On March 21, 2023, Department of the Treasury and the Internal Revenue Service released Notice 2023-27 (the Notice), which discussed their intent to issue detailed guidance characterizing certain nonfungible tokens (NFTs) as collectibles for U.S. federal income tax purposes under Internal Revenue Code Section 408(m). The Notice took the unusual step of requesting comments prior to the issuance of formal guidance, strongly suggesting that the Treasury and the IRS were struggling to correctly define and characterize the ever-expanding variations and flavors of NFTs. While the Notice could be a harbinger of the Treasury and IRS’ long-awaited guidance that’s been long sought by tax professionals and enthusiasts of the Web3 ecosystem, it poses significant questions that will hopefully be reconciled and discussed in further guidance.
The Notice defined NFTs as “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.” Further, ownership of a NFT may provide the holder with two distinct sets of rights:
- The right to a digital file itself, such as a digital image, music file, trading card or sports moment; or
- A non-digital right, such as access to a ticketed event or the NFT functions to certify ownership of a physical item, like real estate or a piece of art.
The Notice proposes using the definition of collectible under IRC Section 408(m)(2), which is “any work of art, rug or antique, metal, gem, stamp, certain coins, alcoholic beverage, musical instrument, historical object, or other item of tangible personal property that the Secretary of the Treasury determines to be a collectible.” Because Section 408(m)(2)(F) uses the phrase “any other tangible personal property,” an intangible can’t be a collectible, which contradicts the nature and use of many NFTs, especially those that would otherwise qualify as works of art. The Notice proposes using “look-through analysis” to determine whether the NFT’s associated right or asset is a collectible. The look-through analysis states that if a NFT certifies or represents ownership of a collectible, the sale of the NFT is the sale of a collectible. Conversely, if a NFT certifies or represents ownership of something other than a collectible, such as real estate or a membership in a club, then the sale of the NFT isn’t the sale of a collectible.
The Notice discusses two significant tax consequences of characterizing a NFT as a collectible. First, individual retirement accounts can’t hold collectibles. If an IRA purchases or possesses a collectible, Section 408(m)(1) deems the collectible (or an amount of cash equivalent to its cost) to be distributed by the IRA. Second, collectibles are taxed at 28%, while capital gains can be taxed as high as 20%.
While the Notice is a positive step, many unresolved issues remain due to the broad nature of the definitions employed. For example, the definition of collectible under Section 408(m)(2) is limited to tangible personal property, excluding both intangible property and real property. Having different tax consequences for selling a NFT that’s a digital representation of a physical object and one that doesn’t represent a physical object creates differing tax consequences that will make it more difficult to determine the correct characterization and create an incentive to take an aggressive position due to definitional ambiguity. There are many NFTs that have such insignificant differences to other NFTs, such as a different color border, that they’re essentially fungible. If one NFT represented ownership of a physical asset and the other didn’t, the one that didn’t represent physical ownership would be worth more due to the lower tax rate and not its underlying desirability or characteristics. The best way to resolve this issue and ensure tax parity would be for Congress to amend the definition of a collectible to include certain intangible property or, at least, NFTs.
One significant question posed by in the Notice is how to correctly characterize a NFT that has the potential to receive additional right(s) or asset(s) due to its attributes. The receipt of the additional rights or assets would be taxable as an airdrop under Revenue Ruling 2019-24, but the characterization of the underlying NFT would be important if it were sold prior to the receipt of any rights or assets. Would a NFT that has the right to receive NFTs that have undetermined characteristics be considered a collectible for income tax purposes? Or would the fact that the character of the potential future right(s) or asset(s) is undetermined be determinative, that is, if it isn’t known to be a collectible, would its sale avoid being characterized as the sale of a collectible?
Somewhat unusually, there was no discussion of an effective date. This may suggest that the Treasury and the IRS believe that the NFTs at issue are properly characterized as collectibles, allowing for future guidance to be issued in the form of a revenue ruling, allowing the Treasury and the IRS to take the position that the guidance is merely stating law as it has always stood, thereby allowing the IRS to characterize certain NFTs as collectibles retroactively.
Additionally, many states are studying this issue in the context of sales and use taxes. It would be advisable for the Treasury and the IRS to work with states to develop a consistent and authoritative set of terminology and definitions, although they shouldn’t be bound by the views of states and shouldn’t delay issuing guidance.
Finally, the Notice requested comments to help resolve numerous issues relating to definitions and terminology, how to characterize a NFT if it has less than full ownership or multiple underlying assets and a number of other issues.
Matthew E. Foreman, J.D., LL.M. is counsel at Chiesa Shahinian & Giantomasi PC