IRS Takes New Approach to NFT Taxes and “Collectibles” | ASKramer law

[co-author: Julia Vastano*]

Until quite recently, the tax authorities have been silent on the tax treatment of non-fungible tokens (NFT). An almost unknown market in 2020, NFTs skyrocketed in 2021 with an early 2021 capitalization of $91 million.[1] A common prediction about NFTs is that their “market size is expected to grow at least 33% year over year and is predicted to reach approximately $80 billion in net sales volume by 2025 and nearly $350 billion by 2030.”[2]

With the issuance of Notice 2023-27 on March 21, 2023, the IRS has broken its silence on NFTs. This note is unique in several ways. First, it says that the tax authorities intend to in the future to provide guidance on the treatment of certain NFTs, but only those to be classified as ‘collectibles’. Second, the notice signals a more cautious regulatory approach to providing guidance on the tax treatment of digital assets. Instead of issuing a notice or publishing FAQs without allowing for public comment, the IRS now solicits comments. Third, the notice appears to reflect recognition of recent criticism of the IRS guidance that did not follow the notice and comment provisions of the Administrative Procedure Act.

The Nitty-Gritty on NFTs

An NFT is a unique digital resource that is often – but not always – recorded and transferred on a blockchain, i.e. a digital ledger. It can be a representation of something; a piece of art, a digital trading card, a token in the metaverse or proof of ownership. It can also be an original creation that only exists in digital form. It can be a single, unique item, or it can be one of any number of copies of the same content. Just about anything can be represented in an NFT, and it is now common for NFTs to include access to experiences, events, concerts, physical goods and services.

Each NFT has its own unique metadata, making it non-fungible, so it cannot be exchanged for another NFT or any other digital or non-digital property. NFTs are “smart contracts”, meaning that their metadata includes the contractual terms and conditions that govern their use. For example, NFT creators include in NFT tickets the terms and conditions applicable to their use and resale, goods available in connection with their use, and royalties and other proprietary rights included. NFTs are typically sold to buyers for an agreed amount of cryptocurrency or the digital token native to the blockchain on which the NFTs are registered. (Some NFTs can now be purchased with actual currency or with a credit card.) The value, if any, of an NFT is only what a willing buyer will pay a willing seller.

What the new IRS notice means for defining NFTs

In Notice 2023-27, the IRS 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.”[3] The IRS views NFTs as having two parts: the digital file itself and the property or rights to which the file provides access. According to the IRS, NFTs therefore involve a see-through aspect — regardless of what the digital file “sees through to — whether it’s a physical object, digitized assets, or rights.”[4] In seeking public comment, the Treasury Department and the IRS are asking whether the notice provides an accurate definition of an NFT, or whether there are other definitions of NFTs that should be used in future guidance.

Where the guidance on NFT taxes stands, for now

If the right or asset that the digitized file “sees through” is considered to be a Code §408(m) collectible, the IRS proposes to consider the NFT itself a collectible. For example, if an NFT certifies ownership of a pearl, which is a collectible under Code §408(m), the NFT is itself a collectible. On the other hand, if the NFT grants “a right to use or develop a ‘lot’ in a virtual environment,” it is not a collectible.

Treasury and the tax authorities are seeking comments on whether an alternative analysis might be more appropriate than this comprehensive analysis. The agencies ask questions such as: What burdens does the analysis impose? How can the analysis be applied to an NFT with more than one associated right or asset where one is a collectible but another is not? How can the potential for an NFT holder to receive additional rights or assets (such as receiving additional NFTs) be addressed?

Clarify what qualifies as collectibles (and therefore taxable)

Examples of collectibles in Code §408(m) include art, rugs, antiques, metals, gems, stamps, coins (with certain exceptions for gold, silver, and platinum coins), alcoholic beverages, musical instruments, historical artifacts, and other “tangible” personal property” as defined by the Treasury.[5]

But in the context of an NFT, the definition of a collectible is not simple. The Treasury and the tax authorities are therefore asking:

• Can a digital file by itself constitute a “work of art” and thus a collectible under Code §408(m)(2)(A)?

• Can a digital asset be “tangible personal property” under Code §408(m)(2)(F)?

• What factors might be relevant if the NFT’s associated right is less than full ownership of an asset (for example, if the associated right is only personal use of a digital file)?

