What if NFTs are taxed as collectibles?

The IRS wants to tax non-fungible tokens (NFTs) as collectibles and is seeking public comment on whether that’s a good idea. If NFTs are treated as collectibles, any profit you make from selling one may be subject to a higher capital gains tax rate.

The IRS plans to tax NFTs as collectibles

On Tuesday, the IRS issued a notice providing general information on the tax treatment of NFTs as collectibles and soliciting public comments on various aspects of NFT taxation.

An NFT is a token issued via a blockchain that represents something unique such as digital art, music or a trading card. The NFT phenomenon has been promoted as a new way to monetize content at a time when various forms of art can be copied, pasted and sent around the internet with a few clicks. Fans are rewarded with the opportunity to prove their patronage to a particular artist, while creators gain access to a new source of income via the initial sale of tokens – and potentially a percentage of future sales.

When it comes to taxes, NFTs can be complicated because they can be viewed through a number of different lenses. Creators generate new digital assets out of thin air, crypto market participants trade them by the day, and platforms like OpenSea build marketplaces to trade them.

The IRS intends to use “look-through analysis” to determine whether NFTs should be treated as collectibles under the tax code. This means that NFTs associated with materials that would traditionally be considered collectibles will also be considered collectibles. “For example, a gemstone is a collectible under section 408(m); therefore, an NFT certifying ownership of a gemstone is a collectible,” the IRS said.

The Treasury Department and the IRS are seeking comment on how NFTs work on a technical level and how that might affect their mission as collectibles under the Act.

“The notice specifically asks for help defining ‘NFT’ for tax purposes, providing a rare chance for the industry to provide direct comment to a regulator on a key issue,” said Joshua Garcia, partner at legal advisory and consulting firm Ketsal.

“This is good for crypto. Regulators should engage in this type of outreach on a more frequent basis. This provides a clear path for anyone with a vested interest in the taxation of their NFTs to try to control their own taxes,” he said .

What does it mean for NFTs to be taxed as collectibles?

NFTs were among the darlings of the crypto bull market that ended in 2021, peaking with the sale of digital artist Paks The merger for $91.8 million late that year. NFT sales volume was reportedly $24.7 billion in 2022, a shade below $25.1 billion the previous year.

For NFT collectors and traders, the most relevant aspect of NFT taxation relates to potential profit. In the US, collectibles that are sold at a profit after being held for more than a year face a long-term capital gains tax that can vary depending on income.

Long-term capital gains tax is capped at 28% for collectibles compared to the top tax rate of 20% for most other types of assets. If held for a year or less, ordinary income tax rates apply.

Notably, the guidance from the IRS does not include any new information for creators selling newly issued NFTs.

According to Freeman Law Managing Member Jason Freeman, those creating NFTs need to make a living treating proceeds from NFT sales as income for tax purposes, but that depends on how much of the rights they transfer with the NFT sale.

“In contrast, a limited transfer of rights would likely be treated as a license for federal tax purposes. In such circumstances, the creator would recognize royalty income, which is taxed at ordinary tax rates, but would not be able to offset such income against the NFT basis,” wrote Freeman.

Does it make sense to classify NFTs as collectibles?

It can be difficult to adapt new types of digital assets in existing tax codes.

“The look-through approach makes sense and future guidance from the IRS that will include factors on when the associated right or asset resembles a collectible will be well received,” said Nicholas Mowbray, solicitor at law firm BakerHostetler. “There are a number of areas where taxpayers desperately need guidance, and this is one of them.”

However, it is also clear that there is much work to be done in terms of finalizing the tax classifications of NFTs. “There remain a number of open questions related to NFTs and how they are treated for federal income tax purposes,” Mowbray said. “I welcome guidance on how creators or dealers of NFTs should be treated for federal income tax purposes. For example, could they take the position that the NFTs are not capital assets or collectibles?”