Money Is Fungible. NFTs Are Not.
- "NFTs" are non-fungible tokens that represent an underlying but disassociated asset to which the NFT owner may or may not have rights.
- They are programmed on smart blockchains, purchased in NFT marketplaces and held in crypto-wallets.
- The value of an NFT is derived from demand and, generally, based on its collectible or cultural value.
"Fungible" is an adjective that describes something easily capable of mutual substitution, such that one part or quantity may be exchanged by another equal part or quantity. Money is fungible. It is designed to be completely interchangeable: one dollar always equal to another dollar. Cryptocurrencies are also fungible and designed to operate similarly to fiat currencies. In contrast, NFTs are not.
NFTs are non-fungible tokens, so they are explicitly designed to be unique assets that are irreplaceable and not interchangeable. An NFT is a token built on a blockchain and "minted" using the same technology as cryptocurrencies, but they represent a distinctive underlying asset, which renders them non-fungible in character.
Each NFT fundamentally has an identifier, metadata and a smart contract. Beyond those very basic parameters, the possible applications of NFTs vary widely. They are differentiated by aesthetic and arrangement. Conceptually, you should think of an NFT as a deed that utilizes blockchain to track a real-world asset, but the stylistic aspect of NFTs, like art, is practically limitless.
Purpose and Embodiment of NFTs
NFTs were created as a better means of tracking chain of title, and they accomplish this goal exceptionally well. The immutable nature of blockchain means title is more securely and reliably recorded than by other currently existing means.
Like a deed, an NFT tracks ownership, but for most the real question is: ownership of what? The simplest answer is: a digital collectible embodied in an electronic file. The general consensus is that NFTs (associated with art) should gain some collectible or cultural value over time.
Identifying What You Own
An NFT is a digital asset in and of itself, but it is fundamental to recognize that NFTs are distinct from the underlying work of art or other asset. Rather, an NFT is representative of the asset. Just as nothing prevents an artist from making and distributing reproduction of an original work of art, they are not preventing from minting numerous NFTs of that piece of art.
Minting an NFT fundamentally requires an identifier and coding. NFTs can exist only on blockchains with an NFT standard, such as Ethereum, which is a blockchain that can be programmed with a smart contract. Ethereum is considered the NFT standard, and it is the most popular blockchain for NFTs. The underlying asset is disconnected from the NFT. The following items have been minted into NFTs:
- graphic art
- digital art and GIFs
- videos and sports highlight clips
- virtual assets, such as avatars, skins and videogame assets
- metaverse or virtual real estate
An NFT ledger may be programmed to credit the original artist/creator, indicate copyright ownership or contract for commissions or royalties. Copyrights and copyright licenses may also be incorporated into smart contract aspects of the NFT ledger. Whether an NFT purchaser is obtaining anything other than the right to use/display the NFT is dependent on the particulars of the NFT sale. If you intend to purchase copyrights or enter into a license related to an NFT, you should consult an intellectual property attorney with knowledge of NFTs.
Identify Your NFTs in Your Estate Plan
Ownership mechanics of NFTs operate similarly to ownership of cryptocurrencies. NFTs transactions mostly occur within NFT marketplaces that are specifically designed for sale and purchase of NFTs. NFTs are purchased with cryptocurrency, held in a wallet and programmed on the blockchain.
If you own an NFT, be sure to tell your estate planner and, conversely, estate planners should inquire about NFT ownership upon intake and when updating estate plans. Because NFT ownership is recorded on the blockchain, there are special considerations and provisions that must be taken in order to guarantee that they pass to desired heirs. Simply providing an intended heir an electronic NFT file without more would be akin to providing keys to a house without more – i.e., without the deed. It is insufficient to transfer ownership. A change in NFT ownership must be entered as a transaction on the blockchain. Sophisticated planners can ensure the proper transfer will occur.
Valuing Your NFTs
The value of an NFT is demand-based. In terms of value, you can think of an NFT like a baseball card. Some are very valuable, and some are not. Instead of having a baseball card in hand, an NFT owner has a digital file. Similar to baseball cards and artwork, rarity or uniqueness is directly related to desirability, demand and value.
Other issues with valuing NFTs and their ultimate taxation include: 1) the NFT's fundamental tie to the blockchain it is programmed on – e.g., if programmed on Ethereum, the value of Ether is linked to the NFT and itself would be subject to possible gain taxation; 2) the potential status of some NFTs as collectibles, which would subject the NFT to the higher 28 percent long-term gains treatment; and 3) domicile of an NFT, which is not yet defined and thus could be transferrable to other tax jurisdictions, etc.
Additional NFT Applications
While the intended use of NFT is deed replacement, the creative world has taken hold of NFTs. Some practitioners think of NFTs as a new genre of copyright that recognizes the value of token rights in copyrighted works.
Emerging uses of NFTs include linking an NFT to original artwork and its creator by including authorship credit, reserving moral rights, automating royalties on future sales, and providing additional services or subscriptions, etc., in the smart contract. For example, a musical artist might sell an NFT that comes with a subscription to all music content generated by that artist in the future. Copyright owners who mint NFTs of their own artworks may include assignment or transfer of all or a portion of the associated copyrights along with the NFT purchase. NFTs have also been utilized as indicators of membership or to allow access to an exclusive club. These are just a few creative uses of NFTs, and there is no consensus on intended future use of NFTs at this time.
Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.