Is there a tax on buying NFTs now? Quickly understand the IRS's new proposal on NFT taxes

Written by: Megan DeMatteo

Compiled by: Cecilia, bfrenz DAO

Cryptocurrency is still in its early stages of development, and NFTs are a completely new asset class that has gained widespread attention only after the launch of CryptoPunks in 2017. Ownership of digital currencies is rapidly being realized and promoted, and various policies and laws are still adapting to and digesting this new reality, which is understandable.

Last week, the Internal Revenue Service (IRS) released a document requesting public comments and proposed new guidance on the tax treatment of NFTs. The statement (Notice 2023-27) questions whether NFTs should be classified in the same category as traditional collectibles (such as stamps, artwork, and fine wine). The document also poses questions regarding whether digital art can be included in the collectibles category or if a new category needs to be created, openly seeking public opinion.

TL;DR:

• According to the proposal notice released on March 21, the IRS plans to tax NFTs as collectibles.

• Currently in the proposal phase, public comments are being solicited, and it has not been finalized.

• The IRS intends to use a "look-through analysis" to determine whether NFTs qualify as collectibles. Final guidelines will be issued after the public comment period.

• If the proposal is adopted, NFTs will be defined as collectibles and taxed as such, with a maximum long-term capital gains tax rate of 28%. Other assets, such as stocks and cryptocurrencies, generally have a maximum federal tax rate of only 20%.

• More comprehensive tax measures may help eliminate uncertainty in the market.

Interpreting the Current IRS Guidance on NFTs

Historically, under IRC Section 408, only five asset categories are classified as collectibles: artwork, rugs or antiques, metals or gems, stamps or coins, and alcoholic beverages. Section 408 grants the IRS the authority to define new collectibles but specifically states that these must be "tangible personal property." Miles Fuller, head of government affairs at cryptocurrency tax firm Tax Bit and former chief counsel at the IRS, calls this a "legal conundrum." He stated, "In fact, the IRS cannot say at a regulatory level that they classify all NFTs as collectibles because NFTs are intangible."

Nevertheless, he believes that "Notice 2023-27" helps clarify the tax responsibilities of NFT holders/collectors. Specifically, the IRS intends to treat those NFTs associated with physical items as collectibles, which is described in the document as a form of "look-through analysis." Essentially, it will assess whether the rights or assets associated with the NFT meet the current definition of collectibles in tax law; if so, the NFT is also defined as a collectible. NFTs can represent anything—truly anything—so the IRS means that how they are taxed depends on what they represent.

According to the IRS's "look-through analysis," when an NFT serves as a certificate of ownership for a physical asset, it will be considered a collectible. For example, an NFT certifying ownership of a gemstone will also be treated as a collectible. Conversely, NFTs that provide rights to use or develop "land" in a virtual environment typically do not qualify as collectibles, so NFTs associated with the use or development of that virtual land generally do not qualify as collectibles.

The IRS will use this "look-through analysis" until it releases NFT guidelines in the coming months.

There are already some specific cases using this "look-through analysis": the fractional NFT platform Otis sells NFTs associated with physical assets, such as rare books and trading cards; or Web3 companies like BlockBar focus on NFTs connected to physical high-end wines and spirits. In these cases, NFTs can function like certificates of ownership or title deeds. Fuller explains, "The IRS does not necessarily tax the NFT as an asset itself, but rather the connection of the NFT to the physical asset gives it value. The IRS is not trying to tax the technology but is trying to tax the economic units produced by that technology. The purpose of tax law is to tax actual economic property."

Additionally, the proposal notice seems to question whether the "look-through analysis" applies to digital art files themselves and whether digital artworks can be classified as collectibles like their physical counterparts. New York CPA Justin Macari predicts that the IRS will closely examine intellectual property rights when determining whether digital assets have collectible value. The IRS also noted that it is unclear whether digital files constitute "art" (for example, writing NFTs, such as a Medium article collected as an NFT). The IRS is soliciting opinions on this issue and other NFT tax-related questions, listing two main questions for feedback in the notice:

• How might the potential implications of NFT owners obtaining other rights or assets (such as other NFTs, community benefits, etc.) due to owning an NFT (even if this is not specified in the NFT) be handled?

• If the rights associated with an NFT are less than full ownership of the asset (for example, if the rights are merely for personal use of a digital file), what factors might be relevant?

