Cryptocurrency is still in its early stages of development, and NFT is a brand new asset class that has only gradually attracted widespread attention since the launch of CryptoPunks in 2017. It is understandable that various policies and laws are still adapting and digesting this new fact that digital currency ownership is being rapidly realized and promoted.
Last week, the U.S. Internal Revenue Service (IRS) released a document requesting public comment and proposing new guidance on the tax treatment of NFTs. The statement (Notice 2023-27) questioned whether NFTs should be classified in the same category as traditional collectibles such as stamps, artworks, and high-end wines. The document also asked questions and publicly sought public opinion on whether digital art can be included in the category of collectibles or whether a new category needs to be created.
TL；DR：
The IRS plans to tax NFTs as collectibles, according to a notice of proposal published on March 21.
The proposal is currently being released and public opinions are being collected, and it has not yet been finalized.
The IRS intends to use a “perspective analysis” to determine whether NFTs are collectibles. Final guidelines will be issued after a public submission period.
If the proposal is followed, NFTs will be defined as collectibles and taxed as collectibles, 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 20%.
A more comprehensive plan of tax measures may help to eliminate uncertainty in the market.
Decoding the current IRS guidelines on NFTs
Historically, only five asset classes have been classified as collectibles under IRC Section 408: works of art, rugs or antiques, metals or gemstones, stamps or coins, and alcoholic beverages. Section 408 gives the IRS the power to define new collectibles, but specifically states that they must be "tangible personal property." Miles Fuller, head of the government division at cryptocurrency tax firm Tax Bit and a former IRS chief lawyer, called this a "legal dilemma." "Because the fact is, the IRS can't say at a regulatory level that they classify all NFTs as collectibles because NFTs are intangible," he said.
Nonetheless, he believes that "Notice 2023-27" will help clarify the tax responsibilities of NFT holders/collectors. In particular, the IRS intends to treat those NFTs that are associated with physical items as collectibles, which is described in the document as an interpretation of "look-through analysis." Basically, it will determine whether the rights or assets associated with the NFT meet the standards of collectibles currently defined in the tax law under current tax laws. If so, the NFT is defined as a collectible. NFTs can represent anything, really anything, so what the IRS means is that how to collect taxes depends on what it represents.
According to the IRS’s “perspective analysis method,” when an NFT serves as a certificate of ownership of a physical asset, it will be considered a collectible. For example, an NFT that certifies ownership of a gemstone will also be considered a collectible. But on the contrary, the use or development of “land” in a virtual scene is generally not a collectible, so NFTs that provide for the use or development of the virtual land are generally not collectibles.
The IRS will use this “perspective analysis” before issuing NFT guidelines in the coming months.
There are already some concrete examples of this “perspective analysis” in action: Otis, a fragmented NFT platform, sells NFTs tied to physical assets, such as rare books and trading cards; or Web3 companies like BlockBar focus on NFTs that connect to physical high-end wines and spirits. In these cases, NFTs can act like certificates of ownership or property rights, and Fuller explains that “the IRS does not necessarily tax NFTs as assets themselves, but rather the connection of NFTs to physical assets that makes them valuable. The IRS is not trying to tax technology, but rather the economic units generated by that technology. The purpose of the tax law is to tax actual economic property.”
In addition, the proposal notice seems to question whether the "perspective analysis method" applies to digital art files themselves, and whether digital artworks can be classified as collectibles like their physical counterparts. Justin Macari, a New York CPA, predicts that the IRS will pay close attention to intellectual property rights when determining whether digital assets are collectible. The IRS also pointed out that it is not clear whether digital files constitute "artworks" (such as writing NFTs, a medium article collected as an NFT). The IRS is soliciting comments on this and other issues related to NFT taxes. In the notice, two main questions for requesting feedback are listed:
How might the potential impact of NFT owners acquiring other rights or assets (such as other NFTs, community benefits, etc.) as a result of owning the NFT (even if the NFT does not specify this right) be handled?
If the rights associated with the NFT are less than outright ownership of the asset (for example, if the rights in question are simply a digital file for personal use), what factors might be relevant?
