Are NFTs Now Taxable at a Higher Rate?
Nonfungible Tokens (NFTs) Can Be Artwork
The Internal Revenue Service (IRS) recently issued a notice (the “Notice”) regarding its intention to provide guidance related to determining when nonfungible tokens (NFTs) will be treated as collectibles under the Internal Revenue Code (the “Code”). This planned guidance would have important consequences for NFT enthusiasts: collectibles are taxed at a higher capital gains rate on sale (28%, as opposed to the normal 20%), and Individual Retirement Accounts (IRAs) cannot hold collectibles as a matter of law. Currently, tax practitioners must make difficult judgment calls in assessing their clients’ NFT portfolios and applying old standards to new technologies.
In its most basic form, each NFT represents an individually exchangeable token that provides the holder with an “associated right or asset” that is stored digitally and can be bought and sold on online marketplaces.
An NFT asset for the holder may include:
- a digital image
- a digital sports “moment” (akin to a physical sports card)
- a game
- the right to attend a ticketed event; or
- the right to ownership of a plot of virtual land.
For purposes of the Notice, the IRS makes a distinction that it intends to assess whether an NFT is a collectible by applying a “look-through analysis” to determine whether the NFT’s associated right or asset meets the definition of a collectible under the Code. This means the IRS would ignore the NFT itself and look to the corresponding right or asset when determining tax treatment.
Under the current definition of a “collectible” under the Code, it is reasonable to question whether it must be a “tangible” item. It is safe to say that NFTs themselves are not tangible property and do not meet this aspect of the statutory definition. Nevertheless, it is unclear whether the holder of an NFT’s associated right to digital art should be construed as a collectible under the tax law.
Of course, until recently, it was inconceivable that a work of art selling for thousands of dollars in a marketplace would be intangible, despite the notion that an NFT may be colloquially regarded as something that is considered valuable by collectors.
For most, the practical importance of whether an NFT is treated as a collectible under the Code stems from its relevance to the sale or exchange of collectibles. In general, when a collectible is held for more than one year, it is subject to a maximum 28% capital gains tax rate, versus the current 20% long-term capital gain tax rate for other non-collectible capital assets.
The IRS is presently seeking commentary related to its proposed tax treatment for NFT collectibles. Either way, taxpayers and their advisors should bear in mind the IRS’s current proposal when taking relevant positions on tax returns before a final notice is released.
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