NFTs. Sounds familiar? For sure. But not quite sure what it is? Yeah, me too.
NFTs became the newest big thing in popular culture in 2021 when every millennial and Gen Z seem to own one, mint one, or be on the verge of buying one. The first NFT “Quantum” was minted by Kevin McCoy on May 3, 2014 on NameCoins and sold for $1.47 million on June 10, 2021 for which a lawsuit was later filed. Just last year, on March 11, 2021, Beeple’s “Everydays: The First 5000 Days” sold for $69.3 million as the most expensive NFT ever sold. Sales of NFTs reached $25 billion in 2021 (Source: Reuters) and while monthly sales have declined in 2022, total sales could still total up to $90 billion by the end of 2022 (Source: Yahoo Finance).
Predictably, celebrities like Bella Hadid, Snoop Dogg, and Shawn Mendes and companies like Taco Bell, Coca-Cola, and Nike are hopping on the NFT craze. So, this begs us to questions: are NFTs here to stay? If so, what are the accounting implications involved?
1 Kevin McCoy, “Quantum” (2014-21) 2 Beeple, “Everydays: The First 5,000 Days” (2021)
What is an NFT?
\ ˌen-ef-ˈtē \
: Non-Fungible Token: a unique digital identifier that cannot be copied, substituted, or subdivided, that is recorded in a blockchain, and that is used to certify authenticity and ownership (as of a specific digital asset and specific rights relating to it) (Source: Merriam-Webster)
Well, that sounds like a gimmick to me.
An NFT is unique data on a blockchain that can be linked to digital and physical objects to provide an immaculate proof of ownership. The record of ownership is stored on digital ledgers and the owners have access to the asset and may use it for commercial purposes. Common NFTs include graphic art, songs, videos, exclusive merchandise, GIFs, collectibles, cars, yachts, designer sneakers, healthcare records, and more.
Essentially, NFTs are like the digital version of a museum collection. It enables artists and content creators a unique way to monetize their products and platform. It is crucial to note that the NFT owner does not own the underlying asset, but rather the exclusive ownership of the unique token.
How do NFTs Work?
A person who wants to sell an NFT would first need to mint the asset by creating a unique asset, buy tokens such as Ether, deposit the crypto into a non-custodial wallet, then add the asset to the NFT collection on an NFT marketplace such as OpenSea, Rarible, SuperRare, Foundation, etc. The NFT now represents the asset on the blockchain and can be kept as part of a private collection, or can be bought, sold, and traded.
NFTs are nonfungible, hence, the hefty price. In simple terms, it creates digital scarcity. An NFT cannot be replaced with an identical one because there are no identical NFTs. The skepticism surrounding NFTs is: Why should I spend millions of dollars on something that I can just screenshot off of the internet right now?
One of the main reasons why people own NFTs is because it enables the creators to mint and sell their work while retaining the IP and creative control and monetizing through royalties and secondary sales rather than going through a third-party management company. Having the unique rights to the asset drives the market value of NFTs. Another reason would be its investment value albeit there are high risk and volatility involved. NFTs can be fractionalized and “as NFTs become more sophisticated and integrate into the financial infrastructure, it may be possible to implement the same concept of tokenized pieces of land (differing in value and location) in the physical world” (Source: Investopedia).
What are the Accounting and Tax Implications of NFTs?
As it currently stands, GAAP does not have set guidance over digital assets and NFTs though the AICPA’s Accounting for and Auditing of Digital Assets lists characteristics of digital assets that are considered intangible assets that can be measured at cost and tested for impairment. NFTs are treated as property for tax reporting purposes and indefinite lived intangible assets for financial reporting purposes. It is worthy of note that there are many complications surrounding the matter due to the type of underlying asset tied to the NFTs (ie. digital asset vs commercial real estate) among others.
Gains on sales of NFTs are subject to taxes though they may be taxed at a higher collectibles tax rate and may not receive the preferential long-term capital gains rates. Additionally, the cryptocurrencies used to purchase the NFT may also be taxed for gains.
It further raises the question of how content creators and owners are paid for their royalties. Taxes and accounting implications for payment via fiat currencies vs. tokens are vastly different, with the latter being much more conjectural.
“Put simply, the current IRS classification of all digital assets, virtual assets, or crypto assets as property creates the following conundrum for creators, investors, and practitioners:
If block rewards, or the payments related to an NFT, take the form of newly created/issued crypto assets, are these payments taxable when accrued by the investor? A parallel can be drawn – directly from the IRS code – that gold or other minerals are only taxed when they are sold to an external party, not simply when they are mined or refined. Building on that, it is possible – as highlighted by the specific facts and circumstances of Joshua and Jessica Jarrett vs. United States – those taxpayers may be overpaying taxes” (Source: WSBA).
In simple terms, investors of NFTs should be aware of the complexities surrounding the tax planning implications as well as the risks and necessary internal controls associated with holding such assets.
What are the Valuation Challenges of NFTs?
There are not many CPA’s and firms that offer NFT Valuations as it is a new and challenging area. Caroline Taylor, founder of Appraisal Bureau, pointed out that traditional artworks are judged for their beauty, collectability, rarity, and provenance whereas NFTs are judged for different things depending on its life cycle. NFTs have inbuilt utility and trade on blockchain with huge price swings.
Since cryptocurrencies are used to purchase NFTs, the value of cryptocurrencies also matters. “The value of an NFT is based on a third-party transaction between a willing buyer and seller. If using cryptocurrency that is actively traded to buy an NFT, the value of the asset is likely determined by the value of the cryptocurrency used in the transaction, at the time of the transaction, as it has the more readily ascertainable fair market value,” said Rob Massey, CPA.
For NFTs that are newly minted, their intrinsic value or cost to recreate may be considered, though it is important to note that there are a lot of assumptions at play.
For NFTs that generate royalties, their value can be approximated using a Discounted Cash Flow (DCF) method as the value of future royalties plus the value of the underlying asset. Appraisers need to consider the benefit of owning the NFT written on the contract, if any. Note that someone who owns the NFT only owns the token and not the underlying asset itself. As such, the underlying asset needs to be separately appraised and verified in a traditional manner (e.g., art appraiser). This aspect gets increasingly scrutinized as NFTs move from digital artwork to tangible real estates and assets of the likes where further questions should be considered. Additionally, at a certain point in time, a specialist is needed to verify the ownership of the NFTs as well as the trademarks and infringements in case a litigation arise.
The IRS most likely considers NFTs as property, so gift donations of NFTs also need to go through qualified appraisals by a person or entity that has proven a level of competence with the asset in which they are appraising. In addition, the nonprofit that accepted the NFT needs to first think about the liquidation process of such NFT.
- Owners of NFTs only own the unique token, not the underlying asset(s), unless specified otherwise in a contract.
- Investors should be aware of the risks and volatilities associated with owning NFTs since they tie directly to the value of cryptocurrencies as well as the type of underlying assets.
- GAAP has not issued set guidance on digital assets and NFTs so appraisers face many challenges and investors should discuss with professional tax planners specialized in this area.