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 has auctioned off a non-fungible token, or NFT, from the first tweet ever sent. Dorsey’s historic message: “just configure my twttr”. Quite ordinary for sure. Still, crypto entrepreneur Sina Estavi made the winning bid for $2.9 million, presumably assuming the world’s first tweet would surely appreciate.

Investor enthusiasm for an NFT can quickly run out of steam, with many getting bored and looking for the next cool thing.

Akorcagin/Dreamstime

But when Estavi recently attempted to sell this NFT, he received mixed interest. The highest bid was only $280.

Clearly, the nascent NFT market is highly volatile. Yet it also attracts many investors. According to research by Art Basel and

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

Although financial advisory firms that allow the buying and selling of NFTs for their clients are still rare, this probably won’t be the case forever. Now is the time for advisors to deepen their knowledge of the NFT market so they are 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 authentication certificate whose details about the NFT and its owner are embedded in a blockchain, such as Ethereum. This provides a unique identifier for a digital item, like the tweet Estavi bought, or something physical, like artwork, record albums, and even real estate.

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

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

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

But note that this is an unregulated arena. “Many NFT marketplaces put the buyer at risk knowing what you’re buying,” says Dale Werts, partner at Lathrop GPM. “The buyer must therefore exercise due diligence to ensure that the seller owns the NFT.”

What factors go into the valuation of an NFT? It is generally a subjective process. Value is often determined by the reputation of the person who created the NFT. So, Estavi made millions for this tweet because it was Dorsey’s first ever. Another example is Beeple, a renowned digital artist who goes by the name of Mike Winkleman. In 2021 he auctioned an NFT of his digital work called Every day: the first 5000 days for $69.3 million.

Another determinant of value is the support of the NFT. “One of the biggest factors influencing the value of NFTs in the market today is the exclusivity and uniqueness of the community behind the collection,” says Alex Salnikov, co-founder and chief strategy officer of Rare.

But investor enthusiasm for an NFT can quickly run out of steam, with many getting bored and looking for the next cool thing. “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? Piracy is one of the biggest problems. The most notable case happened in March with Axie Infinity, a blockchain-based video game that uses NFTs. Hackers seized $615 million (end-March value) worth of ether and USDC tokens, a type of stablecoin pegged to the US dollar. The company says it is seeking to recover stolen funds and reimburse victims.

But piracy is not the only risk. Fraud is also a big concern. For example, a “rug pull” describes when an NFT developer abandons a project and runs away with funds that have already been invested. “It’s easy for someone new to the space to click on 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 cryptocurrencies. But the process can be tricky because you will likely be using cryptocurrency to transact.

Say you used ETH that is now worth $3,000 to buy an NFT at the same price. But when you bought the cryptocurrency two years ago, it was worth $500. This means that 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. You will now have a short term capital gain of $1,000.

“Some tax experts believe the IRS may treat NFTs as collectibles, meaning any long-term capital gains realized on NFT sales would be taxed up to 28%,” says Olya Veramchuck, head of taxation at Lukka.

Tom Tauli 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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