What’s a digital asset? Tokens, crypto, and NFTs explained

Getting into cryptocurrencies might feel like learning a new language. Overly technical terms like “tokenization” and “fungibility” can be off-putting when you’re trying to get the basics down. It might be more effective to begin your crypto journey by asking what a digital asset is. Since the term covers a broad range of technologies like cryptocurrency, it’s a great starting point for new users looking to understand what sets them apart.

This guide provides a clear definition of digital assets and gives you an overview of their legal implications – including your tax obligations. You’ll be in a stronger position to decide how and whether to engage with digital assets once you can confidently explain this term.

What’s a digital asset?

“Digital asset” is an umbrella term for a wide range of intangible, electronically stored items. Although digital assets are often associated with decentralized blockchain technology, they don’t need to use this peer-to-peer (P2P) system to record and process transactions. The Internal Revenue Code (IRC) §6045(g)(3)(D) formally defines digital assets as “any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary.” So, even though there’s a close association between digital assets and blockchain, they aren’t inseparably linked.

Despite the term “currency” in cryptocurrency, the IRS doesn’t treat crypto as currency for tax purposes. Instead, the IRS treats all digital assets as property under IRS Notice 2014-21. Anyone who trades digital assets throughout the year has to report their gains and losses to the IRS and either pay capital gains tax or claim capital losses.

Digital assets vs. virtual currencies: Is there a difference?

Although “virtual currency” is sometimes used interchangeably with "digital assets,” virtual currencies are technically a kind of digital asset. The word “currency” highlights a shared trait among these digital assets: They’re all digital representations of value that function as a medium of exchange or a substitute for traditional money.

Bitcoin (BTC) is a prime example of a digital asset that’s also a virtual currency. Bitcoin has a reputation as “digital gold,” with commodity status under the Commodity Futures Trading Commission (CFTC) and a transparent market value that’s easily convertible to fiat currencies.

Types of digital assets

There are dozens of online objects that can be called digital assets, but a few major categories are widely used and recognized today.

Cryptocurrencies

Cryptocurrencies are common digital assets on blockchain networks. A cryptocurrency typically represents value and serves as a medium of exchange on its respective blockchain.

Instead of relying on third parties like banks to approve payments, a blockchain uses cryptography and algorithms to secure its systems and publish transactions on transparent, globally distributed payment ledgers. Decentralized blockchains don’t have intermediaries, so traders have more direct control over their assets, and centralized blockchains have more regulations under a single owner.

Tokens

Tokens are a type of cryptocurrency, but they differ from “coins” that are native to a blockchain’s structure. Coins like BTC are built into the essential infrastructure of their blockchains, and tokens are “add-on” projects on top of a pre-existing blockchain.

Developers use a blockchain technology called smart contracts to create automated commands that issue their tokens without intermediaries. Certain blockchains like Ethereum (ETH) have token standards like ERC-20 that give developers guidelines to follow when coding their tokens.

Although tokens often have monetary value, they aren’t always used as a medium of exchange. If a token has a specific use case within its ecosystem, it’s considered a utility token. For example, governance tokens offer a way for users to vote on proposals and upgrades for specific protocols in decentralized autonomous organizations (DAOs). There are also security tokens that represent ownership rights over assets like real estate or company shares and meet high standards with securities authorities like the United States Securities and Exchange Commission (SEC).

NFTs and digital collectibles

Unlike other token categories, non-fungible tokens (NFTs) aren’t easily traded on exchanges because they don’t have a clear 1:1 market price. NFTs have unique metadata that makes each one a distinct asset on the blockchain, so there’s no easy way to assign consistent value.

Common examples of NFTs include art or profile picture collections like CryptoPunks and Bored Ape Yacht Club, but an NFT could represent anything from sports highlights to a property deed.

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Depending on what the NFT represents, the IRS reserves the right to categorize it as a “collectible” rather than property for tax purposes per Notice 2023-27. In these cases, the maximum potential tax a crypto trader could pay on their NFT if they sold it for a profit changes. IRC §1(h)(5) sets the highest long-term capital gains rate for collectibles at 28% rather than the 0%, 15%, or 20% used for traditional long-term capital gains.