“I think the most fundamental one is about the use of intellectual property,” Macari told CoinDesk. “I’ll be making comments to the IRS because there’s a lot to say about that.” Different types of NFTs may fall under different types of capital gains. Macari gave the example of Snoop Dogg’s Bored Ape #6723. Bored Ape owners own the intellectual property associated with their NFTs. As Macari said, if owning a specific avatar NFT (PFP) or an NFT attached to a 1/1 NFT gives the holder the right to create physical goods (sell peripherals) and start a profitable company based on it, then this may be a clear identifier of long-term collectible value. In contrast, NFTs that only represent digital assets (such as metaverse land) are closer to the IRS definition of ordinary assets, so both types should be taxed accordingly.
Ordinary assets are taxed at rates ranging from 0% to 20% depending on an individual’s income level, while collectible assets are taxed at 28%. Although NFT collectors may face the risk of increased tax rates, both Fuller and Macari believe that the increased legal clarity is a positive. “In one sense, this proposed notice is a good thing because it brings more legitimacy to NFTs as a whole,” Macari said.
How is tax on collectibles collected?
Investors are required to pay capital gains tax when they sell an asset. The tax is based on the seller's profit.
Short-term capital gains apply to assets held for less than a year. The profit from such sales is subject to ordinary income tax rates, which also apply to things like wages. (There are seven marginal tax rates, ranging from 10% to 37%.) Long-term capital gains apply to assets held for more than a year. These rates are generally lower than ordinary income rates. Stocks and cryptocurrencies are taxed at a maximum rate of 20%, which applies to high-income taxpayers. (Individuals with less income pay 0% or 15% tax.)
But collectibles (often owned by the super-rich) are subject to a different tax regime. They are taxed at a top rate of 28%. They are also structured differently: collectibles are taxed at ordinary income rates, up to 28%. This is different from the three-tier system for stocks (0%, 15% and 20%).
In short: The highest-income Americans pay higher taxes on collections.
In general, taxpayers generally cannot hold collectibles in individual retirement accounts because retirement accounts are tax-favored. Lewis, a partner at an accounting firm, mentioned that the recent IRS proposal notice continues to support this, meaning that if NFTs are classified as collectibles, these retirement accounts cannot be used to purchase NFTs, otherwise income taxes and penalties may be triggered.
Have an idea? How to submit a comment to the IRS
If you have ideas on this topic, you may submit comments in writing on or before June 19, 2023. Be sure to include a reference 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 home page to find this notice and submit comments).
There is still a gray area in the field of collectibles and NFTs
Lewis said the IRS guidance is “a significant step forward for taxpayers and tax practitioners.” It’s also creative in how it takes old tax laws that deal with tangible collectibles and applies them to modern digital assets.
However, there are still some gray areas in the definition of what exactly is a "collectible", and it is not always black and white, let alone for the emerging NFT.
For example, a person has a collection of rare cars in his garage, which he uses for his collection. However, if another person owns the same car but drives it to work every day, is the car a collectible or a means of transportation? Similarly, if a person uses an antique table for daily use, is it also a collectible?
The same is true for NFTs. Some people keep them for collection, while others use them for practical purposes.
Understanding the future of NFT taxation
Although the IRS’s guidance plan is still awaiting feedback, it is already possible to see the possibility of future taxation of NFT owners’ assets.
Individual investors who purchase and trade cryptocurrencies and NFTs should be aware of the tax implications, and cryptocurrency and NFT exchanges need to begin promoting relevant tax knowledge learning programs to help holders avoid future problems.
With a 28% capital gains tax replacing the previous 15% capital gains tax rate, this news may bring more challenges to the NFT ecosystem that has struggled to maintain trading volume over the past year. However, looking at it from another perspective, these more comprehensive tax measures may help eliminate uncertainty in the market.
Some people have already gone to court to oppose these new IRS measures, but it is worth noting that these documents are still preliminary guidelines and may be revised many times in the future. Since the mainstream NFT market is affected by the IRS, the final decision and implementation of these plans will have a significant impact on the entire NFT field.