The IRS’s recent announcement that it would treat certain nonfungible tokens (NFTs) as collectibles ended an ongoing debate about whether gains from the sale of NFTs would be subject to the ordinary capital gains tax or the higher tax on collectibles. The distinction is significant for investors who are weighing whether to invest in NFTs or other digital assets like Bitcoin.
As a general rule, when digital assets held for more than a year are sold for more than the purchase price, the profit is treated as a capital gain and subject to a maximum 20% tax rate. Plus, any losses from the sale of digital assets are usually treated as deductible capital losses. However, collectibles are taxed at a maximum of 28% when held for longer than a year, and the IRS generally does not allow a deduction for losses on collectibles held for personal use.
Notice 2023-27 says the IRS is still finalizing some of its rules, including specifying which NFTs will be considered collectibles. But the temporary rules that will be used until final guidance is issued provide a window into the IRS’s thinking. The temporary rules use the tax code’s definition of collectibles to determine which items will be taxed at the 28% rate. Therefore some types of NFTs will not be treated as collectibles, at least until final rules are issued. However, since many existing NFTs represent the type of assets the IRS generally considers collectibles — such as images, videos and audio files — it may be difficult to keep the agency from taxing them as collectibles.
It should be noted that the IRS’s rules on NFTs are not final and that the agency is still looking for comments that address several questions it raised in the notice and other issues related to the new rules.
What does the IRS consider an NFT?
For those unfamiliar with how NFTs and other digital assets work, the technical definition of an NFT the IRS provides in Notice 2023-27 is unlikely to be of much help. Therefore, we will begin with a general overview of what an NFT represents before moving on to the IRS’s definition.
The “nonfungible” portion of a nonfungible asset generally means that the item is unique and can’t easily be replaced. Thus, it is similar to a one-of-a-kind digital trading card representing ownership of a unique asset, often a digitized image, movie or sound recording. But it could be almost any type of real-world or digital asset. Most NFTs are part of the Ethereum blockchain. Ethereum is a cryptocurrency like Bitcoin, but its blockchain also tracks who has ownership rights to specific NFTs. Blockchains are a type of distributed ledger technology that securely and accurately stores information independent of any specific software or data hosts.
In Notice 2023-27, the IRS gives a more specific definition of an NFT:
- 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. Ownership of an NFT may provide the holder a right with respect to a digital file (such as a digital image, digital music, a digital trading card or a digital sports memento) that typically is separate from the NFT. Alternatively, NFT ownership may provide the holder a right with respect to an asset that is not a digital file, such as a right to attend a ticketed event, or certify ownership of a physical item. For purposes of this notice, the right that an NFT provides or the ownership of an asset that an NFT certifies is referred to as the NFT’s associated right or asset.
How are ‘collectibles’ defined by the IRS?
The IRS plans to treat certain NFTs as §408(m) collectibles. While §408(m) governs the acquisition of a collectible by an individual retirement account (IRA), S408(m)’s definition of collectible is also used in other parts of the tax code. That includes the section defining collectibles that are subject to the 28% capital gains tax rate. Section 408(m)(2) specifically states that the term collectible means any:
- Work of art
- Rug or antique
- Metal or gem
- Stamp or coin
- Alcoholic beverage
- Other tangible property the secretary of the treasury has specified as a collectible
Certain coins and bullion are excluded from the definition of collectible by §408(m)(3).
IRS to use temporary ‘look-through’ analysis
Until final guidance has been issued on the tax treatment of NFTs, the IRS plans to use a “look-through” analysis when determining how an NFT should be taxed. Under the look-through analysis, an NFT would be a §408(m) collectible if its associated right or asset falls under the definition of collectible. For example, the IRS says an NFT certifying ownership of a gem would constitute a collectible because gems are listed as collectibles under §408(m)(2)(C). Likewise, an NFT that provides the right to use or develop a plot of land in a virtual environment would usually not be treated as a collectible because §408(m)(2)(C) does not list a virtual plot of land as a collectible.
The IRS acknowledged that applying a look-through analysis to an NFT if its associated right or asset is a digital file raises the question of whether the digital file itself constitutes a §408(m) collectible as a work of art. The IRS and Treasury Department are still considering the extent to which a digital file may constitute a work of art.
Comments sought on unanswered questions
The IRS and Treasury Department are also seeking comment on the following questions:
- Does the notice provide an accurate definition of an NFT, or should a different definition be used in future guidance?
- With regard to the look-through analysis:
- Are there instances where applying an alternate analysis would be appropriate?
- What burdens does the IRS’s analysis impose?
- How might the analysis be applied to NFTs with more than one associated right or asset?
- How might the potential for the owner of an NFT to receive additional rights or assets — such as additional NFTs — due to their ownership of the asset be treated?
- Are there other factors that should be considered when determining when an NFT is a collectible?
- Does the application of S408(m) to an individually directed account under a qualified plan raise any issues other than those raised for individual retirement accounts?
- What other NFT guidance would be helpful?
The deadline for comments is June 19.
Information included in this article is accurate as of the publish date. This post is not reflective of tax law changes or IRS guidance that may have occurred after the date of publishing. All taxpayer circumstances are different, and NATP recommends contacting research services if you have specific questions about your clients’ tax situations.