How NFTs Are Taxed: The IRS Plan

The IRS said it plans to tax some non-fungible tokens, or NFTs, as collectibles similar to art or gems — an approach that would tax profits for wealthy owners at a higher rate than assets like stocks, real estate and cryptocurrency .

The federal government imposes taxes on collectibles held for more than a year at a top rate of 28%. It usually imposes a top 20% interest rate on other investments.

In a notice on Monday, the IRS said it intends to issue guidance regarding the treatment of certain NFTs as collectibles.

NFTs are essentially unique digital assets, which can extend beyond digital art to include things like tweets and GIFs. Sometimes they also give owners a right in respect of a non-digital asset, such as a right to attend a ticketed event or confirm ownership of a physical item.

The IRS requested comments from the public, which are due by June 19.

“The IRS hasn’t said anything about NFTs until now,” said Shehan Chandrasekera, an accountant and head of tax strategy at CoinTracker. “This is kind of like half a tutorial because it’s not finalized yet.”

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NFT enthusiasm swelled in recent years along with the popularity of cryptocurrencies such as bitcoin.

However, that energy has since cratered. NFT volume fell 77% to $1.7 billion in Q3 2022 from $7.4 billion in Q2, according to NonFungible.com. There was also a broad market decline among assets such as shares and bonds last year.

The IRS plans to use a “look-through analysis” to determine whether an NFT is a collectible.

Initially, it will assess whether the NFT’s associated right or asset is a collectible as defined in the Tax Act – and if so, the NFT is also a collectible.

“NFTs can represent anything, literally anything,” Chandrasekera said. “The IRS says that tax depends on what it represents.”

Section 408(m) of the Federal Internal Revenue Code defines a collectible as tangible personal property, such as any work of art; rug or antique; metal or precious stone; stamp or coin; or alcoholic beverages.

Here’s an example of how the IRS would conduct a “look-through” analysis: Since a pearl is a clearly defined collectible, an NFT certifying ownership of a pearl is also a collectible for tax purposes, the agency said.

Conversely, a right to use or develop a “lot” in a virtual environment is generally not a collectible. An NFT that offers a right to use or develop the virtual lot is also not a collectible, the IRS said.

The tax authorities will use this transparency analysis until it provides NFT guidance in the coming months.

“This [guidance] is right around crunch time for tax filing,” said Troy Lewis, an associate professor of accounting and taxation at Brigham Young University. “As you move toward tax day, you might want to think about this.”

This year, the federal tax deadline is April 18 for most Americans.

“Clearly the IRS signaled, ‘Until we give you something else, this is how we look at life,'” Lewis added.

Investors pay capital gains tax when they sell an asset. The tax is due to the seller’s profit.

Short-term capital gains apply to assets held for one year or less. Profit from these sales is taxed at ordinary tax rates, which for example apply to wages. (There are seven marginal tax rates, from 10% to 37%).

Long-term capital gains apply to assets sold after more than one year of ownership. These tax rates are generally lower than ordinary income tax rates.

Stocks and cryptocurrency have a maximum rate of 20% for high-income taxpayers. (Less wealthy individuals pay 0% or 15%).

But collectibles – which tend to be owned by the super-rich – are subject to a different tax regime. They are taxed at a maximum of 28%.

Their structure is also different: collectibles are taxed at ordinary income tax rates, up to 28%. It differs from the three-part system (0%, 15% and 20%) for shares.

Simply put: Americans with the highest incomes pay a higher tax rate on collectibles.

Taxpayers generally can’t hold a collectible in an individual retirement account, which is tax-advantaged, Lewis said.

The recent IRS notice supports this view, indicating that an NFT categorized as a collectible cannot be purchased from these retirement accounts without possibly triggering income taxes and penalties.

The IRS guidance is “a serious step forward” for taxpayers and tax preparers, said Lewis, who owns an accounting firm in Draper, Utah.

It is also creative in how it leverages old tax law for tangible collectibles and applies it to a new digital asset in the modern world, he said.

However, there are still some gray areas as the notion of what constitutes a collectible is not always black and white.

“They don’t really take the hard issue at face value,” Lewis said of the IRS notice. “What constitutes a collector’s item is still somewhat unclear.”

For example, Lewis said, consider a rare car that someone has in their garage. That person may treat the car as a collector’s item. Now consider that another person has the same vehicle but drives it to work every day. Is the vehicle a collector’s item, or is it instead a means of transportation? Similarly, what about an antique desk that someone uses in their daily life?

Whether (and to what extent) a digital file constitutes a “work of art” is also somewhat unclear, the IRS said in its NFT notice. The agency seeks input on this question and a number of other questions related to NFT taxation.