How Canadian taxpayers should handle gain or loss from disposition of NFTs: Unfortunately, most NFTs are worthless; A high percentage of NFTs have almost zero capital value

According to a recent report from dappGambl, based on data provided by Non-Fungible Tokens (NFTs) Scan and CoinMarketCap, it was revealed that out of the 73,257 NFT collections examined by the researchers, a staggering 95% of them, which amounts to 69,795 collections, had a market capitalization of zero. This data was reported by Business Insider on September 20. It's worth noting that approximately 23 million individuals currently possess NFTs in their cryptocurrency wallets. 

The world of NFTs has always been synonymous with speculative trading within the crypto realm. With the decline of this speculative fervour, the question arises: should crypto investors now consider engaging in the aftermath of this decline and what are the Canadian cryptocurrency tax implications? Which NFTs merit closer examination, and why? Gennady Volchek, the CEO of Shping based in Melbourne, offers insights into this matter. Shping is an online shopping rewards app that is not available in the United States.

Volchek notes, "Initial hype tends to inflate prices, driven by the allure of limited supply and increasing demand. However, as the NFT market expands and the supply of NFTs increases, more conventional economic principles come into play."

Sustainable value for NFTs, he emphasizes, relies on genuine demand rather than merely being propelled by FOMO-induced excitement. NFTs that exhibit true scarcity and have practical, real-world applications are more likely to stand the test of time. He points to the collaboration between Walmart and Pudgy Penguins, which started as NFTs and was announced in September, as an example of this trend. If your investment is tied to a project dependent on hype and "digital flexing," such as the multitude of profile picture NFTs, it may struggle to maintain its price point as the supply surpasses the demand. However, NFT holders cannot claim a tax deduction just because the value has plummeted, the holders must dispose of NFTs to crystalize the losses.  

Investors' interests in NFTs decline, but genuine participants are still passionate

The crypto market entered a bearish phase in 2021 following a vigorous bull run in the early months of the pandemic. NFTs felt the impact of this downturn as investors began offloading their holdings. Alexander Casassovici, the co-founder and CEO of Azarus, a web3 platform for live streaming based in San Francisco, points out the importance of distinguishing between investors and genuine participants who actively employ NFTs, particularly in the realm of gaming. He observes, "The latter group remains dedicated and passionate about their NFT holdings," implying that they are more likely to weather the storm of market fluctuations.

Tax characterization of a taxpayer's gain or loss from NFTs disposition

The gains from the disposition of NFTs can be characterized as business income or capital gains. Canadian legal jurisprudence has accumulated a substantial body of case law dealing with the challenge of distinguishing between investment activities that yield capital gains and trading activities that result in business income. Courts take into account a variety of factors when deciding whether to classify the gains or losses of a transaction as either on a capital account or an income account. These factors encompass:

1. Transaction Frequency: For instance, a pattern of frequent buying and selling of non-fungible tokens or rapid turnovers of NFTs may indicate a business-oriented approach.
2. Length of Ownership: Short periods of holding non-fungible tokens suggest business transactions rather than capital investment.
3. Knowledge of NFT Markets: Greater familiarity with and experience in NFT markets lean toward categorizing the activity as a business.
4. Relationship to the Taxpayer's Other Work: If NFT transactions or similar dealings are integral to a taxpayer's employment or other business activities, it tends to signify a business-related endeavor.
5. Time Invested: A substantial commitment of time to studying non-fungible token markets, investigating potential purchases, or actively managing an NFT portfolio is more likely to be seen as a business endeavor.
6. Financing: Leveraged NFT transactions point toward a business context.
7. Advertising: If a taxpayer has advertised or publicly disclosed involvement in non-fungible tokens, there is a higher probability of the activity being characterized as a business.

Ultimately, the most critical criterion for courts in determining whether a transaction resulted in a capital gain or loss or business income or loss is the taxpayer's intention when acquiring the property. However, to ascertain a taxpayer's intention, the court focuses on the objective circumstances surrounding both the purchase and the sale of the property. In essence, a taxpayer's intent is determined by evaluating the factors mentioned above.

NFT and cryptocurrency holders may be required to file form T1135

Canadian tax residents (first-year residents are exempt) who hold specified foreign property with a total cost exceeding $100,000 at any time of the year are required to file the T1135 form. The definition of “specified foreign property” under the Income Tax Act should include offshore cryptocurrency and NFTs, and other blockchain-based assets as intangible property. The T1135 form is due on April 30 the following year, failure to file crypto tax reports on time will lead to a penalty of $25 per day up to 100 days. Fortunately, a voluntary disclosure application may help waive off the penalties and offer partial interest relief to taxpayers who qualify for the general program. Therefore, it is recommended that a taxpayer consult with an experienced Canadian crypto tax lawyer to confirm the proper tax treatment of his/her cryptocurrency and NFT to avoid any potential T1135 issues.

Pro tax tips – How to crystalize the losses of worthless NFTs

NFT’s that have gone down in value do not qualify for tax deductions unless a loss is realized. Taxpayers may have the following options to crystalize the losses of worthless NFTs:

• If there’s still a liquid NFT market, the easiest way realize losses is to sell the NFTs at a nominal value or swap the NFTs if possible.

Alternatively, taxpayers can give away their NFTs as gifts, which deems the NFTs to be disposed at the fair market value at the time of gifting.

FAQ:

I am holding a large portfolio of largely worthless NFTs. What can I do to deduct these losses for tax purposes?

NFT’s that have gone down in value do not qualify for tax deductions unless a loss is realized. To claim the losses on worthless NFTs, a holder may either sell the NFTs for a nominal value or swap them if there’s still a liquid market, or simply gifting the NFTs so the NFTs will be deemed to be sold at the fair market value at the time.

What is the requirement to file the T1135 form?

Taxpayers who hold specified foreign property (SPF) with a total cost in excess of 100,000 Canadian dollars at any time during a tax year will be required to report these assets to the CRA by filing form T1135.

Cryptocurrency and NFT that are considered as capital properties should qualify for SPF, but business inventories will be treated as an exception.

What is the voluntary disclosure program?

The voluntary disclosure application allows non-compliant Canadian taxpayers to come back into the tax system by correcting or changing the tax returns they have already filed. It only applies to the most recent ten years, and the taxpayers who are accepted under the program may receive partial interest relief and a full removal of penalties.

However, not all voluntary disclosure applications will be accepted by the CRA. It is highly recommended that a taxpayer consults with an experienced Canadian tax lawyer to maximize his/her chances.

Disclaimer:

The information provided in this article is general in nature. Only as of the posting date is it current. It hasn't been updated and might not be relevant. It should not be relied upon because it does not provide legal advice. Every tax situation is different from the ones discussed in the article because of its unique circumstances. Consult a Canadian tax lawyer if you have specific legal questions.