IRS NFT guidance is starting to take shape

by James · May 17, 2023

Treasury and the IRS are requesting feedback on upcoming guidance on the tax treatment of non-fungible tokens, or NFTs, as collectibles. NFTs that are collectibles will be taxed at a rate not exceeding 28%, while an asset that is not a collectible will be subject to a lower capital gains rate.

In IRS Notice 2023-27, the IRS proposed using a “look-through” approach, according to Charles Kolstad, a partner in the private client, tax and corporate team at law firm Withers Bergman. “In such a case, the classification would turn on the nature of the underlying assets,” he observed.

In related material, the IRS defines an NFT as “a unique digital identifier that is recorded using distributed ledger technology and can be used to certify the authenticity and ownership of an associated right or asset.” Distributed ledger technology, such as blockchain, uses independent digital systems to record, share and synchronize transactions, the details of which are recorded simultaneously across multiple nodes in a network. A token is a record of data encoded on a distributed ledger, which can be used to identify ownership of both NFTs and fungible tokens, such as cryptocurrency, as described in Revenue Ruling 2019-24.

Section 408(m)(2) of the Internal Revenue Code provides a specific list of items that constitute collectibles for certain purposes. Acquisition of a collectible by an IRA or individually directed account for a qualified plan is treated as a distribution from the account equal to the cost to the account of the collectible. Collectibles do not guarantee the more favorable capital gains because buying and selling them is not considered a factor in increasing the economy.

The IRS includes artwork, rugs or antiques, metals or gems, stamps or coins, and alcoholic beverages in its list of collectibles.

An illuminated neon sign of an NFT shown in Hong Kong

Pending the issuance of guidance, the IRS intends to determine whether an NFT constitutes a section 408(m) collectible by analyzing whether the NFT’s related right or asset is a section 408(m) collectible using a look-through analysis. Under the look-through analysis, an NFT constitutes a Section 408(m) collectible if the NFT’s associated right or asset is a Section 408(m) collectible.

“For example, a gemstone is a section 408(m) collectible under section 408(m)(2)(C), and therefore an NFT certifying ownership of a gemstone constitutes a section 408(m) collectible,” the service explained . “Similarly, an NFT does not constitute a Section 408(m) collectible if the NFT’s associated right or asset is not a Section 408(m) collectible. For example, a right to use or develop a ‘lot’ in the virtual environment usually constitutes not a section 408(m) collectible.

The IRS noted that applying the “look-through” analysis where the NFT’s associated right or asset is a digital file raises the question of whether the digital file is a “work of art” under § 408(m)(2)(A) ).

“An NFT is very much a ‘certificate of origin’ and not an asset in itself,” Kolstad said. I agree with this approach, but I think there is a need for clarity in the treatment of digital assets. Since digital assets are intangible assets, such as JPEGs or PDFs, and not physical art objects, I believe the proper treatment is not to classify digital art NFTs as collectibles.”

The notice states that the tax authorities will look to see what the NFT actually represents, noted Tony Tuths, practice leader for digital assets at KPMG Tax: “This is an outcome that most practitioners in the digital asset space had been pushing for. If an asset, including an NFT, constitutes a collectible for tax purposes, then the long-term capital gain for that asset rises from 20% to 28%, and the asset is not eligible to be held in an IRA or other qualified retirement account, among other tax effects. It is still an open question whether a piece of digital art can constitute a “work of art” or whether it must be tangible. Regardless, the notice is very welcome and takes a logical approach to the taxation of NFTs, not rushing to judgment on open cases but rather seeking public comment.”