Proposed IRS rules for non-fungible tokens have been seen as a good first step to accounting professionals in this space, indicating that the agency is finally taking these assets seriously.
A non-fungible token, or NFT, is a digital asset that represents ownership of something unique, like a piece of art, music, or a collectible. When someone buys an NFT, they are not buying the physical item, but rather the right to claim ownership of that item. In this sense it operates like a digital certificate of ownership that is stored on a blockchain.
The proposed regulations, which were released on Tuesday, concerns the treatment of certain NFTs as section 408(m) collectibles, which concerns investment in collectibles treated as distributions. While the IRS said it is seeking more information and feedback on the topic, until additional guidance is issued, the agency intends to determine when an NFT is treated as a collectible by using a “look-through analysis.”
Under the look-through analysis, an NFT is treated as a collectible if the NFT’s associated right or asset falls under the definition of collectible in the Tax Code. For example, a gem is considered to be a collectible under Section 408(m) of the Tax Code, so that means an NFT that certifies ownership of a gem is a collectible as well. In contrast, if an NFT represents a right to a plot of virtual land in a metaverse, since the “plot” is not a collectable under the terms of 408(m), the NFT is not a collectible either.
Gabriel Brin, vice president of tax and accounting products at Ledgible, a cryptocurrency tax and finance management platform, said the IRS guidance indicates the government is awakening to the idea that an NFT is more than just ownership of a JPG. The proposed guidance represents a step forward in agencies realizing that not all NFTs should be taxed the same given that not all NFTs represent the same type of underlying asset.
“Some may see this as an over exertion of taxing authorities and worry this may drive away blockchain innovation. However, we at Ledgible see this as more proof pointing to blockchain and its technology being adopted into real world use cases. You don’t have to look far for proof, just start with the once comical NFT JPEG now being transformed into a tool used in verifiable ownership of a plethora of different asset types,” he said.
Sean Stein Smith, chair of the accounting working group at the Wall Street Blockchain Alliance and a Lehman College professor, was similarly encouraged by the proposed guidance, as it shows the IRS is taking this sector of the crypto market seriously. Smith did note, however, that even if the guidance is approved as-is, which is unlikely, it would still represent a major shift in how NFTs are taxed.
“Other cryptoassets are subjected to capital gains tax, [but] as a collectible-equivalent, NFTs would be subjected to a higher rate of 28%. Secondly, and reflecting the breadth of use cases that NFTs can be applied to, the IRS will use a ‘look-through’ analysis, i.e. the NFT itself will be taxed the same as the underlying asset it is connected to. So, an NFT representing a gemstone (a collectible) would be treated as a collectible, but an NFT connected to a virtual plot of land would not be treated and taxed as a collectible. Lastly, if an NFT is determined to be a collectible-equivalent, this will impact the effect of these instruments on retirement accounts in the form of less favorable tax treatment versus other assets,” he said.
Patrick Camuso, leader of Camuso CPA, an accounting firm that specializes in digital assets like NFTs, similarly thought it was good that the IRS was finally paying attention to this sector. The proposed approach of treating NFTs like its underlying asset, he said, makes sense but will need further clarification to be useful, especially around whether the guidance would be applied retroactively. However he said it appears the IRS understands the complexity of this issue, and is taking a careful approach.
“This will create further accounting complexity since NFTs will have to be classified for tax purposes based on each NFTs specific tax requirements. With that considered, given the overall nature of NFTs, I think this is a logical and reasonable tax approach,” he said.
He added that the IRS proposal is similar to the ways state governments have been treating NFTs for sales tax purposes.
“It will be interesting to see what consistency, if any, there will be between federal taxes and state sales tax definitions and look through analysis procedures,” he said.