Other digital assets

Not all digital assets depend on blockchain, and some have been around long before Bitcoin burst onto the scene. While they might not be as widely traded or discussed today, these digital assets still play an important role in the online economy:

• Domain names: Anyone developing a webpage establishes its online presence by registering a unique Internet address through official domain registrars. Since domain names serve as a primary identifier, they hold significant value as transferable digital property.
• Digital files: Any form of electronically stored intellectual property – like photos, manuscripts, and research datasets – can be valuable. The files’ owners might earn money by distributing or licensing their holdings, like MP3s of songs sold through an online platform, depending on copyright rules and contractual agreements.
• Software licenses: Developers or publishers set the terms for users to legally install and access their software applications through licenses. Examples of software licenses range from individual subscription plans to enterprise-level agreements for specialized features and services.
• Video game items: Many popular online games include in-game items like skins or special characters that can enhance a player’s status. Although these assets are part of the governing platform’s terms and service, they still hold value for users and can often be monetized in online marketplaces.

How do you trade digital assets?

It’s getting easier to find some digital assets on mainstream platforms like brokerages and fintech apps, but it’s still most common for people to buy and sell these assets on centralized crypto exchanges (CEXs). CEXs are run by brokers and larger financial institutions who hold your crypto wallet and make moves on your behalf.

Decentralized crypto exchanges (DEXs), on the other hand, use a novel blockchain-based architecture to do away with intermediaries. And NFTs aren’t traded on exchanges at all: They have special marketplaces that sell pieces at auction, similar to traditional art auctions, because of their changing value.

What are the risks of digital asset trading?

Although it’s possible to earn a profit by picking up these assets, don’t discount the uncertainties they bring to your portfolio:

• High volatility: Despite reaching a multi-trillion dollar market cap, harsh, unexpected price swings are the norm – even for established coins like BTC.
• Security and custody risk: Traders who move their cryptocurrencies from exchanges to self-custodial wallets have no recourse to third parties or insurance protections if they lose their assets.
• Liquidity and market risk: Compared to mature markets like equities or precious metals, there isn’t as much trading volume for cryptocurrencies. This relative lack of liquidity could mean larger price discrepancies when closing orders or larger volatility spikes when trading smaller projects.
• Regulatory uncertainty: Crypto traders have to pay careful attention to the latest laws in their territory to avoid restrictions and comply with their jurisdiction’s tax policies.
• Stablecoin and “bank run” risk: Even cryptocurrencies like stablecoins that have a “fixed” valuation aren’t immune to issues. There have been cases of “bank runs” where traders sell off their stablecoins at a rapid pace and the underlying token temporarily or permanently loses its valuation.
• Technology risk: Many parts of the crypto industry are in the early development stage, which means glitches are more likely to happen. Possible issues like code bugs or network outages can create a crisis of confidence.

How to report income from digital assets

Whether you pay taxes on your digital assets depends on how you acquired and used them throughout the year. Since digital assets are property under current IRS guidelines, any sale or transfer counts as either capital gains or losses on a tax return. However, there are some cases where crypto assets count as taxable income.

If you sold, exchanged, or otherwise disposed of a digital asset within the tax year, you need to check “Yes” on Form 1040 for digital assets. But if you just bought crypto with USD or transferred between private wallets you own without selling anything, you can check “No.”

Digital assets held as capital assets

Any time you sell a digital asset, it counts as a disposal event and automatically triggers capital gains or losses. To calculate your taxable proceeds, you need to subtract the average price you paid for a cryptocurrency from the fair market value (FMV) at the time of sale. For example, if you bought one ETH for $2,000 and sold it when one ETH was worth $2,500, the transaction’s taxable capital gain is $500.

The IRS uses different tax percentages depending on your yearly income and how long you had the cryptocurrency. For any digital assets you held for less than a year, you need to pay short-term capital gains with rates that match your federal tax bracket. Cryptocurrencies you held for over one year qualify for lower long-term capital gains rates.