NFTs: A Tale of Two Classifications | Blank Rome LLP
On March 21, 2023, the Department of the Treasury and the Internal Revenue Service (“IRS”) issued Notice 2023-27, announcing their intention to provide guidance on the classification of certain non-fungible tokens (“NFTs”) as ” collectibles’ which may impose higher long-term capital gains tax on owners of NFTs.
Digital assets, such as NFTs and cryptocurrencies, are currently generally classified as “property”. Therefore, under current law, gains from the sale or exchange of NFTs are taxed based on how long such NFTs were held by the owner. For example, if the owner sells an NFT that he or she has held for one year or less, the sale of such NFT will be subject to short-term capital gains tax. Short-term capital gains are taxed at ordinary income rates, and the federal one ordinary income tax rates vary today from 10 per cent to 37 per cent depending on the taxpayer’s taxable income. On the other hand, if the owner sells an NFT that he or she has held for more than one year, the sale of such NFT will be subject to federal long-term capital gains tax. Long-term capital gains are subject to federal tax at a rate of zero percent, 15 percent or 20 percent depending on the taxpayer’s taxable income.
Notice 2023-27 is the first notice in which the IRS has announced its intention to distinguish NFTs from other digital assets. Notice 2023-27 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 a associated right or asset.” The IRS further defines the NFT’s “associated right or asset” as the holder’s right to a “digital file” (i.e. picture, music, trading card or sports moment) or a right in respect of an asset that is not a digital file (i.eright to attend a ticketed event or confirm ownership of a physical object).
The IRS has requested written comments from the public, on or before 19 June 2023on its intention to classify NFTs as collectibles under section 408(m)(2) of the Internal Revenue Code of 1986, as amended (the “Code”), and further guidance on how the IRS should determine whether an NFT is a collectible or property.
Section 408 of the Code applies to individual retirement accounts (“IRAs”), and therefore Notice 2023-27 specifically addresses the tax treatment of transactions in which NFTs are acquired by IRAs. Nevertheless, the classification of an asset as a collectible under section 408 of the Code may also result in the classification of such asset as a collectible for purposes of an ordinary sale or exchange. Section 408(m)(2) of the Code defines a “collectible” as: “(A) any work of art, (B) any rug or antique, (C) any metal or gem, (D) any stamp or coin, (E ) any alcoholic beverage or (F) any other tangible personal property specified by the Secretary for the purposes of this subsection.” Like real estate, the sale or exchange of a collectible held by an owner for one year or less will be subject to short-term capital gains tax at the same rates set out above. However, the sale or exchange of a collectible that an owner has held for more than one year will be subject to long-term capital gains at a rate as high as 28 percent, depending on the taxpayer’s taxable income, which is eight percent higher than the maximum long-term capital gains tax on sale or exchange of property.
Pursuant to Notice 2023-27, the IRS is proposing the use of a “look through analysis” to determine whether a specific type of NFT should be classified as a collectible or property. Under such an analysis, an NFT would be classified as a collectible if its “related right or asset” (as defined above) is considered a collectible under section 408(m)(2) of the Code. For example, a stamp is considered a collectible under section 408(m)(2)(D) of the Code. Under the look-through analysis, if an NFT certifies ownership of a stamp, such NFT will be classified as a collector’s item. On the other hand, if an NFT grants the right to use or develop a “plot” in the metaverse, such NFT would not be classified as a collectible. Therefore, buying a plot of land to be next door to Snoop Dogg or another celebrity in the metaverse would not be considered a collectible.
While some of the items listed as collectibles under the Code are clear, the IRS specifically requests additional guidance on the extent to which a digital file may constitute a “work of art” under section 408(m)(2)(A). This can raise a number of concerns for NFT owners, especially if such a definition is widely applied to images. This further raises the question of how “multi-purpose” NFTs, such as Bored Ape Yacht Club, would be classified under the transparency analysis. Bored Ape Yacht Club is a collection of 10,000 unique images that have gained popularity among NFT owners. In fact, Sotheby’s Metaverse marketplace sold a Bored Ape NFT for approximately $3,400,000 in October 2021. Bored Ape NFTs are used as profile pictures and status symbols, and also provide owners of Bored Ape NFTs with special benefits such as exclusive online areas that are only for members , limited edition merchandise and exclusive entry to real events for Bored Ape NFT owners.
With the June 19, 2023 deadline fast approaching, taxpayers with significant NFT investments should strongly consider taking advantage of the opportunity to submit comments to the IRS regarding whether NFTs should be classified as collectibles and, if so, the appropriate test for determining whether a specific NFT is a collectible or common property.
 Depending on the taxpayer’s state tax residence, the taxpayer may also be subject to income tax at the state level.