Selling Sound: Tax Considerations for Musical NFT Creators
Beanie Babies, Pokémon cards, POGs, and digital pictures of bored apes: one of these things is not like the others. All have experienced unexpected surges of popularity, and all have been coveted by collectors, some collecting for fun and others in the hopes of turning a profit. However, only one of these items might be considered a taxable collectible by the IRS…
Digital pictures are just one type of NFT or non-fungible token. NFTs are unique digital identifiers used to confirm the authenticity and ownership of an asset, such as a digital file. This identifier is recorded on a blockchain—that ensures the asset cannot be copied and allows the owner to sell or trade it. For the past decade, NFTs have been soaring in popularity. NFT trades reached over $17 billion in 2021 before a dramatic crash in 2022 to only 97% of previous sales.
The question before us is: can the sale or trade of an NFT be taxed by the IRS? The answer has not been clearly outlined yet, but amid this ambiguity, NFT investors can benefit from working with a tax professional to ensure you have a tax plan in place that accounts for possible taxation. Below we have detailed what we know so far about the IRS’ approach to NFTs and what the future may hold.
What is a Collectible?
The question of whether an NFT could be subject to taxation depends on the definition of a “collectible.” Collectibles are mentioned in an unexpected section of the Internal Revenue Code that focuses on Individual Retirement Accounts (IRAs). This section simply says that IRAs cannot invest in a collectible, such as a “work of art, rug or antique, metal or gem, stamp or coin, alcoholic beverage, or any other tangible personal property specified by the Secretary” (see Section 408(m)).
As would be expected with the IRS, this definition is provided for the purpose of taxation. A collectible that has been held for at least a year can be taxed if it is sold at a profit, and its special tax rate is currently set at 28%.
The final detail that should cause digital investors to sit up and pay attention appears in IRS Notice 2023-27: the IRS and the Treasury Department announced its intent to issue guidance on the treatment of certain NFTs as collectibles.
Which NFTs Could Be Taxed?
Since the types of NFTs can vary widely—from gaming tokens to virtual real estate to wearables in virtual fashion—we first need to identify which NFTs could count as a collectible. Most of the items in the IRS definition above do not seem to apply. NFTs are not rugs, antiques, metal, gems, stamps, coins, or alcoholic beverages. NFTs are also intangible, rather than tangible, assets, so the agency would be hard pressed to use that part of the definition. That leaves us with one final option: works of art.
Since the Internal Revenue Code does not provide a definition for a “work of art,” this leaves the door open for the IRS to include digital images under this umbrella. How will the IRS decide whether to classify a specific NFT as “art” or “not art”? The criteria has not been publicly disclosed yet, but a concern for taxpayers is whether they will know the difference while making the decision to invest in an NFT. Fortunately, certain NFTs, such as certificates of course completion, ENS domains, or conference entry tickets, are unlikely to fit under the “art” classification.
The “Look-Through Analysis”
The nature of NFTs adds another layer of complexity. An NFT is separate from the object it represents. If you purchase an NFT of an image of a cantaloupe, the NFT is basically a digital roadmap that points to that specific image of a cantaloupe. If the blockchain where the NFT is recorded disappeared, the digital image of the cantaloupe would still exist somewhere in a data center. Conversely, if the data center burned down and the image had never been backed up elsewhere, the cantaloupe could vanish from existence, but the NFT itself would still exist—it would just point to an empty digital address.
So how will the IRS treat the relationship between the token (NFT) and the object (digital cantaloupe image) itself? If we go back to IRS Notice 2023-27, we see that the IRS intends to determine whether an NFT is a collectible by analyzing whether the right or asset associated with the NFT is a collectible. This is known as a “look-through analysis.” According to these rules, if the NFT is associated with a collectible, then the NFT itself is a collectible. In other words, if the NFT has an associated right to a gemstone, then that NFT would be a collectible, since gemstones are considered collectibles by the IRS.
Summary
The final verdict is still out when it comes to taxing NFTs, but taxpayers would be wise to be wary. Current evidence suggests that the IRS will apply the 28% collectibles tax rate to at least some types of NFTs. Taxpayers should factor this into any NFT investments they make in the immediate future—at least until the IRS issues clearer guidance.
For expert advice on how to factor NFTs and other possible investments into your tax plan, get connected with a tax professional.
