What is an NFT? A complete guide to how they work

The age of digital collectibles has officially arrived: rare artwork, limited-edition trading cards, virtual real estate in the metaverse. The list of possibilities is endless, and one key element making it all happen are non-fungible tokens – NFTs. 

In this guide, we’ll explain what NFTs are, their underlying technology, and the basics of minting and trading them.

Understanding NFTs vs. fungible assets

NFTs are unique blockchain identifiers that store all details regarding ownership and authenticity, providing a secure record of an asset, whether digital, like a graphic design or music, or physical, such as a real estate title. Each NFT is one of a kind, meaning no two have the same value. While they commonly represent virtual artworks, they can also represent tangible assets. For example, houses have been sold as NFTs, with ownership records transferred via the blockchain. The blockchain's secure and immutable ledger ensures the integrity and authenticity of these transactions.

In contrast, fungible assets like Bitcoin or the U.S. dollar have uniform value across all units, allowing them to be used as a medium of exchange. Unlike NFTs, fungible assets can be divided into smaller subunits to facilitate transactions. For example, a dollar can be divided into half-dollars, quarters, dimes, or pennies, each maintaining a consistent value and being widely accepted as payment.

Despite their distinct nature, NFTs are tradable and transferable assets with real-world value. As such, trading NFTs can have tax implications, including capital gains taxes on profits from sales and potential deductions for losses.

How are NFTs created?

Creating – or minting – an NFT involves converting a digital file, such as artwork, music, or video, into a unique token on a blockchain. The process begins when the creator, typically an artist or digital content producer, prepares the digital asset and enters its details, such as metadata (title, description, properties), into a blockchain ledger.

To mint the NFT, the creator selects a blockchain platform – like Ethereum, Solana, Base, Binance Smart Chain, or Polygon – based on factors such as fees, speed, and security. They then upload the digital file to an NFT marketplace, such as OpenSea, Rarible, or Zora, and connect their crypto wallet (e.g., MetaMask, Coinbase Wallet, Phantom), which must be funded to cover transaction costs or gas fees.

The minting is finalized when the creator signs the blockchain transaction with their wallet’s private key, confirming and securing the asset's details on the blockchain. This process includes validation by the network's nodes, assigning the NFT a unique identifier or token ID. Once recorded, the NFT’s information is easily verifiable and transferable, allowing for it to be sold and resold. Creators can also embed royalties into the NFT’s smart contract to earn a percentage of future resales, creating a sustained revenue stream.

How to buy NFTs

The NFT purchasing process is relatively straightforward. It begins with the buyer browsing available tokens on an NFT marketplace, such as those previously mentioned. NFTs can be filtered by popularity, type, or floor price (the lowest price for an NFT within a larger collection). The platform provides details about the creator, the collection it belongs to, and information on its rarity, usually based on specific traits shared by NFTs within the collection.

Before purchasing, buyers should verify the authenticity of the NFT by checking the creator’s profile and any associated verification badges, as well as researching the collection to ensure it's legitimate.

Once the buyer has found the digital asset they want to purchase, they connect their digital wallet to the NFT marketplace. After connecting, the buyer exchanges a specified amount of cryptocurrency for the NFT and cryptographically signs the transaction (usually with a single click within their wallet). The transaction typically takes a few seconds to authenticate. The platform notifies both the buyer and seller after verifying the transaction, completing the trade.

After purchasing an NFT, the asset remains in the custody of the buyer’s wallet. They can choose to re-list it for resale, move it to another wallet for safekeeping, or simply keep it where it is to maintain custody. 

Benefits of NFTs

When effectively managed, NFTs offer several advantages to their holders, primarily due to the blockchain technology that underpins them. Noteworthy benefits include:

• Security: Blockchain technology employs cryptographic security to safeguard asset records from hacks. However, NFT holders must protect their digital wallets by keeping wallet keys or passphrases secret.
• Market efficiency: NFTs often provide a faster and more cost-effective way to purchase collectibles. By enabling direct interaction between buyers and sellers, they eliminate the need for agents and other intermediaries. Transactions can occur anywhere with a reliable internet connection and usually take minutes to complete.
• Intellectual property: NFTs help protect IP, such as books and songs, by simplifying ownership tracking. Blockchain technology ensures that intellectual property rights are upheld and not infringed upon.
• Authenticity: Investors can verify the authenticity of assets before purchasing them. The blockchain allows anyone to confirm the ownership and existence of digital content.
• Portability: NFTs, like all cryptocurrencies, are highly portable. As long as an NFT holder has access to a computer or smartphone and their wallet passphrase, they can trade their NFT from anywhere.
• Community: Owning NFTs can offer unique community benefits, such as granting access to exclusive online groups and events. NFTs often act as membership passes, fostering connections and collaborations among like-minded individuals within niche interest groups.
• Transparency: The blockchain records every transaction detail, including the wallet addresses involved in a trade. This transparency enhances trust between buyers and sellers.
• Immutability: The blockchain’s immutable nature means that information cannot be altered. This ensures that NFT transactions are secure and that assets are delivered as described.

Challenges of NFTs

While NFTs are exciting and new, they're not without risks. Here are some factors to consider before purchasing an NFT:

• Complexity: NFTs involve sophisticated, relatively new technology, and fully understanding it requires time and effort. While acquiring the knowledge necessary to make successful trades is rewarding, finding reliable information can be challenging.
• Legal and regulatory liability: While regulations around NFTs are still evolving, minting and trading them is currently legal in many parts of the world, including the United States. The Internal Revenue Service considers NFT trading a taxable event, and some NFT marketplaces enforce strict know-your-customer (KYC) requirements, often requiring buyers and sellers to provide government IDs and other identifying information, such as proof of address.
• Price volatility: NFT values can fluctuate due to market demand, creator reputation, and perceived rarity. Unlike traditional investments, NFTs lack historical pricing data and established valuation models, making future price predictions difficult. An NFT's value can drop significantly after purchase, which poses financial risks to investors.
• Scams: NFT buyers must remain vigilant against schemes designed to steal their information and assets. Common scams include phishing, pump-and-dumps, and counterfeit NFTs. Awareness and caution are crucial when navigating the marketplace.
• Evolving technology: The rapid innovation in the NFT space can make adoption challenging. Keeping up with cryptocurrency developments often requires following NFT creators and trading experts across various social media platforms.
• Hidden fees: NFT marketplaces may charge high or hidden fees for facilitating trades, which can discourage creators and buyers. In some cases, these fees have led to canceled trades. Therefore, it's essential to research a platform's fee structure before connecting a crypto wallet.

Track and manage your NFTs with confidence

Once your collection of digital assets begins to grow, you'll need an easy way to track it all. CoinTracker can help. 

With powerful blockchain and platform integrations, CoinTracker connects to all your favorite crypto wallets, NFT marketplaces, and exchanges. It analyzes your trades and ensures tax compliance, regardless of which blockchain your NFTs are on.

Discover why more than 2 million users trust CoinTracker to streamline their crypto and NFT portfolio management, understand their tax liabilities, and maximize their investment returns.

Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.