Non-fungible tokens (NFTs) have been one of the hottest topics in finance this year. In August, trading volume on OpenSea, the most popular NFT marketplace, surpassed $3.4 billion, representing a leap of more than 1,100% from July. The digital blockchain art industry is a new phenomena -- there was almost no trading in January -- but it is rapidly picking up steam. 

Ethereum (ETH -4.86%) is the coin of choice when it comes to buying and selling NFTs because of its value as an investment and functionality for smart contracts, agreements that execute on their own once certain terms are met. So what can investors gain by participating in this digital asset mania? 

Examining digital art at a NFT gallery.

Image source: Getty Images.

What are NFTs? 

NFTs are digital certificates of ownership representing images, music, videos, baseball cards, and more. The certificates themselves are stored in one's digital wallets, with transactions notarized on the Ethereum ledger and analytics platform Etherscan. Because of their size, the actual NFTs are not stored on the blockchain, the shared digital ledger where transactions are recorded. So it's just these "digital papers" being traded around. Without an external, off-blockchain agreement with the creator, users do not own the copyright to the artwork. Anyone can copy and paste showcased NFTs at will, although they won't be the verified rightful owner.

What's in it for me? 

The most obvious question readers will have is how something like this could possibly have any value. But that's not what market participants seem to think. The average NFT price, which was zero a few years back, had soared to $5,800 by late August.

Like many things in finance, NFTs abide by the 80/20 rule -- 20% of an NFT's value derives from the underlying asset while the other 80% comes from generous tax treatment. Some NFTs are classified as intangible capital assets, while others are classified as collectibles. In the case of the former, investors can have their NFTs appraised for sale at an auction and donate the proceeds to a registered charity. This would allow them to write off the full market value of their NFT against taxes on their ordinary income, usually over a few years. 

For example, if an average investor bought a pixelated gorilla NFT for 0.5 ETH two years ago ($90.36) and donated it now when it has appreciated to two ETH ($6,948), he would receive the latter amount as a refund from the IRS.

The rise of NFTs has drawn sharp criticism from some public policy watchdogs, who claim this kind of move is akin to being a tax cheat. Meanwhile, others disagree and counter by asking what could be controversial if someone donated an NFT to a local food bank for a tax break to cover personal medical bills. In addition, high-net-worth individuals have been using this tax break with physical art since 1917, and there's never been much controversy. But somehow, the issue blows up when average investors try their hands at it -- so there's clearly a double standard. 

As for the other 20%, it's important to note that all NFTs could benefit from the charity-tax write-off protocol, but not all of them could see capital appreciation. This has to do with the reputation of the artwork itself. For example, NFTs (certificates representing copies of their digital work) produced by Snoop Dog, Lindsay Lohan, Ellen Degeneres, Paris Hilton, Jack Dorsey, and Edward Snowden have generated tens of thousands to millions of dollars per token. As with physical artwork, no one would pay money for even a high-quality piece if the artist is unknown.

The verdict 

Donating NFTs could be a lucrative way to further one's financial goals while also donating to charity. However, it's important to note that until now, the IRS hasn't been accustomed to seeing individuals with middle-class incomes claiming four or five figures in charitable deductions. Even if it's done correctly, the stratagem could subject one to an onerous audit, so it makes sense to consult with a tax attorney or accountant. 

If NFTs sound too troublesome to donate, consider simply buying and holding them with Ethereum or Bitcoin (BTC -1.89%). Because NFTs are denominated in ETH, investors could see compound gains during cryptocurrency bull runs when the value of NFTs and ETH increases. Bitcoin is two months away from its Taproot network upgrade that would enable smart contracts functionality. That means there's a chance that BTC one day surpasses ETH's position as the currency of choice for NFTs.