What Financial Advisors Need to Know About NFTs

Until fairly recently, the idea of selling a tweet wouldn’t have made much sense. But last year,

Twitter

co-founder Jack Dorsey auctioned a nonfungible token, or NFT, of the first tweet ever sent. Dorsey’s historic message: “just setting up my twttr.” Pretty mundane for sure. Still, crypto entrepreneur Sina Estavi made the winning bid for $2.9 million, on the likely assumption that the world’s first tweet would surely appreciate.

Investors’ enthusiasm for an NFT can quickly fizzle, with many getting bored and looking for the next cool one.


Akorcagin/Dreamstime

But when Estavi attempted to sell this NFT recently, he received tepid interest. The top bid was a mere $280.  

Clearly, the fledgling market for NFTs is highly volatile. Yet it’s also attracting many investors. According to research from Art Basel and

UBS
,
74% of high-net-worth individuals purchased NFTs based on artwork.

While financial advisory firms that permit buying and selling of NFTs for clients are still rare, that won’t likely be the case forever. So now’s the time for advisors to sharpen their knowledge of the NFT marketplace to be ready to help clients navigate this emerging, alluring, yet highly speculative category. Let’s take a look:

What is an NFT? Think of it as a digital certificate of authentication whose details about the NFT and who owns it are embedded on a blockchain, such as Ethereum. This provides a unique identifier for a digital item, like the tweet that Estavi bought, or something physical, like artwork, record albums, and even real estate.

“Because NFTs are created, purchased, and stored on the blockchain, there is no longer a need for avid art creators to pay for physical storage for artwork,” says Anthony Georgiades, co-founder of Pastel Network.

How do you acquire NFTs? You will usually need to buy an NFT with a cryptocurrency, typically Ether (ETH), which you can buy from an exchange such as Coinbase. 

You place your cryptocurrency in a digital “wallet” and connect it to a marketplace like OpenSea or Rarible. You can then make a purchase, either for a fixed price or at an auction.  

But note that this is an unregulated arena. “Many NFT marketplaces put the risk of knowing what you are buying on the buyer,” says Dale Werts,  a partner at Lathrop GPM. “So the buyer needs to do some due diligence to be assured the seller owns the NFT.” 

What factors go into an NFT’s valuation? It’s generally a subjective process. Value often is determined by the reputation of the person who created the NFT. Thus, Estavi ponied up millions for that tweet because it was Dorsey’s very first one. Another example is Beeple,  a renowned digital artist who’s name is Mike Winkleman. In 2021, he auctioned an NFT of his digital artwork called Everydays: The First 5000 Days for $69.3 million.

Another determinant of value is the backing of the NFT. “One of the most important factors influencing the value of NFTs on the market today is the exclusivity and uniqueness of the community behind the collection,” says Alex Salnikov, co-founder and chief strategy officer of Rarible.

But investors’ enthusiasm for an NFT can quickly fizzle, with many getting bored and looking for the next cool one. “If the market for a particular NFT collection is primarily driven by other speculators, you should stay away,” says Roger Beaman, CEO of Novel.

What are the risks of NFTs? Hacking is one of the biggest problems. The most notable case happened in March to Axie Infinity, a blockchain-based videogame that uses NFTs. The hackers made off with  $615 million (value as of end-March) worth of ether tokens and USDC, a type of stablecoin linked to the U.S. dollar. The company says it’s seeking to recover the stolen funds and reimburse the victims. 

But hacking isn’t the only risk. Fraud is also a big concern. For example, a “rug pull” describes when a NFT developer abandons a project and absconds with funds that have already been invested. “It’s easy for someone new to the space to click a fraudulent link and become a victim,” says Rob Petrozzo, founder of Rally.

How are NFTs taxed? The IRS treats them as property, much the same as it does for cryptocurrencies. But the process can be tricky because you will likely use cryptocurrency to make your transactions.

Say you use one ETH now worth $3,000 to buy an NFT for the same price. But when you bought the cryptocurrency two years ago it was worth $500. This means you have a long-term capital gain on this transaction of $2,500. Then less than a year later, you sell the NFT for $4,000. Now you’ll have a short-term capital gain of $1,000.

“Some tax practitioners believe that the IRS may treat NFTs as collectible items, which means that any long-term capital gains realized on NFT sales would be taxed up to 28%,” says Olya Veramchuck, head of Tax at Lukka.

Tom Taulli is a freelance writer, author, and former broker. He is also an enrolled agent, which allows him to represent clients before the IRS.

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