"I think fundamentally it involves the use of intellectual property," Macari told CoinDesk. "I would provide feedback to the IRS because there is a lot to say about this." Different types of NFTs may fall under different capital gains categories. Macari cites Snoop Dogg's ownership of Bored Ape #6723. The owner of the Bored Ape has intellectual property rights associated with their NFT. As Macari states, if owning a specific profile picture NFT (PFP) or a 1/1 NFT allows the holder to create physical merchandise (selling merchandise) and start a profitable business, this could be a clear identifier of long-term collectible value. In contrast, NFTs that merely represent digital assets (such as metaverse land) are closer to the IRS's definition of ordinary assets, and thus the two should be taxed accordingly.

Ordinary assets have tax rates ranging from 0% to 20% based on an individual's income level, while collectible assets are taxed at a rate of 28%. Although NFT collectors may face the risk of higher tax rates, both Fuller and Macari believe that increased legal clarity is a positive development. "On one hand, this proposal notice is a good thing because it brings more legitimacy to NFTs as a whole," Macari said.

How Collectibles Are Taxed

Investors must pay capital gains tax when selling assets. This tax is based on the seller's profit.

Short-term capital gains apply to assets held for less than one year. Profits from such sales are taxed at ordinary income tax rates, which also apply to wages, etc. (There are seven marginal tax rates, ranging from 10% to 37%). Long-term capital gains apply to assets held for more than one year. These rates are generally lower than ordinary income tax rates. The maximum tax rate for stocks and cryptocurrencies is 20%, applicable to high-income taxpayers. (Individuals with lower incomes may pay 0% or 15% tax.)

However, collectibles (typically owned by ultra-wealthy individuals) are subject to a different tax regime. Their maximum tax rate is 28%. Their structure is also different: collectibles are taxed at ordinary income tax rates, up to 28%. This differs from the three-tier system for stocks (0%, 15%, and 20%).

In short: the highest-income Americans pay a higher tax rate on collectibles.

Overall, taxpayers generally cannot hold collectibles in individual retirement accounts, as retirement accounts are tax-advantaged. A partner at an accounting firm, Lewis, mentioned that the recent IRS proposal notice continues to support this, meaning that if NFTs are classified as collectibles, they cannot be purchased using these retirement accounts, or it may trigger income tax and penalties.

Have Thoughts? How to Submit Comments to the IRS

If you have thoughts on this topic, you can submit comments in writing by June 19, 2023. Be sure to include references to Notice 2023-27.

The easiest way is to submit comments electronically through the federal eRulemaking website (www.regulations.gov) (type "Notice 2023-27" in the search field on the Regulations.gov homepage to find this notice and submit comments).

Gray Areas Still Exist in the Collectibles and NFT Space

Lewis stated that the IRS's guidance "is a significant advancement for taxpayers and tax professionals." It is also quite creative in how it utilizes old tax laws to address tangible collectibles and apply them to modern digital assets.

However, there are still some gray areas regarding the definition of "collectibles," which is not always black and white, especially concerning emerging NFTs.

For example, consider a scenario where someone collects rare cars in a garage solely for collection purposes. But if another person owns the same model car but drives it to work every day, is that car a collectible or a mode of transportation? Similarly, if someone uses an antique table for daily life, does that count as a collectible?

The same applies to NFTs; some are kept solely for collection, while others may have practical uses.

Understanding the Future of NFT Taxation

While the IRS's guidance is still awaiting feedback, the potential for future taxation of NFT owners' assets is already becoming apparent.

Individual investors buying and trading cryptocurrencies and NFTs should be aware of the tax implications, and cryptocurrency and NFT trading should begin promoting relevant tax education programs to help holders avoid future issues.

With a 28% capital gains tax replacing the previous 15% capital gains tax rate, this news may pose more challenges for the NFT ecosystem, which has struggled to maintain trading volume over the past year. However, from another perspective, these more comprehensive tax measures may help eliminate uncertainty in the market.

There are already individuals challenging these new IRS measures in court, but it is worth noting that these documents are still preliminary guidance and may be modified multiple times in the future. Since the mainstream NFT market is influenced by the IRS, the final decisions and implementations of these plans will have significant implications for the entire NFT space.

References

1. https://www.coindesk.com/web3/2023/03/31/how-will-nfts-be-taxed-understanding-the-irs-new-proposed-guidelines/

2. https://www.makeuseof.com/best-software-for-filing-crypto-taxes/

3. https://www.cnbc.com/2023/03/22/how-are-nfts-taxed-the-irs-plan.html