NFTs Bring New Challenges

While 2021 has seen Bitcoin and other cryptocurrencies rise in notoriety and value, we cannot overlook the increased popularity of NFTs—non-fungible tokens. Recently digital designer Mark Winkelman (aka Beeple) sold his digital collage NFT for $69 million in March.

What is an NFT? Technically speaking, an NFT is a unique, cryptographically secured digital asset that resides on a blockchain; it is unique and irreplaceable—like a sports card or work of art. In comparison, a bitcoin is fungible—meaning that one bitcoin can be swapped for another bitcoin for essentially the same value (ignoring fees)—much like a quarter.

Since NFTs live on a blockchain, a decentralized and distributed transaction ledger, they have immutable data records to prove authenticity and ownership changes.

You can create any digital asset as an NFT on an NFT marketplace with a digital wallet and cryptocurrency such as Ethereum (ETH). Popular marketplaces are Mintable, Rarible and Valuables. Winkelman sold his NFT on Valuables.

NFTs can generate income for the owner as well as the creator. Most NFTs have embedded smart contracts that give the creator and owners fees based on the number of views—similar to royalties paid to a songwriter. A smart contract is a self-executing agreement between a buyer and seller embedded in code lines on a blockchain.

While NFTs raise many issues and challenges, three that loom large are accounting, valuation and taxation.

Accounting for NFTs is a challenge because no accurate guidance currently exists in GAAP on how to account for them. NFTs do not meet the criteria for cash or cash equivalents, marketable securities, financial instruments or inventory. Some accounting professionals argue they are intangible assets and should be treated as such. If that is the case, they would have to be tested routinely for impairment and recorded at the lower cost of fair value—but what is fair value? That brings us to our next issue—valuation.

The valuation of NFTs is extremely challenging. Currently, there is not an approach that really enables the valuation of an NFT. A market approach could be used, but the problem is that there are very few, if any, guidelines or comps available. For NFTs related directly to art or other collectibles, it is possible that an appraiser in this field could offer an opinion as to value. Remember, these are digital assets—not something you can touch.

The taxation of NFTs has its unique issues and challenges. The IRS considers digital assets to be property. The creation and subsequent sale of an NFT create multiple taxable transactions. The creator of the NFT will have ordinary income when it is sold. Since most NFTs are bought with cryptocurrency, the buyer will have a capital gain or loss on the currency used to purchase it. If and when that buyer sells the NFT, a capital gain or loss will be realized. But, the question arises—is it a collectible or property—both of which will be taxed at differing rates. Remember that NFTs also pay fees to the creator and current owner—all of which will be taxable income. If you recall, a few years ago, the IRS put the virtual currency question on the 1040, signaling their awareness and future intentions. And, it has become easier to purchase cryptocurrency and NFTs—it is as simple as downloading an app to your phone. But a word of caution to parents, your kids may be purchasing NFTs without your knowledge. Popular online games are already selling NFTs, and this will only become more prevalent.

NFTs and other digital assets are here to stay. Already, entire virtual ecosystems are being built where digital real estate is being sold. Hopefully, guidance on these, especially in the areas of accounting, valuation and taxation, will be forthcoming soon.

Chris Etterlee, CPA, ABV, is a partner with Fuller, Frost & Associates, CPAs and an adjunct instructor in the Hull College of Business of Augusta University.