The World Of NFTs: Taxation And Compliance

Max Dilendorf of the Dilendorf Law Firm PLLC discusses non-fungible tokens, or NFTs, and the related tax planning and compliance issues. 

This transcript has been edited for length and clarity.

David D. Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Tax Notes Today International. This week: breaking down NFTs.

As cryptocurrency has risen in popularity, it’s paved the way for other digital assets, such as non-fungible tokens, or NFTs. You’ll hear a more thorough definition of NFTs in the upcoming interview, but essentially an NFT is a digital file that’s uniquely identifiable via blockchain.

This new asset has many in the tax world wondering about implications and its consequences, especially with the million-dollar sales of some recent NFTs. So, what do potential owners, investors, and tax preparers need to be aware of?

Here to talk more about this is Tax Notes contributing editor Carrie Brandon Elliot. Carrie, welcome back to the podcast.

Carrie Brandon Elliot: Thank you, David. It’s good to be here again.

David D. Stewart: Now you recently spoke with someone about NFT compliance issues. Could you tell us about your guest and what you talked about?

Carrie Brandon Elliot: I spoke with Max Dilendorf of the Dilendorf Law Firm in New York City. They have several practice areas that include digital assets and tax planning, specifically their practice areas include advising clients that want to launch and trade NFTs and who need tax planning and compliance around cryptocurrency issues.

Max and I discussed how they advise clients on structuring transactions and digital assets from a tax planning and compliance viewpoint. We also touched on bank secrecy, anti-money laundering, and Know Your Customer aspects of these transactions.

David D. Stewart: All right, let’s go to that interview.

Carrie Brandon Elliot: Hi, Max. Welcome to the podcast. We’re here today to talk about NFTs, so let’s get started.

Max, can you just take a few moments to sort of describe or define a NFT?

Max Dilendorf: Well, first of all, thank you so much for having me on your show. The way to describe NFTs, let’s think of them as unique digital art that cannot be copied or reproduced. Non-fungible, so one of a kind, and that one of a kind is facilitated by the virtue or fact that it’s being stored in a blockchain.

Anyone at any given point of time can look at your digital art and confirm that you are a true owner of that art by the virtue of a digital signature and digitaliser that everyone gets to see.

Carrie Brandon Elliot: I understand there’s a market for these?

Max Dilendorf: That’s right. There’s a huge market for those digital paintings, prints, whatever you call that.

Carrie Brandon Elliot: We understand that you can create the art, you can buy an NFT, or you can sell an NFT. Can you briefly describe sort of how some of these transactions work?

Max Dilendorf: Sure. We can, I guess, look at this market from different perspectives. There are people that create it, so the artists. There are people that actively engaged in these transactions as buyers and sellers. Then there are promoters of digital art.

There are multiple platforms that facilitate the sale of digital art, both in the U.S. and globally. There is an upward trend in terms of how fast this market grows and develops. We see that the volume of sales is just skyrocketing.

Carrie Brandon Elliot: Can you talk a little bit about the intersection between NFTs and the blockchain and cryptocurrency?

Max Dilendorf: Well, in order for someone to be able to purchase or sell an NFT, the person needs to be familiar with what a cryptocurrency is, right? They need to have certain devices and wallets to connect to those marketplaces, to exchange their cryptocurrency for any given NFT token that they like.

The most commonly used wallet in the ecosystem is called MetaMask wallet. It’s a digital wallet that stores different types of crypto. Your Bitcoin and your ERC20. It stores the ERC20 tokens like Ethereum. You can connect that wallet to a gallery or you can connect that wallet to any given marketplace that trades NFTs and make an exchange.

Pretty much you’re exchanging your cryptocurrency, either Ethereum or stablecoin, for the selected piece of art. The intersection is that someone needs to know what a crypto is, how to buy it, how to manage it, how to store it on a wallet, like how to obtain sort of rights and safekeep the NFT that they just purchased.

Carrie Brandon Elliot: How would you advise a client on the tax consequences of a sale of an NFT?

Max Dilendorf: Well, the IRS, they see each cryptocurrency as a property. NFT is not a legal term or tax term. It’s a digital token and according to the tax rules like, “Hey, if you are trading one type of cryptocurrency for another, every time you complete the transaction, you either have a gain or a loss.” If you’re trading NFTs, which are digital tokens, then every time you have a taxable transaction to report.

