and used to certify authenticity and ownership (as of a specific digital asset and the specific rights relating to it).” 

You can think of an NFT as similar to a casino chip. The chip you use represents a specific amount of money, and different chips are worth varying amounts. However, the biggest difference is that no two NFTs are alike. Each NFT is digitally different from the next to protect the privacy and security of the NFT. In this way, these virtual assets are more similar to snowflakes or fingerprints.

NFTs can also be collectible items, similar to rare coins or baseball cards, and are only as valuable as how atypical they are. When I was younger, I collected record albums. Millions of WHAM!’s Make It Big and Michael Jackson’s Bad records sold, making my copies the same value as anyone else’s. However, if one of the artists had signed and dated my copy, my album would have increased in value significantly.

What Products Can Be Sold as NFTs?

NFTs are being sold as digital art, pieces of property, and even as protection of property. One of the most expensive NFT artworks sold so far was Mike Winkelmann’s piece, The First 5000 Days. This collage of 5,000 individual pieces of artwork over a 13-year time frame was sold by Christie’s for $69,346,250 on March 11, 2021—the most notable NFT sold thus far.

Even companies such as Nike are using NFTs. Nike wanted to ensure that their shoes were not counterfeit in the metaverse, so they purchased a company that makes virtual NFTs and sneakers. There’s no limit to what an NFT could represent—they might even be used for electronic documents such as wills or estate plans in the future.

Where Is an NFT Stored?

An NFT is normally stored on the blockchain to ensure its authenticity and to prevent it from being interchanged with another asset. The NFTs “on-chain” are completely written on the blockchain, along with their smart contracts and metadata. Each NFT is different, and the blockchain acts like a digital wallet.

Is There a Password for NFTs?

NFTs do not have a password in the traditional sense. Instead, they use a “seed phrase,” typically 12, 18, or 24 words in a random order that will recover the NFT from a digital wallet. A seed phrase might look similar to “flower run judge water rose ocean triple liquid tape weight shake every.”

Where Should I Keep My Seed Phrase?

Your seed phrase is the key to Pandora’s Box, so it is imperative to keep it private. How can you keep this random set of words safe from hackers? Some people keep their phrase in an old-school safety deposit box, while others have sections kept at multiple locations. For example, your cousin Joe keeps the first four words in a secure place, your brother John keeps the next four words in his safe, and you hide the last four words. 

However, who will be the one person besides you who knows how to put this puzzle of seed phrases together? What happens in the unexpected event that you’re unable to communicate with your brother and cousin? Your lawyer can communicate with them and ensure that your account is kept safe or managed as you wish.

How to Calculate NFT Taxes

The IRS treats NFTs as property for tax purposes. You must report NFT transactions on your tax return. The IRS has increased enforcement, so good records (dates, values, wallets, etc.) are essential. 

Taxable events include:

• Capital gains. If you sell, exchange, or use an NFT and make a profit, it may be subject to NFT capital gains tax. The rate depends on how long you held the NFT: short-term (under 1 year) is taxed as ordinary income; long-term may get lower rates.
• Selling collectible items. If held long-term, NFTs tied to collectibles (like digital art) may be subject to the 28% collectibles tax rate. 
• Purchasing with cryptocurrency. Using crypto to buy an NFT is also a taxable event in itself—selling or using the crypto triggers a capital gain or loss. [If the NFT is sold for crypto too, then the taxable transactions are breeding rather quickly.]
• Creator income. If you’re a creator (artist or developer), income from selling an NFT you created is taxed as ordinary income, not capital gains. If you receive an NFT as payment for work or services, it’s also ordinary income based on fair market value at the time received.

It’s worth noting that losses from NFT sales can offset gains and some income, offering tax relief strategies.

Can I Include an NFT in My Will or Trust?

Instead of including your NFT in your will, it’s much more effective to create a digital estate plan to safeguard all of your virtual assets. Without this noteworthy property in your estate planning, your virtual property could be lost forever. Your digital executor should know your NFT’s details and how you want your portfolio to be handled in the future. 

A quick word of warning: the probate process exists to allow your creditors to be paid before your beneficiaries. This includes any outstanding capital gains tax on NFTs, so you may want to consult with an asset protection advisor to minimize your losses.

Let Us Guide You Through the Nuances of Your Digital Assets

After you’ve taken the time to buy the right NFT, let us help you protect your physical and digital assets for the future. Call or email us at hello@yolofskylaw.com today to get started.