IRS Guidance Could Expose NFTs To A Higher Tax Rate Than Other Digital Assets

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The U.S. Internal Revenue Service has taken its first formal steps in laying out rules for the taxation of non-fungible tokens (NFTs), potentially exposing them to a maximum long-term capital gains tax rate of 28% if they are considered collectibles rather than the 20% that applies to other digital assets and to securities. The March 21 Notice 2023-27 says that the agency is intending to issue specific rules for NFTs, which can represent collectible assets (Artwork like the BoredApe Yacht club or Crypto Punks series) and non-collectibles (event tickets) and sometimes both.

This notice marks the first formal attempt by the IRS on laying out guidelines for NFT taxation. Previously taxpayers have been applying general rules applicable to property for NFT transactions, relying on IRS Notice 2014-21 issued in 2014. This notice also comes as part of a visible if undeclared campaign by the executive branch, federal agencies, and some members of Congress against the digital-assets industry.

Key Concepts

What is an NFT?

According to the IRS, “an NFT is a unique digital identifier that is recorded using distributed ledger technology and may be used to certify authenticity and ownership of an associated right or asset”.

There are two types of NFTs: NFTs that give you the right to a digital file such as a digital image, digital music, a digital trading card, or a digital sports moment, and NFTs that give you the right to a non-digital file such as a right to attend a ticketed event or certify ownership of a physical item.

NFT Tax Treatment

Section §408(m)(2) of the U.S. Tax Code defines a collectible as:

• any work of art
• any rug or antique
• any metal or gem
• any stamp or coin
• any alcoholic beverage
• any other tangible personal property specified by the secretary of the Treasury

Taxation of an NFT under current IRS practice depends on the asset it represents. The agency calls this “look-through analysis” and encourages filers to use it when determining tax consequences until the new guidance is issued. For example, a gemstone represented by an NFT would be a collectible, but the right to develop a plot of land in the metaverse would not.

Collectible Vs. Non-Collectible

The status matters for tax rates and reporting requirements. Long-term capital gains generated from NFTs classified as collectibles could be subject to a 28% tax rate, above the 20% of other capital assets. Moreover, collectible-NFT sales should be reported on Form 8949, Column (f) with code “C” to indicate to the IRS that it’s a collectible as opposed to a regular capital asset.

Impact on NFT Holders

Although the IRS’s analysis in the notice is useful when thinking about the general tax consequences of NFTs, this topic is not entirely free from ambiguity. For example, an NFT that represents “any work of art” could technically be a collectible under §408(m)(2)(A). Unfortunately, this phrase is subject to interpretation and can introduce inconsistencies to the tax treatment. Also, until more specific rules are published by the IRS, the burden of figuring out whether an NFT is collectible for tax purposes falls on taxpayers who are already struggling with reporting cryptocurrency activity due to a lack of information made available by exchanges.

Moreover, some NFTs could have both collectible and non-collectible components. Think about an NFT that gives you the right to a precious digital artwork (collectible component) and access to an event (non-collectible component). These hybrid NFTs might require even more advanced look-through analysis, such as determining the value of the portion subject to the higher 28% tax rate and the 20% tax rate. These cases will further complicate crypto filings for the average taxpayer.

The notice states that “the Treasury Department and the IRS are considering the extent to which a digital file may constitute a ‘work of art’.” The feedback for the questions listed on the notice will also shape how the regulators define “any work of art.”. It is likely that popular NFT collections like Bored Ape Yacht club and Crypto Punks will be classified as collectible artwork unless the IRS hears a solid argument against it in the public comments. If this is the case, holders of these NFTs could be subject to a higher long-term capital gains tax rate when they sell.

Next Steps

• You can submit comments to the notice through June 19 at www.regulations.gov.
• Watch out for final tax guidance on NFTs in the latter half of the year.