An NFT is essentially a digital asset – it can be an artwork, a piece of music or an item or character known to the gaming community – that can be created, bought or sold, much like similar assets in the real world. When the NFT has a utility or membership attached to it, such as a weapon used in a popular video game, it can be desirable in that community and, as a result, attract a higher price.

Online marketplaces, such as OpenSea, which was established in 2017, are specifically designed for trading NFTs. Many exchange platforms for cryptocurrencies are also now bringing out their own platforms for trading NFTs, making the marketplace even more competitive. For example, Binance and Crypto.com have launched their own platform for trading NFT’s.

Before diving into the world of NFTs it is important to decide the route you want to take. For example, do you want to create an NFT, which you can then hopefully sell at a profit, or are you more inclined to become a collector of NFTs by buying and selling them on the open market?

Purchasing an NFT is quite easy to do – prospective investors can just choose a platform and create an account. Money can then be transferred into the account and converted automatically into cryptocurrency, which can then be used to purchase NFTs. Alternatively, investors can hold money separately in a ‘digital wallet’, which they can then dip into to buy NFTs and store them independently. There are pros and cons attached to both methods and it is up to the individual to decide which suits them best.

Designing and selling NFTs requires more time and a variety of skills, such as graphic design, coding, minting the NFT and then promoting assets online. This is a similar process to starting up a business venture and should be approached in much the same way.

Despite its growing popularity, the marketplace for NFTs is still incredibly volatile and, in some cases, the value of a specific asset has changed dramatically over the course of a day. Furthermore, as the marketplace is relatively new, no track record exists to indicate how assets might perform in the longer term. Therefore, much like when buying a piece of art in the real world, it is advisable to invest in a piece you genuinely like and want to own, just in case it turns out to be an unprofitable investment.

NFTs and tax

As an increasingly common ‘side hustle’ it is easy to forget that any profits gleaned from trading NFTs must be declared for tax purposes. While there is still no legislation from HMRC on how these profits should be taxed, there are steps that people can take to deal with such income and capital gains tax efficiently and avoid potential trouble in the future.

If an individual profits from buying and selling NFTs, these must be declared for tax purposes. It is not yet clear what rate of tax will be payable on such assets and where possible, advice should be obtained from a tax professional with experience in this area. They will consider whether the profits should be taxed as capital gains or as income tax. It is also important to keep an eye on case law in this area as this could impact tax arrangements in the future.

To be considered ‘trading’ a number of the ‘badges of trade’ as set out in HMRC’s manual will need to be met. Furthermore, if you are minting NFTs and selling them for profit on a consistent basis, this would likely meet several of the trading badges. If you are trading NFTs then your profits will almost certainly be liable for income tax, which can be as high as 45% for additional rate taxpayers.

One upside to trading is that the individual would be able to claim allowable expenses, which means that any necessary purchases, such as new software or design costs, are likely to be tax deductible.

Trading NFTs through a corporate structure could be a tax-efficient option as corporation tax is currently charged at a rate of 19% on profits made. If you are making between £50,271 and £150,000 per annum, income tax would be approximately 40%.

If you are purchasing NFTs as an investment and simply holding on to them in the hope that one day, they will grow in value, then this is likely to be regarded as ‘investing’. In this scenario, any profits made will be liable for capital gains tax when the asset is sold.

While NFTs are a relatively new phenomenon and there is not much practical advice on how to declare them for tax purposes, it is still important to do so to avoid the risk of disputes arising in the future.

A key message to remember is that even assets that only exist in a virtual world are liable for tax if they generate profits.

Sean Hill is manager, and Sam Goodsell is partner at accountancy firm Menzies LLP