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What Are NFTs? Understand Estate Planning Challenges

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Whether or not they prove to have staying power, NFTs continue to make headlines and pique collector curiosity.

From an emergent tech trend to explosive popularity to a hard landing back down to earth, NFTs have been on a wild ride in recent years. While NFT sales were down more than 80% by late 2022 from their late 2021 peak1 — with prices mirroring a comparable decline2 — they remain of interest to many collectors. But the relatively complex and new technology on which NFTs are based can make the concept itself difficult to understand — and the estate planning and fiduciary challenges associated with fully digital assets thorny to navigate.

Below, we answer several of the most commonly asked questions regarding NFTs from collectors and provide color on recent legal and tax developments.

What is an NFT?

In essence, NFTs are encrypted units of data, referred to as “tokens,” that exist on a blockchain — the technology that makes cryptocurrency possible — to denote ownership of a unique digital asset. A blockchain, in turn, can be described as a transparent, publicly available electronic ledger that exists across a network of computers. The key innovation is the blockchain’s unique properties in securing a transparent, publicly available record of data without the need for verification by a third party.

The abbreviation NFT stands for “non-fungible token.” In economic terms, “fungible” denotes a good or asset that can be substituted for another, substantively identical, good or asset. For example, units of traditional currency, common shares of stocks, precious metals and units of cryptocurrency like Bitcoin are considered fungible items. Conversely, artworks and collectibles are considered non-fungible as, generally, they cannot be traded for identical items of the same value and possess unique properties.

The majority of discussion surrounding NFTs today pertains to their use as metaphors, or symbols, of ownership of unique digital assets — most often digital images such as artwork or photos, but also audio files, videos or, in theory, any digital file.  

Why have NFTs been in the news so much the last few years?

The technology discussed above made it recently possible to confer the qualities of rarity, scarcity and uniqueness on digital assets, which are inherently easily replicable. Visual artists, celebrities, athletes, musicians, businesses and others — collectively often referred to as “creators” — have in turn taken this new opportunity to sell their digital creations to an eager public.

The NFT surge in popularity reached, at least for the time being, a crescendo in 2021, before the market plunged in tandem with the larger drop in crypto currencies in 2022. Consequently, prices for many NFTs have declined substantially.

High-profile NFT developments in recent years include:

  • Starbucks recently launched Starbucks Odyssey, which incorporates NFTs into a loyalty program, and Nike launched .Swoosh, a new home for its “virtual creations” that will reportedly eventually sell NFT collections
  • Artist Beeple’s collage EVERYDAYS: The First 5000 Days, sold for $69.3 million, by Christie’s, in early 2021
  • Twitter founder Jack Dorsey’s first tweet, sold for $2.9 million, on auction platform Valuables by Cent, in early 2021
  • Musician Grimes sold 10 pieces of digital art, including images and short videos, as NFTs for $10 million on Nifty Gateway, in early 2021
  • The NBA sells NFTs of athletes and dramatic plays through NBA Top Shot, resulting in more than $1 billion in sales since its launch.

When I buy an NFT, do I own the copyrights to the image?

Unless specifically stipulated by the creator, no. Ownership of the NFT confers no ownership of copyrights and, all else equal, the creator retains the rights to the image — which is generally easily replicable, regardless. The value of the NFT is therefore derived from its “smart contract” capabilities used to denote ownership as well as its verifiable, authenticated association to the image, a file of which is linked on the blockchain, and often, though not always, stored on the Interplanetary File System (IPFS). In some cases, however, creators will collaborate with purchasers on ways to display the image, if they wish to do so.

It can be helpful to think of an NFT as a signed baseball card — many prints of the card exist, but only a rare few are signed. Similarly, NFTs also share characteristics with traditional art print runs, as many creators will offer a limited amount of NFTs for a given work.

What else should I know about NFTs?

