Why NFT Tax-Loss Harvesting Remains a Challenge for Investors

It’s been a rough year for NFT (non-fungible token) investors. Between market constrictions, rug pulls and failed projects, many buyers are left holding assets that represent a considerable unrealized loss.

As the 2022 tax year comes to a close, NFT traders may hope to tax-loss harvest, or sell their assets at a loss in order to offset current or future capital gains. That, however, is easier said than done.

Zac McClure is the co-founder of TokenTax. This article is part of CoinDesk's Tax Week.

There are many reasons NFT tax-loss harvesting is a challenge. One is financial: Because each token is a unique asset, it is difficult to estimate what an NFT’s fair market value might be. This makes it hard to pinpoint which assets are the best opportunities for harvesting.

Crypto tax platforms, portfolio trackers and NFT valuators are rising to meet the challenge, allowing investors to get a better idea of the losses they could expect to lock in from the sale of underwater tokens.

A more intractable problem stems from market illiquidity, or in plainer terms from an asset being worthless. Many traders are holding NFTs for which there is no (or little to no) market. This could be the result of an NFT rug pull (like Frosties) or a project that simply didn’t make it (like Loot).

So how do you legally realize a loss on a worthless NFT? The Internal Revenue Service says one must sell an asset in an “arm’s length transaction.” This means a trade in which both parties are acting independently, in their own best interest and without any pressure from one another. Typically, this would mean that the involved parties have no prior relationship. Selling a token on an exchange is an example of an arm’s length transaction.

When an NFT has little to no value, finding an independently motivated buyer is difficult. Why would anyone pay you for something with no value? Some investors have tried to skirt the issue by burning worthless tokens, but there’s no guidance from the IRS to suggest the agency would consider this a valid way to realize losses; the asset didn’t transfer into someone else’s custody.

Other would-be tax-loss harvesters have set up reciprocal services. While the details of these arrangements vary, the basic idea is “you pay me 0.001 ETH for my worthless NFT and I’ll pay you 0.001 ETH for yours.”

Tax professionals warn that this kind of agreement doesn’t meet the criteria for being an arm’s length transaction – the parties established a prior relationship before conducting the trade.

See also: IRS Expands Key US Tax Language to Include NFTs

So, what’s a trader with an illiquid NFT to do? Unfortunately, there aren’t many answers. At this time, the best that crypto tax accountants can advise is to do all you can to sell the asset for a nominal sum on an exchange or in arm’s length transaction on a marketplace.

All in all, this is another example of the need for further federal guidance and regulation on digital assets. Until clarity is provided on if and how the IRS expects traders to realize losses on illiquid tokens, NFT tax-loss harvesting will remain one of the many murky gray areas of crypto tax.