On March 21, 2023, the Department of the Treasury (“Treasury”) and the Internal Revenue Service (“IRS”) issued Notice 2023-27, announcing that Treasury and the IRS intend to issue guidance related to the treatment of certain non-fungible tokens (“NFTs”) as collectibles under Internal Revenue Code (“Code”) section 408(m).
Because the investment of IRA assets in collectibles can result in immediate taxation of IRA holdings, this announcement and subsequent IRS guidance will likely have a significant impact on IRA providers as well as owners of NFTs through their IRAs and HSAs -is.
Background
The notification 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. Ownership of an NFT may entitle the holder to a digital file (such as a digital image, digital music, a digital trading card, etc.) that is usually separate from the NFT. Ownership of an NFT may also entitle the owner to an asset that is not a digital file, such as attending an event or confirming ownership of a physical object.
Code section 408(m) treats a number of assets as “collectibles” subject to special rules under the Code. Examples of collectibles include artwork, rugs or antiques, metals or gems, stamps or coins (subject to certain exceptions), alcoholic beverages, or other tangible personal property specified by the IRS.
Code section 408(m) provides that if an IRA acquires a “collectible,” the acquisition of the collectible is treated as a distribution from the IRA equal to the cost of the collectible. Gains on collectibles are also subject to a top federal capital gains tax rate of 28% (while real estate such as stocks are generally subject to a top federal capital gains tax rate of 20%). As such, collectibles are not typically held in IRAs.
Summary
In the announcement, the Treasury Department and the IRS announced their intention to issue guidance regarding the treatment of certain NFTs as collectibles under Code section 408(m). In particular, pending the issuance of guidance, the IRS intends to determine whether an NFT constitutes a collectible using a “look-through analysis.” Under this transparency analysis, the tax authorities will treat an NFT as a collectible if the associated right or asset is a collectible. For example, because a pearl is a collectible, an NFT certifying ownership of a pearl would also be treated as a collectible. However, if the NFT’s associated right or asset is not a collectible, the NFT will not be treated as a collectible at this time. Treasury and the IRS further noted that they consider the extent to which a digital file may constitute a “work of art.”
USER INSIGHTS: Prior to the issuance of Notice 2023-27, there was some uncertainty regarding the possible treatment of NFTs as collectibles. Some practitioners treated NFTs as property separate from the underlying assets they represent, so this new guidance could have a significant impact on taxpayers who had completed transactions based on this assumption.
Treasury and the IRS also requested comments on a number of issues related to the notice, including the following:
- Does the notice provide an accurate definition of NFTs, or are there other definitions of NFTs that should be used in future guidance?
- What concerns and burdens apply to the transparency analysis?
- What other factors should be considered when determining whether an NFT is a collectible in Code section 408(m)?
- Does the application of Code section 408(m) to an individually directed account under the qualified plan rules raise different issues than those raised for IRAs?
- What other guidance relating to NFTs would be useful?
In the notice, comments were requested on or before 19 June 2023.
Next step
The rules for taxation of NFTs are growing in complexity. If certain NFTs are treated as collectibles under the look-through analysis, IRAs will effectively be prevented from owning those NFTs. Furthermore, any gains on NFTs may be subject to higher rates of federal income taxation. Finally, given the evolving market for NFTs, even if rollover relief is offered by the IRS, in some cases it may be challenging to dispose of NFTs to maintain the tax advantage of an IRA.
The content of this article is intended to provide a general guide to the subject. You should seek specialist advice about your specific circumstances.