Ethereum remains the dominant blockchain for purchasing NFTs. Therefore, to purchase NFTs from popular marketplaces — such as OpenSea, Rarible and Super Rare — buyers obtain a digital wallet (Metamask, Binance  and Coinbase, for example) and some amount of the Ether cryptocurrency to conduct the transaction. When you purchase the NFT by auction or fixed price, the currency is extracted from your digital wallet and placed in the creator’s, while the NFT is placed into your wallet.

In addition to the purchase cost, you will also have to pay a “gas” fee — a surcharge from the platform used, in part, to cover the cost of “minting,” or creating, the NFT. While these fees range across platforms and are variable depending on the cost of energy at the time of the transaction as well as how many other transactions are taking place concurrently, they are generally 2.5-5% of the NFT price.   

What are the primary estate planning challenges currently surrounding NFTs?

Technology changes faster than the law, and estate planning is broadly adapting to the “digital deluge” of our era — such as the legal issues surrounding executors and trustees accessing financial information stored on digital platforms. Nearly every state, including the District of Columbia, has adopted or is considering some form of digital asset protection. For example, the Revised Uniform Fiduciary Access to Digital Assets Act (RUFADAA) has been adopted by the vast majority of states. While the RUFADAA provides some help and guidance surrounding these issues, it unfortunately does very little to address the issues and risks associated with the administration of estates and trusts that hold fully digital assets like cryptocurrency and NFTs. Indeed, they are expressly excluded from the definition of the term “digital asset” in the RUFADAA.

That said, one of the key considerations for all digital assets is ensuring that your advisors, designated agents for property and your fiduciaries have up-to-date information on your cryptocurrency and NFT holdings, along with detailed instructions on how to access your digitally stored account information upon your death or disability. A complete list of assets, including access information, should be stored in a secure location that can be accessed in the event of your death or incapacity. (In a widely reported 2021 news story,3 few envied the Silicon Valley CEO with only two password attempts left to retrieve $220M in cryptocurrency.) It is also important to understand that, due to the volatile nature of these assets, holding cryptocurrency or NFTs in an estate or trust can significantly increase the risk of exposure to personal liability for your fiduciaries.

For these reasons, your estate plan and/or powers of attorney for property should include very specific provisions for owning, liquidating and buying cryptocurrency or NFT assets that you may hold upon your death or incapacity. You should also be sure to provide instructions to your agents and fiduciaries to ensure that they are aware of the risks and that they will still be willing and able to serve when the time comes.

For those who hold NFTs or other digital assets that exist solely on a blockchain, keep detailed records of the assets you own, the digital wallets in which they are stored and the crypto key that your fiduciary will need to access, secure, value and liquidate or transfer those assets as soon as possible following death or incapacity. To ensure your digital assets are secure, you will need to  confirm that you are using reputable wallets, exchanges, brokerages and apps, and broadly adhere to established best cybersecurity practices, such as unique passwords and two-factor authentication, where possible.

Additionally, remain aware that fully digital assets such as cryptocurrency and NFTs are still relatively new, and the rules surrounding their tax treatment continue to evolve. In recent years, for example, the Internal Revenue Service has added to the first page of income tax returns a requirement in which taxpayers must disclose if they received or exchanged digital assets. And in 2021, the Infrastructure Investment and Jobs Act included new provisions requiring brokers to file a 1099-B form identifying customers, as well as businesses and exchanges, to report transactions of more than $10,000. While these provisions are being challenged in Congress and will ultimately be subject to interpretation by the Treasury Department, continued regulation surrounding fully digital assets is likely.

As an example, the Office of Chief Counsel of the IRS issued an Advice Memorandum on January 13, 2023 confirming that in order to obtain a charitable deduction for a gift of cryptocurrency in excess of $5,000, the taxpayer must obtain a “qualified appraisal.”  Generally, a “qualified appraisal” is an appraisal signed by a recognized appraiser with at least two years’ experience valuing the type of property at issue.  Although the value of cryptocurrency can often be readily obtained from public exchanges, the definition of “digital assets” under the Infrastructure Investment and Jobs Act differentiates virtual currency or cryptocurrency from assets like cash, marketable securities and other assets that do not require a “qualified appraisal.”

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Disclosures

This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.

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