By Michael J. Bologna
Thousands of investors with nearly worthless nonfungible tokens, or NFTs, rushed to tax-loss-harvesting marketplaces during the final days of last year, dumping their once pricey digital collectibles to offset gains elsewhere in their portfolios.
That created an opportunity for at least two online platforms launched to do something counterintuitive—create liquidity for assets that are, by design, illiquid, and nonfungible. While most markets capitalize on growth opportunities for tradable assets, these platforms quickly launched to help investors realize losses during a year in which NFTs saw both a boom and a bust.
Business was brisk on both platforms as investors raced the year-end tax deadline to sell their one-of-a-kind digital assets for a fraction of a penny after purchasing them for hundred, or thousands, of dollars earlier in the year.
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After launching in November, the website Unsellable grabbed nearly 18,000 NFTs, acting on its mission to prop up beleaguered NFT investors and build “the world’s largest collection of worthless NFTs.” Another platform, NFT Loss Harvestooor, developed by the cryptocurrency tax software company CoinLedger Inc., launched a few weeks later and purchased 5,000 NFTs, collectively valued at $1.3 million at the height of a bull market. After sending those tokens to “the NFT graveyard,” CoinLedger customers could tap up to $380,000 in tax savings according to the company.
“Unfortunately, there is a lot of garbage in the marketplace that is diluting the possibilities in what NFTs can do,” said Skyler Hallgren, one of Unsellable’s founders. “So we saw an opportunity to clean up that space and create some real value for investors and allow them to realize their losses in legitimate ways.”
Kirk Phillips, managing director of consulting firm Global Crypto Advisors, called the platforms the digital economy equivalent of a “flea market,” offering a badly needed tool to bolster a sagging class of assets.
“You are fulfilling a need and it’s a very simple solution,” said Phillips, a member of the American Institute of CPAs’ Virtual Currency Task Force.
NFTs, digital assets that serve as certificates of authenticity for works of art, music, tickets, and collectibles, had a difficult year after ending 2021 as a superstar. The market for NFTs dropped throughout the year, responding to investor uncertainty and a series of scandals that eroded the value of cryptocurrencies, which are essential for most NFT transactions. The slide was a moment of gravity after the celebrity-driven hysteria that bubbled in 2021 and the first quarter of 2022.
According to the analytics firm DappRadar, 2022 began on a promising note with NFT trading totals surging to an all-time high of $12.4 billion during the first quarter. A steady slide followed, with $8.4 billion in trading volume for the second quarter, $2.7 billion during the third quarter, and $1.2 billion during the final quarter.
As 2022 drew to a close, executives at Unsellable and CoinLedger said they were frustrated by the lack of a rational system for investors to unload their NFTs and recognize their losses.
“NFT volume on OpenSea had fallen off 85%; prices had also fallen off a cliff,” said Lucas Wyland, CoinLedger’s co-founder and chief technology officer. “So we wanted to build a smart contract and open tool to help NFT traders realize some of those losses for illiquid NFTs that have no value on paper anymore.”
While tax-loss harvesting is new in the context of NFTs, Hallgren and Wyland said it’s common practice with other assets as investors seek to minimize their capital gain tax liabilities. An investor may have gains from the sales of stocks, real estate, or cryptocurrency and can strategically offset those gains by selling a declining or worthless asset elsewhere in their portfolio. The losses can offset an unlimited amount of gains from the same year.
For example, one investor purchases two NFTs for $1,000 each. One NFT doubles in value and is later sold, creating a $1,000 capital gain for the investor. The other NFT loses its value, and no party is willing to buy it. The investor sells the token to Unsellable or CoinLedger, creating a loss of $999.99. Assuming there are no other asset transactions for the tax year, the investor reports a short-term capital gain of $.01 and pays the ordinary income tax rate. Assuming a federal and state tax rate of 33%, the taxpayer racked up $330 in tax savings by harvesting.
Tax-loss harvesting also may be worthwhile in a year when the NFT investor has no capital gains, or losses that far outstrip any gains. Under current Internal Revenue Service rules taxpayers are permitted to carry over net losses up to $3,000 per year indefinitely until the full loss is used up.
Though NFTs are relatively new, tokens held for more than a year and sold for a loss would be subject to long-term capital loss rules. Generally, taxpayers can deduct up to $3,000 of the loss against other forms of income.
Tax loss sales of NFTs over Unsellable are transacted in the cryptocurrency ether (ETH). The platform pays 0.0000064 ETH for a worthless token, less than a penny. It also charges a platform fee and a gas fee, which is required for any contract executed over the Ethereum blockchain.
The new tax-loss providers may help investors settle some of their federal and state income tax problems from investments in NFTs, but they may have some lingering state sales tax issues to address. A handful of states including Minnesota, Pennsylvania, and Washington have said NFTs must solely be characterized as taxable digital products and potentially subject to retroactive taxes.
Despite the NFT collapse last year, both Hallgren and Wyland remain bullish. Tax-loss-harvesting platforms, they said, represent a chapter in the evolution of NFTs that may be unnecessary in a few years.
“I think the core technology has a ton of utility,” Wyland said. “What we saw in 2021 was a major overhyped cycle where greed took over the investment decisions people were making. Looking at the long-term horizon, three to ten years, we will see real applications result.”
Hallgren agreed and noted the most important use cases haven’t been created and won’t involve digital cartoon figures or virtual tickets to rap concerts.
“It’s a moment of cleaning out of low-quality projects that have been crowding this space,” he said. “There are a lot of folks doing really innovative work on use cases for NFTs and in ways that can truly change the world.”
To contact the reporter on this story: Michael J. Bologna in Chicago at mbologna@bloomberglaw.com
To contact the editors responsible for this story: Kimberly Wayne at kwayne@bgov.com; Jeff Harrington at jharrington@bloombergindustry.com
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