Is Your Bored Ape NFT a work of art? The tax authorities must decide

The IRS will have to decide in the coming months whether your Bored Ape non-fungible token is a work of art or a membership card to an exclusive “yacht club”.

Such decisions by a federal agency are causing concern among tax practitioners who say determining the use of an NFT is often subjective and can subject their clients to a 28% capital gains tax.

The IRS issued Notice 2023-27 in March, announcing plans to provide guidance on the treatment of NFTs as collectibles under section 408(m) of the Internal Revenue Code.

The notice describes how the agency thinks about assessing a digital asset as a collectible, using what is called a “look-through analysis.” It also asks for feedback from the public on what makes a digital file a “work of art” for tax purposes.

“Is Bored Ape a collectible?” said Jordan Bass, CPA, tax attorney and founder of Taxing Cryptocurrency. “Is it only an NFT that gives them rights to access this membership? Maybe, maybe not. There are many different considerations that come into play.”

Experts say that an NFT’s ability to serve multiple purposes simultaneously for an investor will complicate the tax authorities’ task of writing clear guidance, and tax preparers say they want an established set of criteria for classifying an NFT as a collectible.

“That’s the beauty of an NFT, right? It’s the multi-purpose thing,” says Gabriel Brin, vice president of tax and accounting at Ledgible. “And that’s where there’s going to be some tension, some growing pains there.”

“Through Analysis”

The review rule analyzes whether an NFT is an “associated right or asset” of an underlying physical collectible under Internal Revenue Code section 408.

Internal Revenue Code section 408(m)(2) defines a collectible as any work of art, rug, antique, metal, gemstone, or alcoholic beverage; the sale of a collectible that has been held for more than a year is subject to capital gains tax of 28%.

If an NFT certifies ownership of an asset such as a Persian rug, the NFT is a collectible. If an NFT is used to develop a plot in a virtual space — such as the metaverse — it is not a collectible, according to the IRS.

Sahel A. Assar, international tax advisor and chairman of Buchanan Ingersoll and Rooney’s Blockchain and Digital Assets Practice Group, said the look-through rule is “simplistic,” the most “basic” and “probably the most correct way” to figure out. if an NFT is a collectible.

“I applaud the IRS because I think it’s a good first step,” Assar said. “I mean, the alternative is for it to just post guidance that says this is not collectible, or this is not collectible, that would be very basic and kind of stupid, wouldn’t it?”

She acknowledged that the first iteration of guidance most likely won’t be perfect.

Multiple purposes

NFTs can serve multiple purposes, including as a piece of digital art, proof of ownership for a tangible asset, membership for entry into a club, ticket to an event, or even a mechanism to collect and record data.

For example, car manufacturer Alfa Romeo announced last year it will release a compact SUV with a feature that allows maintenance data to be recorded on an NFT.

Brin said in this case, a decision had to be made to determine if the NFT has value, or if it is being used solely for tracking purposes.

Bored Ape Collection gained popularity and value after the promotion of celebrities such as Jimmy Fallon, Paris Hilton, Eminem, Snoop Dogg and Justin Bieber.

The images are used as Profile pictures on social media platforms. They also serve as a means of entering a community of other Bored Ape NFT owners, or the “yacht club”, who receive special benefits as owners of these NFTs.

Treasury and the IRS solicited comments from the public in its announcement about the “burdens” that the look-through analysis might impose and cases where there might be concerns about using the look-through rule.

The department also assesses the extent to which a digital file constitutes a work of art – a task tax professionals say can be difficult given that perceptions of art differ from person to person.

“Art is in the eye of the beholder,” Brin said. “How much it’s worth is really in the eye of the beholder.”

Omri Marian, a law professor who specializes in taxation and blockchain at the University of California, Irvine, said he hopes the IRS doesn’t have to define the term.

While he says he doesn’t think it will be a big problem in the long run, he added: “Every time we ask the IRS to do something that is not entirely within the expertise of administering and collecting taxes, I get nervous. .”

Safe harbors

To avoid complications, tax experts say they would like to see clear examples or a list of criteria that will allow them to easily determine whether an NFT is a collectible.

Assar said she would like to see some flexibility in the guidance that comes out and rules that “can be applied practically.”

“So I as a practitioner want the IRS to give me a rule that is not rigid,” Assar said. “It is not inflexible. It allows me maybe four or five criteria that say, ‘OK, if the NFT meets these four or five criteria, it’s more likely than not to be collectible.’

Tom Shea, financial services crypto-tax leader at Ernst & Young, said the first thing he looks to as guidance for solving a technical problem are the examples put forward by the IRS that “outline” the treatment of assets owned by a taxpayer.

“If they could outline some of these examples like Bored Apes, without directly naming them, it would be incredibly helpful to provide these practical examples and applications of such, I think,” he said.