TaxNotes – Micheal Lukacs, Oren P. Margulies, and Lakshmi Jayanthi: ABCs of NFTs: Key Tax Considerations (November 22, 2022)

Michael Lukacs, Oren P. Margulies, and Lakshmi Jayanthi have published an article on the TaxNotes, titled “ABC of NFTs: Key Tax Considerations.” The article begins as follows:

Web 3, the metaverse, digital assets — these rapidly developing technology applications are increasingly discussed in media reports and everyday conversations. Web 3 will enable widespread adoption of the metaverse,1 and digital assets are the means of trade in those environments. Indeed, digital assets have applications far beyond the metaverse. As the growing volume of cryptocurrencies in the market denotes their mainstream adoption, use of a new class of digital assets is also growing rapidly: nonfungible tokens (NFTs).2

NFTs have recently exploded into the mainstream — most prominently with a digital art piece sold at auction for $69 million3 and the first-ever tweet selling for $2.8 million4 — creating a new and substantial market for this type of digital asset.5 At their most basic, NFTs are unique digital assets that prove ownership (that is, functioning as a digital certificate of ownership or authenticity) of a copy of digital content (for example, digital art or music) or tangible property (for example, limited edition shoes). More broadly, NFTs are the next wave of digital assets that simplify the buy-sell process (including by reducing participants’ transaction costs) and elevate an online user’s digital experience in the gaming, music, entertainment, real estate, and collectible industries. Moreover, NFTs can enhance creators’ ability to benefit from the use of their creations, including by offering the possibility of receiving perpetual returns. NFTs have the potential for commercial application beyond just sales of digital art. As a broader group of taxpayers begins to incorporate NFTs into their commercial activities, it is important to understand the myriad tax consequences arising from those activities. Some of the federal income tax consequences are addressed below.

Guidance on the taxation of “digital assets” — a term only recently defined in the code as part of statutory changes to rules applicable to returns of brokers6 — is primarily limited to cryptocurrency (generally fungible in nature) and does not directly address the tax treatment of NFTs.7 As a result, the taxation of NFT transactions, including determining the character and source of income generated from a transaction involving an NFT, must be evaluated through analogies and comparisons with existing tax rules.

This article explains what NFTs are, how various parties engage in NFT transactions, and how NFTs are commonly exploited commercially. We then address some of the common federal income tax questions that arise in NFT transactions.

Click here to see the full article: “ABC of NFTs: Key Tax Considerations

Posted by Melissa Zheng, Associate Editor, Wealth Strategies Journal.

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