Polygon Advisory Group LLC

In a recent development, the Internal Revenue Service (IRS) has issued Notice 2023-27, which announces its intention to provide guidance on the treatment of specific nonfungible tokens (NFTs) as collectibles under §408(m) of the Internal Revenue Code. This treatment is relevant for other purposes of the Code, including the long-term capital gains tax rate under §1(h). The notice also requests comments on the treatment of NFTs as collectibles and other related questions. In this blog post, we will explore the key aspects of this notice and what it means for NFT holders.

What Are NFTs?

Nonfungible tokens, or NFTs, are unique digital identifiers that use distributed ledger technology, such as blockchain, to certify the authenticity and ownership of an associated right or asset. These assets can include digital images, digital music, digital trading cards, or digital sports moments. Ownership of an NFT may also provide the holder with a right to attend a ticketed event or certify the ownership of a physical item.

IRS Notice 2023-27: Key Takeaways

1. Treatment of NFTs as Collectibles: The IRS intends to issue guidance on treating certain NFTs as collectibles under § 408(m) of the Internal Revenue Code.

2. Determinations Pending Further Guidance: Until the issuance of further guidance, the IRS will determine whether an NFT constitutes a collectible by analyzing whether the NFT's associated right or asset is a collectible under §408(m).

3. The IRS does not provide a specific definition for "work of art" under § 408(m)(2)(A). However, it does mention that the Treasury Department and the IRS are considering the extent to which a digital file may constitute a "work of art" under § 408(m)(2)(A). The notice requests comments on factors that might be considered when determining whether a digital file, such as the digital content associated with an NFT, qualifies as a "work of art" for the purposes of §408(m).

Why Does this Matter?

Whether NFTs are defined as collectibles by default – or it is left up to some interpretation – is an issue for a couple of reasons:

1. Gains on the Sale of collectibles are subject to a higher tax rate (28%) than normal capital gains transactions, and

2. There are implications for anyone investing in NFTs through a self-directed IRA. Investment of IRA funds into collectibles is considered a prohibited transaction. It triggers recognition of a distribution from the IRA, meaning a taxpayer will owe tax (and possibly penalties & interest) on any amount of IRA funds invested in NFTs deemed to be collectibles. (See here)

Conclusion

We’ve long believed that the IRS should clarify the issue of NFTs being collectibles, even going so far as to advise clients not to purchase NFTs with IRA funds while the issue remains unclear. While Notice 2023-27 doesn’t provide authoritative guidance on the issue, the IRS may tighten the screws.

The Tax Code does not directly define “work of art,” but the IRS will probably assert that any current art based NFT projects fall under that description. Also, any NFTs that denote ownership of other collectibles (such as tokenized gemstones or jewelry) will likely fit the description of collectibles. If you have investments in NFTs (art-based or otherwise), it is important to work with a knowledgeable tax advisor to determine your possible exposure to negative tax implications of those NFTs being declared collectibles.