The IRS plans to tax some NFTs as collectibles — and the rich would pay up to 28% on profits

The IRS said it plans to tax some non-fungible tokens, or NFTs, as collectibles akin to art or gems — an approach that would tax profits for wealthy owners at a higher rate relative to assets such as stocks, real estate and cryptocurrency.

The federal government levies taxes on collectibles held for more than a year at a top rate of 28%. It generally levies a top 20% rate on other investments.

In a notice on Monday, the IRS said it intends to issue guidance regarding the treatment of certain NFTs as collectibles.

NFTs are essentially one-of-a-kind digital assets, which can extend beyond digital art to include things such as such as tweets and GIFs. They sometimes also give owners a right with respect to a non-digital asset, like a right to attend a ticketed event or certify ownership of a physical item.

The IRS requested comments from the public, which are due by June 19.

“The IRS hasn’t said anything about NFTs until now,” said Shehan Chandrasekera, an accountant and head of tax strategy at CoinTracker. “This is kind of like half guidance because it’s not finalized yet.”

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NFT enthusiasm swelled in recent years along with the popularity of cryptocurrencies such as bitcoin.

However, that energy has since cratered. NFT volume fell 77%, to $1.7 billion, in the third quarter of 2022 versus $7.4 billion in the second quarter, according to NonFungible.com. There was also a broad market pullback among assets such as stocks and bonds last year.

The IRS plans to use a “look-through analysis” to determine whether an NFT is a collectible.

Basically, it will judge whether the NFT’s associated right or asset is a collectible as currently defined in the tax code — and if so, the NFT is also a collectible.

“NFTs can represent anything, literally anything,” Chandrasekera said. “The IRS is saying taxation depends on what it represents.”

Section 408(m) of the federal tax code defines a collectible as tangible personal property such as any work of art; rug or antique; metal or gem; stamp or coin; or alcoholic beverage.  

Here’s an example of how the IRS would conduct a “look-through” analysis: Since a gem is a clearly defined collectible, an NFT that certifies ownership of a gem is also a collectible for tax purposes, the agency said.

Conversely, a right to use or develop a “plot of land” in a virtual environment generally isn’t a collectible. An NFT offering a right to use or develop that virtual plot also generally isn’t a collectible, the IRS said.

The IRS will use this look-through analysis until it issues NFT guidance in future months.

“This [guidance] is right around crunch time for tax filings,” said Troy Lewis, an associate professor of accounting and tax at Brigham Young University. “As you move toward Tax Day, you might want to think about this.”

This year, the federal tax deadline is April 18 for most Americans.

“Clearly, the IRS signaled, ‘Until we give you something else, this is how we view life,'” Lewis added.

Investors pay capital gains tax when they sell an asset. The tax is owed on the seller’s profit.

Short-term capital gains apply to assets held for a year or less. Profit on those sales is taxed at ordinary income tax rates, which apply to wages, for example. (There are seven marginal tax rates, ranging from 10% up to 37%.)

Long-term capital gains apply to assets sold after more than a year of ownership. These tax rates are generally lower than ordinary income tax rates.

Stocks and cryptocurrency carry a maximum rate of 20% for high-income taxpayers. (Less affluent individuals pay 0% or 15%.)

But collectibles — which tend to be owned by the super wealthy — are subject to a different tax regime. They’re taxed at a maximum 28%.

Their structure is different, too: Collectibles are taxed at ordinary-income-tax rates, up to 28%. That differs from the from the three-tier system (0%, 15% and 20%) for stocks.

Put simply: The highest-income Americans pay a higher tax rate for collectibles.

Taxpayers generally can’t hold a collectible in an individual retirement account, which is tax-preferred, Lewis said.

The recent IRS notice supports that notion, indicating that an NFT categorized as a collectible can’t be purchased by these retirement accounts without perhaps triggering income taxes and penalties.

The IRS guidance is “a serious advancement” for taxpayers and tax practitioners, said Lewis, who owns an accounting firm in Draper, Utah.

It’s also creative in how it leverages old tax law for tangible collectibles and applies it to a new digital asset in the modern world, he said.

However, there’s still some gray area since the notion of what constitutes a collectible isn’t always black and white.

“They don’t really deal with the hard issue, per se,” Lewis said of the IRS notice. “What is a collectible is still somewhat unsettled.”

For example, Lewis said, consider a rare car that someone keeps in their garage. That person might treat the car as a collectible. Now, consider a different person has the same vehicle but drives it to work every day. Is the vehicle a collectible, or is it instead a transportation device? Similarly, what about an antique desk that someone uses in their day to day life?

Whether (and to what extent) a digital file constitutes a “work of art” is also somewhat unclear, the IRS said in its NFT notice. The agency is seeking input on this question and a range of other questions relative to NFT taxation.