America’s revenue service has proposed guidelines on the tax treatment of NFTs. Could this determine the future of NFTs worldwide?

Regulators in the US have been grappling with how to update their current set of policies and laws to keep up with digital asset technologies as they become even more mainstream.

Now, the US Internal Revenue Service (IRS) is “soliciting feedback for upcoming guidance regarding the tax treatment of a non-fungible token (NFT) as a collectible under the tax law.” 

Last week, the IRS published a document requesting for comment and guidance for its proposal on how to properly tax NFTs. Titled Notice 2023-27, the document details how NFTs should be classified as a taxable asset class. While not yet enacted, the document may as well serve as a blueprint for other governments to follow suit in taxing NFTs for the coming future.

As NFTs are often called ‘digital collectibles,’ the IRS suggests that NFTs should be classified  the same as traditional collectibles such as stamps, physical artworks, and fine wine. But can the proposed guidelines be open to interpretation? Or should NFTs be put in a totally different tax category on their own?

Here, we’ll look into what guidelines the IRS is working with, and what they’re suggesting. 

The current situation

The IRS doesn’t yet have clear guidelines on how to tax NFTs. As an emerging asset class, NFTs already have pretty confusing tax implications in of themselves. As of writing, here’s what  you need to know:

NFT creation and sales

• When you create an NFT, they’re not taxable. But they become taxable once they’re  sold according to the cash or crypto you’ve received.
• The value of assets received upon a sale of an NFT, to the IRS, is considered gross income. The gross income may be reduced by costs relating to the process of creation and sale (minting and gas fees) for the given NFT.
• The net income from an NFT sale is considered ordinary income for tax purposes – which may also be subject to self-employment taxes if NFT creation activities rise to a level of that of a “trade or business.” There currently is no clear definition on what the IRS means by that. However for tax purposes, it can be seen that a trade or business can be determined as any activity with continuity with intention to make a profit.

Resale and Trading NFTs

• Commissions and royalties received from downstream sales are income to the IRS – but there’s no official guidance on this yet.
• NFT resales are considered a taxable sale of property – similar to cryptocurrencies. Cryptocurrencies are considered property under IRS tax code.

Collectibles?

Meanwhile, it can be possible that some NFTs can potentially be ruled as a “collectible” for tax purposes. While there is no clear guidance on this, the IRS is currently seeking to find answers for taxpayers to report accordingly.

Just to provide a fuller picture of what this can entail: the IRS taxes normal capital assets depending on a person’s income level – from 0% to 20%, while collectibles are taxed at a 28% rate.

But what constitutes a collectible to the IRS?

How are collectibles usually taxed by the IRS?

If you’re planning to include collectibles in your retirement, then you’ll be taxed by the IRS.

But what’s a collectible, according to the IRS? According to IRC Section 408(m)(2) the term “collectible” encompasses items of the following categories:

• 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, or
• Any other tangible personal property that the IRS determines is a “collectible” under IRC Section 408(m).

Section 408 also grants the IRS the authority to define new collectibles, specifically  noting that such items must be “tangible personal property.” So, can the IRS really include NFTs into this definition?

As it turns out, NFTs don’t really fit into this box. At the regulatory level under these guidelines, the IRS can’t actually categorise all NFTs as collectibles, as NFTs are not tangible. After all, NFTs are just proof of ownership of a digital asset.

However, this may not be an endpoint for the possibility of taxing NFTs. If anything, Notice 2023-27 presents a promising opportunity for US regulators to be more clear regarding the tax liabilities of NFT collectors – something that the American crypto industry needs more so than ever today. But would this sort of clarity be beneficial in the long run?

Giving definitions a ‘look-through’ 

In the document, the IRS specifies a kind of interpretation called a “look-through analysis.” With  this kind of interpretation, the revenue service can tax NFTs as collectibles that are associated with physical items.

There’s already a few real-life examples where these sorts of NFTs can be taxed. BlockBar is an NFT platform that links to real-life rare wines and spirits. Otis sells NFTs linked to physical rare books and trading cards.

In cases like these, an NFT would operate similarly to a title or a property deed: the IRS isn’t interested in taxing the NFT’s inherent value as an asset, rather, the IRS sees that what makes an NFT valuable is its tie to a physical asset.

The notice also raises questions as to whether a look-through analysis can be applied to equate digital art (and the files associated) as collectibles, like their physical counterparts.

As a possible avenue, the IRS may pay close attention to intellectual property (IP) rights to determine whether a digital asset has taxable collector value. Amongst the IRS’s request for feedback include topics asking:

1. How might the potential for the owner of an NFT to receive additional rights or assets (such as additional NFTs) due to ownership of the NFT (even in the absence of a specific contractual right under the NFT) be treated?
2. What factors might be relevant if the 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).

These topics mainly concern how an NFT holder decides to use the IP rights that are associated with their NFT. For example, celebrities like Snoop Dogg have used their NFTs – which are tied to a 1-of-1 profile picture – to create physical merchandise, and full-on profit-generating businesses and franchises. To the IRS, factors like these can be part of identifying long-term collector value. 

However, NFTs that simply just represent digital assets, not tied to any physical product, would be closer to how the IRS defines normal capital assets, and would be taxed accordingly. 

All-in-all, if the IRS follows through on creating clear and concise policy that addresses how NFTs can be taxed, it can lead to bringing greater acceptance and legitimacy to NFTs, Web3, and crypto.

Submit your comments to the IRS

Got any thoughts on the matter? The US tax authority is looking for public comment on their proposal. Just make sure to do it before June 19, 2023.

There’s more to it, however. Make sure you also address any questions regarding the treatment of NFTs as collectibles, mentioned on the full notice itself. 

To submit a comment electronically, access the Federal eRulemaking Portal at www.regulations.gov, and then type “Notice 2023-27” in the home page’s search field. After searching for the notice, you can submit your comments.