Key Takeaways

• Notice 2023-27 (the Notice) is the first guidance the IRS has issued on non-fungible tokens (NFTs) and addresses the tax treatment of transactions where NFTs are acquired by individual retirement accounts (IRAs).
• The Notice notifies taxpayers that the IRS intends to issue guidance that certain NFTs will be considered collectibles under Section 408(m) of the Internal Revenue Code of 1986, as amended (the Code), which provides that an IRA that purchases any “collectible” will be treated as having distributed such collectible.
• Pending the expected future guidance, the IRS intends to adopt a “look through” approach in analyzing whether an NFT is or is not a Section 408(m) collectible. Under this approach, if the NFT’s associated right or asset is determined to be a Section 408(m) collectible, the NFT is also a Section 408(m) collectible.
• The classification of an NFT as a Section 408(m) collectible is significant because collectibles that qualify as capital assets are subject to a maximum 28 percent long-term capital gains rate, which is higher than the capital gains rates that apply to capital assets that are not collectibles.
• The IRS requests comments on the proposed guidance by June 19, 2023, on a variety of issues, including the specific factors that should be considered in determining whether a “digital file” and, in turn, an NFT constitutes a work of art under Section 408(m) and the broad question of what other guidance taxpayers would like relating to NFTs.
• Taxpayers with significant NFT activities should strongly consider taking advantage of the opportunity to influence the forthcoming guidance by submitting comments to the IRS on or before the deadline of June 19, 2023. 

The Proposed Guidance and Implications

The IRS and Treasury Department announced on March 21, 2023, that they intend to issue guidance providing that certain NFTs qualify as collectibles under Section 408(m) of the Code. The Notice is the first guidance issued by the IRS addressing the U.S. federal income tax treatment of NFTs. The IRS originally issued Notice 2014-21 in 2014 addressing virtual currencies and how they should be treated as property for federal income tax purposes. In 2019, the IRS issued Rev. Rul. 2019-24 relating to whether the receipt of cryptocurrencies via a hard fork or airdrop resulted in taxable income to the recipient. The IRS has also released Chief Counsel Advice Memoranda addressing how specific federal income tax principles (e.g., the like-kind exchange rules or when an asset is worthless) apply to cryptocurrencies. None of this prior guidance, however, addressed NFTs. Taxpayers and their advisors have accordingly tried to analogize NFTs to other types of property to draw on how the federal income tax laws treat analogous property.

The Notice defines an NFT as “a unique digital identifier that is recorded using distributed ledger technology and may be used to certify authenticity and ownership of an associated right or asset.” According to the Notice, the “associated right or asset” may be a right with respect to a “digital file” or a right with respect to “an asset that is not a digital file, such as a right to attend a ticketed event, or certify ownership of a physical item.” The Notice distinguishes between the NFT, which provides access to or certifies ownership of the associated right or asset, and the associated right or asset itself.

The IRS’s proposed guidance is expected to address parameters on how to determine whether an NFT is in fact a Section 408(m) collectible. The Notice provides that these proposed rules intend to adopt a “look through analysis” that will examine whether the NFT’s associated right or asset is itself a Section 408(m) collectible. An example provided by the Notice of when an NFT is a Section 408(m) collectible is an NFT that certifies ownership of a gem, which is itself a Section 408(m) collectible. In contrast, the Notice states that an NFT that provides a right to use or develop land in a virtual environment is an example of an NFT with an associated right or asset that is not a Section 408(m) collectible. Importantly, the Notice states that the IRS is still determining whether an associated right or asset that is a digital file can constitute a “work of art” and thus qualify as a Section 408(m) collectible. If it can, given that a work of art is a Section 408(m) collectible, the NFT also would be a Section 408(m) collectible. 

Classifying an NFT as a Section 408(m) collectible has significant relevance under the federal tax laws. First, an IRA that acquires a collectible will be treated as if it distributed the collectible to its account holder, with the distribution equaling the cost of the collectible. Another consequence is that the acquisition of a collectible by an individually directed account that qualifies as a plan under Section 401(a) is also treated as a distribution from the account equal to the cost of the collectible. In addition, a collectible that qualifies as a capital asset held for more than one year is subject to a maximum 28 percent capital gains rate, which is higher than the long-term capital gains rates that apply to capital assets that are not collectibles.

The proposed guidance may have a significant impact on the self-directed IRA market. In 2022, the Department of Labor issued guidance cautioning 401(k) plan fiduciaries to exercise extreme caution before allowing a participant to invest plan assets in cryptocurrencies due to the risks and challenges that cryptocurrencies present. The guidance, however, does not appear to extend to IRAs, and over the past several years, self-directed IRA products that allow investments in bitcoin and other cryptocurrencies have become more common. As these products begin to offer NFTs as IRA investment options, they will likely require analysis under Section 408(m) and the forthcoming guidance.

IRS Requests Comments on the Proposed Guidance

The Notice requests a wide range of comments, including on its definition of an NFT and what factors should be considered when determining if an NFT is a Section 408(m) collectible. It also requests guidance on the proposed look-through analysis and what additional guidance relating to NFTs would be helpful. There have been a number of recent challenges to IRS guidance that assert the guidance was invalid because it was a legislative rule that did not comply with the notice and comment provisions of the Administrative Procedure Act (APA).[1] The Notice’s request for comments and notification that future guidance will be issued may be in response to these challenges. It also may permit future guidance to be effective as of the date the Notice was issued.

Several important questions remain about how NFTs should be treated for federal income tax purposes, and these questions are not addressed by the Notice. For example, the federal income tax treatment of NFTs held by dealers or creators of NFTs still lacks clarity. An NFT held by a dealer or creator may not qualify as a capital asset; instead, it may be considered inventory or a created intangible, which would impact the tax rates that apply to the sale of an NFT held as either, and the tax accounting methods available to the dealer or creator. It is also not clear whether an NFT will be subject to the recently enacted broker reporting rules for digital assets. The Notice states that a digital file is not the same as a digital asset that is subject to the reporting rules but, curiously, does not mention whether an NFT qualifies as a digital asset for federal income tax purposes.

The Notice’s request for comments offers taxpayers a unique opportunity to voice their thoughts and concerns regarding the taxation of NFTs. Taxpayers with significant NFT activities should strongly consider taking advantage of the opportunity to influence the forthcoming guidance by submitting comments to the IRS on or before the deadline of June 19, 2023. 

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