Intro

NFTs, which are digital assets that originated in 2014, have been steadily gaining popularity over the years. However, their appeal has skyrocketed in recent times, partly due to the surge in popularity of cryptocurrencies like Matic, which has fueled an unprecedented level of enthusiasm for NFTs.

NFTs are unique digital assets that can encompass more than just digital artwork, such as 1/1 art and generative art. Moreover, they could also grant their owners specific rights, even with respect to non-digital assets, such as the right to attend an exclusive event or to verify ownership of a physical item.

Taxing NFTs

Recently, the IRS has declared that it intends to categorize NFTs as collectibles and is expected to release guidelines outlining how certain types of NFTs will be treated/taxed under this classification. This determination is based on the fact that NFTs can represent a wide range of things, which can potentially affect their taxability.

This is the first time that the IRS has mentioned anything about NFTs, although the guidance provided is considered preliminary and will need to be finalized first. A final version of the guidance will be published after a public-comment period, which is currently ongoing until June 19th. As part of this process, the IRS has solicited input from the public to ensure that the final guidelines are comprehensive and fair.

How Collectibles Are Taxed

The federal tax code, specifically Section 408(m), outlines the taxation of collectibles, which are considered tangible personal property. Examples of such property include antiques, coins, precious metals, works of art, gems, stamps, and even alcoholic beverages. When a collectible is sold by an investor, any capital gains realized from the sale are subject to taxation as ordinary income, based on the amount of profit earned by the seller.

How NFTs (As Collectibles) Will Be Taxed

The IRS has proposed a unique approach to determining the taxability of NFTs by utilizing a 'look-through analysis'. This method involves examining the underlying right or asset associated with an NFT to determine whether it meets the criteria for classification as a collectible under the current tax code. For instance, an NFT certifying ownership of a collectible car would be considered a collectible for tax purposes. On the other hand, an NFT providing a right to use or develop a virtual plot of land typically would not be classified as a collectible. The IRS will continue to employ this method until it releases its comprehensive guidelines for NFTs, which are expected to be issued in the coming months.

Taxing NFTs as collectibles could result in higher tax liabilities for wealthy individuals relative to other assets like real estate, stocks, and cryptocurrencies. For high-income taxpayers, stocks and cryptocurrencies are taxed at a maximum rate of 20%, while collectibles are subject to a higher maximum tax rate of 28%. Additionally, collectibles are taxed differently than stocks, with tax rates being equivalent to ordinary income tax rates. In contrast, stocks are subject to a three-tier system with rates of 0%, 15%, and 20%. As a result, the wealthiest Americans may face a higher tax rate for their collectibles than for other types of assets.

When assets are sold after being held for a year or less, any resulting profit is considered a short-term capital gain and is taxed at ordinary income tax rates. These rates vary across seven different marginal tax rates, ranging from 10% to 37%. For assets held for more than a year, any profit upon sale is considered a long-term capital gain and is typically taxed at lower rates than ordinary income tax rates. Collectibles, however, are subject to a top long-term capital gains rate of 28%, whereas other assets like stocks and cryptocurrencies have a maximum federal rate of 20%.

Gray Areas

The IRS guidance on NFT taxation marks a significant step forward for taxpayers and tax practitioners. It's commendable how the IRS creatively applies old tax law to a new digital asset in the modern world. However, gray areas remain, as the definition of a collectible isn't always clear-cut. For instance, consider a classic automobile that one person keeps in their garage as a collectible, while another drives the same vehicle to work every day. Is the car a collectible or merely a means of transportation? Similarly, the IRS acknowledges that whether a digital file qualifies as a "work of art" is still somewhat unclear. To resolve these uncertainties, the IRS has solicited feedback from the public regarding NFT taxation and a range of other related questions.

IRAs

To maintain tax-preferred status, individual retirement accounts (IRAs) typically cannot include collectibles in their holdings. The recent IRS notice reaffirms this policy by clarifying that NFTs classified as collectibles cannot be purchased by IRAs without potentially incurring income taxes and penalties.

Outro

With the recent IRS guidance on NFTs coinciding with tax season, taxpayers may want to consider how this will impact their filings as the federal tax deadline approaches. This year, most Americans have until April 18 to file their federal taxes, making it all the more important to stay informed about how the IRS plans to treat NFTs as collectibles.

PostScript:

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