Charitable deductions: donating cryptocurrency and NFTs for tax purposes

July 25, 2022 – “Salvator Mundi” by Leonard da Vinci, a painting created more than 600 years ago by one of the most famous artists of all time, sold for $450 million in 2016. The prices achieved for classics and endless desire for owning them has created a highly lucrative marketplace for a limited number of works of art.

However, over the past few years, artworks linked to blockchain technology, particularly Non-Fungible Tokens (NFTs), have completely upgraded valuations and demand, creating a level of volatility never before seen by art collectors. For example, “The Merge” by digital artist Pak was sold for $91.8 million in December 2021. However, as of this writing, NFTs have seen their values ​​plummet, destroying their valuations.

This article explores issues related to charitable contributions by NFTs and includes a brief primer on charitable deductions.

Limitations on charitable deductions

Generally, individual taxpayers can claim a charitable deduction of up to 60% of their adjusted gross income (AGI) for cash donations to public charities. Cash gifts to private foundations are limited to 30% of AGI for cash gifts or 20% for appreciated securities. Unused charitable deductions can generally be carried forward for five years.

Generally, for gifts of non-cash property (eg works of art), the donor can deduct up to 30% of the property’s fair market value provided that such property is related to charitable purposes. This is commonly known as the “related use requirement.” For example, the donation of works of art displayed in an art museum will satisfy this requirement. However, if a donor gives artwork to a charity whose mission is to reduce child poverty, the donor can only deduct the lower of the cost basis or 30% of the asset’s fair market value. Despite these limitations, contributions of non-cash items to charity avoid capital gains tax and potentially reduce gift and estate tax liability.

Justification requirement

Contributions that are not cash must satisfy certain justification requirements to ensure a charitable deduction.

For artwork valued at $5,000 or more, the following requirements must be met:

•A concurrent written acknowledgment from the charity;

•A “qualified appraisal” of the donated property; and

•A completed IRS Form 8283 attached to the tax return.

A donor must file Form 8283 with the donor’s tax return for the year the donor contributes the property and first claim a deduction and any carryover year described in section 170(d) of the Internal Revenue Code of 1986, as amended.

A qualified appraisal must follow the Uniform Standards of Professional Appraisal Practice, as developed by the Appraisal Standards Board of the Appraisal Foundation, and include, without limitation, the information described in Treasury Regulation Section 1.170A-17(a)(3):

•a description sufficiently detailed in the circumstances, taking into account the value of the property, that a person not generally familiar with the type of property can determine that the appraised property is the contributed property;

• the condition of the property;

• the valuation’s effective date;

•the real market value of the property; and

•information about the appraiser, including the appraiser’s (i) name, address and taxpayer identification number, and (ii) qualifications to value the type of property being valued, including the appraiser’s education and experience.

When determining fair market value, the appraisal must show the valuation method used to determine fair market value (eg, the income method, the market data method, or the replacement cost-less-depreciation method), and the specific basis for valuation (eg, specific comparable sales transactions or statistical sample).

The qualified appraiser’s assessment report date must be no earlier than 60 days before the charitable contribution date, and no later than the return due date (including extensions) on which the deduction is first claimed by the donor.

Not just any appraiser can be retained to carry out a valuation. A qualified appraiser should have obtained an appraisal designation from a recognized organization, and meet certain educational and experience requirements. This includes becoming certified for the property in question, with courses at a college or professional level relevant to the property being valued. The appraiser must be working regularly and cannot have been barred from practicing before the IRS under section 330(c) of title 31 of the United States Code.

If a tax return reporting a charitable contribution of artwork is selected for audit, the artwork may be subject to review by the Art Advisory Panel of the Internal Revenue Service (IRS). According to the IRS website, “[a]All taxpayer cases selected for examination that include an item with an alleged value of $50,000 or more must be referred to Art Appraisal Services for possible review by the Commissioner’s Art Advisory Panel.” Since the panel meets only twice a year, the review process can be delayed if considered by the panel.

Donate NFTs

An NFT is a digital resource supported by blockchain technology, which typically represents a file containing a visual image, but can also be an audio file or a moving image. Some NFTs are designed to be static while others are dynamic, so they can be updated from time to time with new features, colors, etc.

Art collectors who purchase NFTs receive no physical ownership (and often not even the copyright) of the works purchased, but only a digital receipt associated with the work: a token. The token is registered to the owner on the relevant blockchain platform.

Unlike owners of traditional forms of artwork, NFTs do not require any storage space, maintenance or restoration costs. More importantly, the ability to determine the provenance of an NFT is protected through blockchain technology, which acts as a living ledger that is immutable and forever tracks ownership.

The IRS currently treats NFTs and all digital currencies, such as bitcoin, as property or goods, not as currency, but Congress and other authorities have considered whether they should be regulated and classified differently.

If NFTs are ultimately classified as non-cash contributions, the donation of NFTs will need to consider the documentation requirements applicable to non-cash contributions, which may prove problematic as follows:

•Lack of qualified appraisers. The art world is filled with professionals who have extensive training in traditional forms of art, where decades of sales data under various economic conditions are available to the appraisers, most of which satisfy the IRS requirements for a qualified appraiser. The same cannot be said about appraisers of NFTs. Since the technology and marketplace for NFTs is so new, it will likely be difficult to identify an individual who will meet the minimum requirements to serve as an expert and provide a qualified opinion acceptable to the IRS.

•Inaccurate valuations. The combination of a lack of market data and extreme volatility will produce valuations that can be unreliable and easier for tax authorities to challenge. The IRS has the benefit of a longer time frame to review past data to test the accuracy of past assessments. Auditing can be an expensive and time-consuming process, and gross misinformation can result in interest and late payment.

•Transfer of ownership. Donors should also be increasingly cautious about the process of transferring NFTs to charity. Donors must ensure that the recipient has an established process for accepting and managing digital assets, as the transfer of NFTs is irreversible. If the receiving organization does not properly accept ownership of the NFT, the tax authorities may argue that the transfer was incomplete and deny the charitable deduction. Although unusual, it is also important to determine whether the donor owns the copyright to the NFT, which, if attached, should be considered when assigning ownership.

• Satisfies the related usage requirement. It is expected that as NFTs grow in popularity, art museums will accept and display NFTs, thus satisfying the related use requirements described above and providing higher charitable deductions. However, with little guidance on this topic, it is still too early to confirm whether donation to arts institutions will meet the related use exception. It is worth nothing that some museums have begun to stamp their own NFTs for works they own the copyright for or for which the copyright has long expired, so there is certainly an evolving institutional awareness. Until donation of NFTs becomes a more widely accepted practice, it is important that a donor contacts each potentially donated museum and determines whether the gifted NFTs will be accepted and displayed.

Currently, most NFT owners simplify the donation process and minimize the above problems by selling their NFTs on auction sites and then donating the proceeds to charity. This simplified approach may be the preferred path for now until the IRS and other regulatory agencies provide better clarity in this area. However, this approach has a cost as a sale may result in capital gains tax, which would be avoided if the NFT was donated directly to charity.

Blockchain technology has created a new asset class for charitable donations. While their value is uncertain and charities are slow to adopt them, practitioners and philanthropists should be prepared to adapt to the ever-changing reporting requirements for NFT donations.

Eric N. Mann is a regular contributing columnist on trusts and estates law for Reuters Legal News and Westlaw Today.

Opinions expressed are those of the author. They do not reflect the views of Reuters News, which is committed under the fiduciary principles to integrity, independence and freedom from bias. Westlaw Today is owned by Thomson Reuters and operates independently of Reuters News.