Carrie Brandon Elliot: What about creators and sellers of NFTs? I understand that you may have gain or loss on the cryptocurrency aspects of the transaction. Is that separate from the transaction in the NFT itself, whether you’re buying or selling or creating?

Max Dilendorf: Well, they’re selling goods. If you are dealing with an artist which has created, let’s say 10,000 NFTs, the question is like, “OK, what are you really selling?” You’re selling a product, right?

You spend, let’s say $10,000 on marketing fees. You spend $15,000 on a digital virtual designer to come up with these elephants or penguins. You’re already out of pocket $25,000 and you generated the profit of, I don’t know, $75,000.

You would probably report it as an ordinary income. But then the question is, “OK, what about a buyer who purchased any given NFT for $1,000 and now three months later he finds out that this NFT is so unique that it’s worth $300,000?” And he wants to sell it, and so upon realizing and completing the sale, there will be a significant gain between what it was purchased for and between what the seller is selling it for.

Carrie Brandon Elliot: In terms of being able to do a transaction in an NFT, and then actually pay a tax liability, can you talk a little bit about some of the questions that clients have when it comes to that piece of it? Like banking rules for example?

Max Dilendorf: Well, I think the biggest trial that the clients are not really realizing is that every time they exchange one NFT for another, it’s a reportable tax transaction. You may be either generating loss or profit. Your clients need to keep track of all of their trading activities.

There are some people out there that can be buying or selling 20, 30, 50 NFTs per day. They could be using their Ethereum to complete a transaction. We would need to know, “Hey, what was the cost basis for that Ethereum at the time when you exchanged it to understand if you generated a loss or you generated profit?” Your records must be immaculate so that you have a clean picture at the end of the year.

Carrie Brandon Elliot: Do you find that the reporting itself, like the tax forms and IRS rules, is up to task for the particular market? Or are there things that could be done to improve the ability of people who deal in NFTs to remain compliant?

Max Dilendorf: Well, we work with CPAs who are knowledgeable in crypto and crypto reporting, but at the end of day, it’s still sitting down and going through every transaction that a client completed, really understanding what type of digital assets the client has in his wallet, when they purchased it, what’s the regional plus basis of that asset. At the time when the transfer or the sale occurred, how do we calculate the tax basis in the new piece?

There’s a lot of micro analysis that goes there. As far as softwares that keep track of everything, unfortunately, even in 2022, there is no solid software solution that can take care of all of these nuances. Oftentimes it’s a lot of manual work.

Carrie Brandon Elliot: Hmm. That’s interesting. Do you have any thoughts on the banking aspects of this? What the banks are doing?

Max Dilendorf: Well, we certainly have a lot of thoughts on what the banks are doing. The banks are subject to the so-called Bank Secrecy Act and Know Your Customer rules, as well as anti-money laundering rules. Whenever there is an interaction between a customer and the bank, your bank wants to know that “Hey, this person for whom we opened the bank account, he’s not doing something illegal, right? Because if he does, we can get in trouble.”

That interaction between crypto and banks is very interesting nowadays, because in the last year, we’ve seen the explosion of peer-to-peer transactions. It’s not like business-to-business or peer-to-business, it’s peer to peer and where the users do not know each other. It’s not like I’ve met you on the street. I know who you are. I know where you live. I check your ID. I have a copy of your passport.

In a digital world, this does not exist. Where the complications could be — let’s say a person sells an expensive piece of NFT for $600,000 and, by the way, those are typical numbers. There are some very expensive digital paintings out there. He says, “Well, I just sold an expensive piece of art, a digital NFT. I spent $2,000 when it was still cheap. And I want to pay tax on the difference. What do I do?”

Then you would ask him, “Well, do you know where the funds came from?” Because if you work with a bank, the bank will probably would want to know that the funds came from a clean source.

A lot of times a client cannot answer this simple question, where the funds came from, because they came from another digital wallet and that digital wallet could be somewhere in Iran or North Korea or another sanctioned jurisdiction. This is where it gets tricky.

When you contact the bank, trying to explain the situation like, “Hey, I have a client, he wants to complete a wire transfer to his bank account but because the transaction was completed in a peer-to-peer style, he can’t really explain the source of funds,” the banker would listen to you and not know what to say. We have those conversations multiple times with different banks in New York and other states.

