Accountants encouraged by proposed IRS NFT rules

Proposed IRS rules for non-fungible tokens have been seen as a good first step for accounting professionals in this area, indicating that the agency is finally taking these assets seriously.

A non-fungible token, or NFT, is a digital asset that represents ownership of something unique, such as a piece of art, music or a collectible. When someone buys an NFT, they are not buying the physical commodity, but rather the right to claim ownership of that commodity. In this sense, it acts as a digital certificate of ownership stored on a blockchain.

The proposed regulations, released on Tuesday, address the treatment of certain NFTs as collectibles in section 408(m), which applies to investment in collectibles treated as distributions. While the IRS said it is seeking more information and feedback on the topic, until further guidance is issued, the agency intends to determine when an NFT is treated as a collectible using a “look-through analysis.”

During the look-through analysis, an NFT is treated as a collectible if the NFT’s associated right or asset falls under the definition of collectible in the Tax Act. For example, a gemstone is considered a collectible under section 408(m) of the Internal Revenue Code, so that means an NFT confirming ownership of a gemstone is also a collectible. In contrast, if an NFT represents a right to a plot of virtual land in a metaverse, since the “plot” is not a collectible under the terms of 408(m), the NFT is also not a collectible.

Gabriel Brin, vice president of tax and accounting products at Ledgible, a cryptocurrency tax and finance management platform, said the guidance from the IRS indicates that the government is waking up to the idea that an NFT is more than just ownership of a JPG. The proposed guidance represents a step forward in agencies recognizing that not all NFTs should be taxed equally given that not all NFTs represent the same type of underlying asset.

“Some may see this as an overreach by the tax authorities and worry that this could drive away blockchain innovation. However, we at Ledgible see this as more evidence pointing to blockchain and the technology being adopted in real-world use cases. You have not to look far for proof, just start with the once comical NFT JPEG which is now being transformed into a tool used in verifiable ownership of a multitude of different asset types,” he said.

Sean Stein Smith, head of the accounting task force at the Wall Street Blockchain Alliance and a Lehman College professor, was similarly encouraged by the proposed guidance, as it shows the IRS is taking this sector of the crypto market seriously. However, Smith noted that even if the guidance is approved as is, which is unlikely, it would still represent a major shift in how NFTs are taxed.

“Other cryptoassets are subject to capital gains tax, [but] as a collectible equivalent, NFTs will be subject to a higher rate of 28%. Second, reflecting the breadth of use cases to which NFTs can be applied, the IRS will use a “look-through” analysis, i.e. the NFT itself will be taxed in the same way as the underlying asset to which it is linked . So an NFT representing a gem (a collectible) will be treated as a collectible, but an NFT connected to a virtual lot will not be treated and taxed as a collectible. Finally, if an NFT is determined to be a collectible equivalent, this will affect the effect of these instruments on retirement accounts in terms of less favorable tax treatment versus other assets,” he said.

Patrick Camuso, head of Camuso CPA, an accounting firm specializing in digital assets such as NFTs, similarly thought it was good that the tax authorities were finally paying attention to this sector. The proposed approach of treating NFTs as its underlying asset, he said, makes sense but will need further clarification to be useful, particularly around whether the guidance will be applied retroactively. But he said the IRS appears to understand the complexity of this issue and is taking a cautious approach.

“This will create additional accounting complexity as NFTs will have to be classified for tax purposes based on each NFT’s specific tax requirements. With that in mind, given the general nature of NFTs, I believe this is a logical and reasonable tax approach,” he said .

He added that the IRS proposal is similar to the way state governments have treated NFTs for sales tax purposes.

“It will be interesting to see what consistency, if any, there will be between federal taxes and state sales tax definitions and review analysis procedures,” he said.