Next Year Your NFT Could Be Subject To Capital Gains Tax Of Up To 28%!

Tax Day has come and gone, but the work is far from over. On March 21, 2023, the Treasury Department (the "Treasury") and the Internal Revenue Service (the "IRS") issued Notice 2023-27 (the "Notice"), which, firstly, explains the Treasury's and IRS's intent to issue guidance related to the treatment of NFTs as collectibles under section 408(m) of the Internal Revenue Code (the "Tax Code") and, secondly, solicits feedback for how to effectively implement this guidance.

To understand the first part, the reader needs to understand what an NFT is and the relevant Tax Code provisions contemplated by the Notice. Fortunately, the Notice lays out the foundational understanding in a simple, yet comprehensive, manner that is easily digestible. If you need a further breakdown, check out our previous article Understanding NFTs and other articles published on our NFT Newsroom.

The main Tax Code provisions contemplated by the Notice are sections 408(m) and 1(h). In essence, section 408(m) of the Tax Code defines an asset to be a "collectible" if it falls into one of six categories: any work of art; any rug or antique; any metal or gem; any stamp or coin; any alcoholic beverage, or any other tangible personal property specified by the Secretary for purposes of this subsection. And section 1(h) applies the definition of a collectible to capital assets.

These sections are relevant and important to the analysis because if an NFT is found to be a section 408(m) collectible (and held by the owner for more than one year), then it may be subject to a maximum 28% capital gains tax rate. (If the NFT were found not to be a section 408(m) collectible, then the NFT would be subject to a lower tax rate.) The Notice explains that to determine whether an NFT is a section 408(m) collectible, the guidance will analyze whether the assets or rights provided by the NFT fall into one of the section 408(m) collectible categories.

In other words, let's say I own a gem. According to section 408(m)(2)(C), my gem is a collectible. Therefore, if I own an NFT that certifies that I own the gem, that NFT (under the Notice and new guidance) is a section 408(m) collectible. The Treasury and the IRS have coined this analysis as the "look-through analysis." Let's try another example. Let's say I own an NFT that provides the right to join an exclusive club. According to section 408(m)(2), the right to join an exclusive club does not fall within the definition of any of the six categories. Therefore, that NFT would not be a section 408(m) collectible and, therefore, not subject to a maximum 28% capital gains tax rate.

I'm sure you can think of an endless number of examples. That's exactly what the Treasury and the IRS are doing by issuing the Notice. The second purpose of the Notice is to solicit "comments" regarding: other definitions of NFTs that should be used in future guidance; analyses alternate to the look-through analysis; how to apply the look-through analysis to NFTs that provide more than one ownership asset or right; other factors to consider when determining whether an NFT is a section 408(m) collectible; what issues the application of section 408(m) may raise, and other guidance that would be helpful. For the full list of questions, check out the Notice.

There are mixed thoughts regarding the impact of the Notice. On one hand, the Notice can provide clarity regarding the tax liabilities of NFT collectors, as stated by Miles Fuller, head of government at crypto tax firm Tax Bit and former IRS chief of counsel. On the other hand, the Notice can create more confusion and unease surrounding the tax liabilities of NFT collectors if it does not address whether the guidance will apply to future NFT sales or apply retroactively, as contemplated by Andrew Gordon, an Illinois-based tax attorney specializing in cryptocurrency and NFTs.

If you have thoughts on the matter, the Treasury and the IRS are accepting written comments through June 19, 2023. You can submit your comments either:

1. Electronically via the Federal eRulemaking Portal at www.regulations.gov (type "Notice 2023-27" in the search field on the Regulations.gov home page to find this notice and submit comments); or

2. By mail to: Internal Revenue Service, Attn: CC:PA:LPD:PR (Notice 2023-27), Room 5203, P.O. Box 7604, Ben Franklin Station, Washington, D.C. 20044 Make sure you include a reference to Notice 2023-27. All comments submitted by either of the two methods will be made available on the Treasury's and IRS's public docket.

Alternatively, or in addition, we'd like to hear your thoughts on the matter. Are the Treasury and the IRS creating an illusion of transparency and collaboration by soliciting comments from the public? Are they asking the public to do a lot of the "heavy lifting" in drafting this guideline and the scope of its application? Will the guideline be a guideline or will it be incorporated into the Tax Code? Would you be interested in reading a summary or overview of the comments submitted?