The answer is like, “Hey, we cannot guarantee you that once you deposit those funds that we will not be sending out a [Suspicious Activity Report] report.” I’m like, “Well, that’s interesting because if I’m an existing client in the bank before wiring the funds, you can tell me what level of due diligence you’ll be using to verify whether or not to file [Suspicious Activity Report] or not to file.” That part is not clear to me when it comes to digital assets and banking.

Carrie Brandon Elliot: If you had a client that’s just starting out in this market, who is ready to create, buy, or sell, how would you advise them to start out of the gate in a way that facilitates compliance, reporting, and tax reporting and tax compliance?

Max Dilendorf: Well, I would recommend to operate only through platforms that are legitimate. We want to know that the platform through which a customer either buys or sells NFTs actually does whitelist all of the users on the platform. In other words, in order for me to participate as a bidder or seller on a platform, a platform needs to collect the copy of my driver’s license. They need to verify who I am.

So, why don’t you work through platforms that already do all the homework for you, as opposed to going onto the platform that does doesn’t do anything? This way you can have a clear record like, “Hey, I purchased this piece of digital art in 2021 using this platform. The platform completed all the [Know Your Customer] and the email checks. We see that the seller of this piece came from the United States, went on to the platform, completed their own due diligence from the seller.” 

If there is ever a question from a banking institution or the Financial Crimes Enforcement Network, you can have a clear record of what happened in any given period of time, as opposed to transacting on questionable platforms that do not have any record-keeping whatsoever. That would be the first step.

Carrie Brandon Elliot: It sounds like the way the platform operates is very crucial to be enabled to do the kind of due diligence and the kind of compliance that ideally would occur. In other words, the platform makes all the difference in the world. Is that true, would you say?

Max Dilendorf: That is true. Think of like a high-end art auction houses, like Sotheby’s. If you’re buying a piece of art or antique from an established auction house, there’s certain standards that an auction house would follow. They would probably do full due diligence on the item that’s being sold. Like, “what’s the title to this piece? Is it a stolen piece? Is it not a stolen piece?” They would have a title report.

In order for you to participate on the auction, you need to register with the auction house or you have to submit your documents. You need to prove that whatever funds you are planning to use in completing the purchase with are legitimate. I guess a respectable NFT marketplace would follow the same principles.

Carrie Brandon Elliot: Let’s say you’ve got certain players in a marketplace that provide participants with tax compliance documents, say a 1099 or a W-2. Do some of these platforms help with that? Are you aware of any that help buyers and sellers on the platforms with their tax compliance?

Max Dilendorf: Actually, no. I haven’t heard of that. No. But I can tell you that there are a lot of platforms and NFT marketplaces. Some of them are good and some of them are really bad.

When a client tells me, “Hey, I was trading on this in this marketplace,” if they tell me the name of the marketplace, it can immediately raise a red flag in my mind. I’m like, “OK, it doesn’t look good. You will have a problem. I guarantee you.”

Carrie Brandon Elliot: OK, well sort of a wrap up question, any traps for the unwary? Anyone that happens to be tuning in and is interested in participating in the marketplace, have you got any words of advice?

Max Dilendorf: Well, I would say buyer beware. If you’re buying something expensive, like half-a-million-dollar digital art, think of it, how’s it different than buying a house? Wouldn’t you want to have a full due diligence on that piece of property that you’re buying? Wouldn’t you want to have like something in writing from the seller making representations that like, “Yes, I’m legitimate seller. The title to this property is clean.”

I would also ask for representations that whatever NFT I’m buying is not a security, because a lot of them could be securities by the way, and if that’s the case, then I’m stuck with an illiquid asset. Once again, everyone who is looking to jump into this exciting world of digital art, just be aware. Do your own your due diligence.

Don’t follow the herd. Be very cautious with how you handle your funds, to whom you send it. If you are accepting large sums of money from someone you’ve never met, I mean, that’s suspicious on its own. We live in 2022. We need to know who are we dealing with. Especially if we live in the U.S.

I would recommend starting out with what I like to call it the “Crypto Bible.” There is the Department of Justice Cryptocurrency Enforcement Framework that the DOJ released last year. It goes like line by line what users should know about this exciting world of digital currencies, what they can and cannot do, what are some of the risky areas. That would be a good start for someone who’s never done them before. Certainly that’s a good document for any tax professional or legal practitioner to use.

Carrie Brandon Elliot: OK. Well, thank you so much for being with us today. That was an fascinating and interesting discussion.

Max Dilendorf: Carrie, thank you so much for having me. It’s been a pleasure and an honor to be part of your podcast.