The Treasury Department and the Internal Revenue Service (“IRS”) are among some of the latest agencies to call attention to non-fungible tokens (“NFTs”), stating in a recent notice (No. 2023-27) that they are soliciting feedback for upcoming guidance regarding the tax treatment of the digital tokens as collectibles under federal tax law. In the brief notice issued on March 21, the agencies defined NFTs as “unique digital identifiers that are recorded via distributed ledger technology” – which uses independent digital systems to record, share, and synchronize transactions – and that “may be used to certify authenticity and ownership of an associated right or asset.”
By way of additional background, the Treasury Department and the IRS stated that Section 408(m)(2) of the tax code provides for a specific list of items that constitute collectibles for certain purposes. NFTs, which are still relatively novel pieces of crypto tech, are not on that list, which includes: “any work of art; any rug or antique; any metal or gem (with limited exceptions); any stamp or coin (with limited exceptions); any alcoholic beverage; and/or any other tangible personal property that the IRS determines is a ‘collectible’ under IRC Section 408(m).”
Among the questions that the agencies are seeking public comment on are whether a digital file can constitute a “work of art” and thus, a collectible under Section 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 simply personal use of a digital file)?
“Until additional guidance is issued,” the agencies state that “the IRS intends to determine when an NFT is treated as a collectible by using a ‘look-through analysis,’” under which an NFT is treated as a collectible “if the NFT’s associated right or asset falls under the definition of collectible in the tax code.” For example, the agencies assert that “a gem is a collectible under Section 408(m); therefore, an NFT that certifies ownership of a gem is a collectible.” 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 instance, “a right to use or develop a ‘plot of land’ in a virtual environment generally is not a section 408(m) collectible,” per the Treasury and IRS, and “therefore, an NFT that provides a right to use or develop the ‘plot of land’ in the virtual environment generally does not constitute a Section 408(m) collectible.”
With the foregoing in mind, the Treasury Department and the IRS said that they are “considering the extent to which a digital file may constitute a ‘work of art’ under Section 408(m)(2)(A).” (Sound familiar? That was a critical issue in the Hermès v. Rothschild case, with Rothschild arguing that his MetaBirkins project amounts to a collection of expressive works of art subject to First Amendment protection; Hermès, on the other hand, has claimed that “Rothschild actually intended to confuse potential customers, [and thus] waived any First Amendment protection.”)
Why does it matter?
The significance of potential classification of NFTs – or more likely, the digital assets tied to NFTS – as “collectibles” would mean that 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 that is held for more than one year are taxed at a maximum of 28 percent, while other long-term capital assets are taxed at a maximum 20 percent rate.
Beyond that, the classification of NFTs as collectibles “would impact 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 note. (Since IRAs are explicitly prohibited from holding collectibles, if you put a collectible item in your IRA, the funds used to purchase the collectible are treated as a distribution from the IRA, which could trigger a tax and a penalty.)
The joint Treasury and IRS notice and call for comments is also noteworthy 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] significantly impact taxpayers that had completed transactions based on this assumption.”
The public comment period is open until June 19.