Tax consequences of an NFT as a collectible

Collectables are subject to a higher capital gains tax than other capital assets. According to §§1(h)(4) and (5) of the code, the sale or exchange of a collectible that is a capital asset held for more than one year is taxed with a maximum of 28% capital gains tax. Other long-term fixed assets at a maximum of 20% interest.

Beyond the higher tax rate, qualified retirement plans and individual retirement accounts (IRAs) are explicitly prohibited from holding collectibles. If a pension plan or an IRA custodian invests in an NFT taxed as a collectible, the NFT contribution is automatically treated as a taxable distribution to the participant or IRA owner. This deemed tax distribution is triggered regardless of whether there is an actual distribution to the plan participant or the IRA owner.

The retirement plan trustee or IRA custodian is required to issue a Form 1099-R to the participant/owner to report the fair market value of the collectible as taxable income in the year it was acquired.

And if an NFT constitutes a collectible, it would be a prohibited transaction for a disqualified person for the IRA owner to display the NFT in the IRA owner’s home.

Questions surround the review rule

The review rule may make sense if the digital file reflects ownership (licensing rights) of something else (digital assets), but how far can review go? How many layers of digital files might have to be peeled back to arrive at a digital asset that can be treated as a work of art? Can digital files ever be tangible personal property under Code § 408(m)(2)(F)? If not, the transparency analysis must be limited to NFTs that ultimately reflect ownership of a tangible asset (art? gems?).

The tax authorities are asking for comments on whether there are concerns with using the transparency analysis or whether an alternative analysis might be more appropriate. And what about NFTs that provide for more than one associated right or asset where one is collectible and others are not? What if the owner of the NFT may receive additional rights or assets, such as additional NFTs?

The notice focuses on whether NFTs can be collectibles under Code § 408(m) without addressing any of the other important questions about how NFTs are or should be taxed. However, the request for comments shows that the government is interested in hearing what taxpayers think about NFTs, as the IRS asks whether the notice provides an accurate definition of an NFT or whether other definitions are more appropriate going forward.

Considers digital assets as Art

The IRS offers two simple examples of whether an NFT’s digital files reflect a collectible. First, if an NFT certifies ownership of a pearl, it constitutes a collectible under Code §408(m)(2)(C). Second, the NFT is not a collectible if the associated right or asset is a right to develop a plot of “land” in the metaverse. The IRS recognizes that digital NFT files do not fit the statutory categories of collectibles except perhaps the category of fine art.

Questions abound. Can a digital resource (reflected in an NFT’s digital file) ever be art? And then who decides what qualifies as a work of art? Not every visual representation of something is art. When does a digital resource go from being just a digital representation of something to being a work of art? Must an NFT owner be given ownership of a tangible asset? Is that the test of when an NFT represents a work of art?

Taxpayers can have a say

Written comments referring to Notice 2023-27 should be submitted electronically or on paper by June 19, 2023. Treasury and the IRS will publish the comments on their public dockets.

Notice 2023-27 shows that the tax authorities have tipped their hand to treat certain NFTs as collectibles. Unfortunately, it does not address the multitude of other tax issues about NFTs. With that said, interested taxpayers should take the opportunity to provide comments on Notice 2023-27.

* Julia Vastano is a Juris Doctor candidate at Cardozo School of Law, Yeshiva University, Class of 2023.

[1] Leeor Shimron, “NFT 2022 Year End,” Forbes21 December 2022.

[2] Christian Heidorn, “Shocking numbers, The NFT Market Size in 2022,” Tokenizedhq.com, 29 Nov 2022.

[3] Message 2023-27.

[4] A digital file is not the same as a digital asset, as defined in Code §6045(g). For reporting by brokers under Code §6045(g), a digital asset is defined as any digital representation of value recorded on a cryptographically secured distributed ledger or similar technology as specified by the Secretary of the Treasury.

[5] Code §408(m)(2). The definition of collectible is also relevant to Code §45D (new markets tax credit); Code § 1397C (business zone business defined); Third. Reg. §301.6111-1T; Q&As-24 and -57E (registration of tax shelters); and Notice 2004-50, 2004-2 CB 196, Q&A-65 (regarding permitted investments for health savings accounts).

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