US Treasury, IRS may tax NFTs as collectibles.

The Treasury Department and the Internal Revenue Service (“IRS”) are among some of the latest agencies to raise awareness of non-fungible tokens (“NFTs”), stating in a recent notice (No. 2023-27) that they are requesting feedback for upcoming guidance regarding the tax treatment of digital tokens as collectibles under federal tax law. In the brief issued on March 21, the agencies defined NFTs as “unique digital identifiers that are recorded via distributed ledger technology” — which use independent digital systems to record, share and synchronize transactions — and which “can be used to certify authenticity and ownership to an associated right or asset.”

As additional background, the Treasury Department and the IRS stated that section 408(m)(2) of the Internal Revenue Code provides a specific list of items that constitute collectibles for certain purposes. NFTs, which are still relatively new pieces of crypto-technology, are not on that list, which includes: “any work of art; any rug or antique; any metal or precious stone (with limited exceptions); any stamp or coin (with limited exceptions); any alcoholic beverage; and/or other tangible personal property that the IRS determines is a “collectible” under IRC Section 408(m).”

Among the questions on which the agencies are seeking public comment are whether a digital file can constitute a “work of art” and thus a collectible under § 408(m)(2)(A)?; whether a digital asset can be “tangible personal property” under section 408(m)(2)(F)?; and what factors might be relevant if an 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)?

“Until further guidance is issued,” the agencies state that “the IRS intends to determine when an NFT is treated as a collectible using a “look-through analysis,” in which an NFT is treated as a collectible “if the NFT’s associated right or asset falls under the definition of collectible in the Internal Revenue Code.” For example, the agencies assert that “a pearl is a collectible under § 408(m); therefore, an NFT that certifies ownership of a gemstone is a collector’s item.” On the other hand, they state that “an NFT does not constitute a section 408(m) collectible if the NFT’s associated right or asset is not a section 408(m) collectible.” For example, “a right to use or develop a ‘lot’ in a virtual environment is generally not a collectible under section 408(m), according to the Treasury Department and the IRS, and “therefore, an NFT that provides a right to use or develop the ‘plot’ in the virtual environment, generally do not constitute a section 408(m) collectible.”

With the foregoing in mind, the Treasury Department and the IRS said they are “assessing the extent to which a digital file may constitute a “work of art” under section 408(m)(2)(A).” (Sound familiar? There was a critical issue in the Hermès v. Rothschild case, with Rothschild claiming that his MetaBirkins project constitutes a collection of expressive works of art subject to First Amendment protection; Hermès, for its part, has argued that “Rothschild actually intended to confuse potential customers, [and thus] waived any First Amendment protection.”)

Why does it matter?

The importance of potential classification of NFTs – or more likely, the digital assets bound to NFTS – as “collectibles” will mean they are subject to a higher capital gains tax rate than other assets, including real estate, stocks and cryptocurrencies. Under the federal tax code, capital gains from the sale or exchange of a collectible held for more than a year are taxed at a maximum of 28 percent, while other long-term capital assets are taxed at a maximum of 20 percent.

Beyond that, the classification of NFTs as collectibles “would affect whether the transfer of an NFT to an Individual Retirement Account (‘IRA’) results in a distribution from the IRA to the account holder,” McDermott Will & Emery’s John Lutz, William Pomierski, Andrew Granek and Dino Ilievski stated in a recent memo. (Since IRAs are explicitly prohibited from holding collectibles, if you put a collectible into your IRA, the funds used to purchase the collectible are treated as a distribution from the IRA, which could trigger a tax and penalty.)

The joint Treasury and IRS notice and call for comment is also notable in light of “some ambiguity regarding the possible treatment of NFTs as collectibles,” according to Groom Law Group’s David Block, David Levine and Richard Matta. “Some practitioners treated NFTs as property separate from the underlying assets they represent, so this new guidance may [in the future] significant impact on taxpayers who had completed transactions based on this assumption.”

The public comment period is open until June 19.