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What Do You Need to Know About the IRS on Taxing NFTs at a Higher Rate

By June 2, 2023January 30th, 2024Tax Laws
Taxing NFTs

The IRS is seeking public input on its proposal to apply the same tax treatment to certain Non-Fungible Tokens (NFTs) as it does to tangible collectibles like artwork or precious metals. Taxpayers have the opportunity to provide comments on this proposal until June 19, 2023. But what is going on exactly? Can NFTs be classified as collectibles? How would they go about taxing NFTs?

The IRS has announced its intention to classify and tax specific NFTs as collectibles, similar to how art or gems are treated. Under this classification, any gains from NFTs that fall into the collectibles category would be subject to a higher tax rate of 28%, exceeding the current capital gains rates. This declaration was made on March 21, 2023.

What is an NFT?

NFT stands for Non-Fungible Token. It is a type of digital asset that represents ownership or proof of authenticity of a unique item or piece of content, such as artwork, music, videos, collectibles, or virtual real estate, among other things. Unlike cryptocurrencies such as Bitcoin or Ethereum, which are fungible and can be exchanged on a one-to-one basis, each NFT has distinct characteristics and cannot be exchanged on a like-for-like basis.

NFTs are typically built on blockchain technology, most commonly on the Ethereum blockchain, which provides a decentralized and transparent system for verifying ownership and transaction history. The blockchain serves as a public ledger that records and verifies the ownership and authenticity of NFTs, making it difficult to counterfeit or tamper with these digital assets.

One of the key features of NFTs is their ability to establish provenance and ownership of digital items. Each NFT contains a unique identifier and metadata that describes the item it represents. This information, along with the immutable record on the blockchain, helps establish the originality and authenticity of the digital asset.

NFTs have gained significant popularity in recent years, attracting attention from artists, collectors, and investors. They have been sold through online marketplaces and auction platforms, often fetching high prices. NFT ownership provides a digital certificate of ownership and can enable creators to earn royalties from subsequent sales of their work.

It’s important to note that the value and market for NFTs can be highly speculative and subject to fluctuations. The concept of NFTs and their applications are still evolving, and their long-term impact and sustainability in various industries are yet to be fully determined.

How Will the IRS Work on Taxing NFTs?

As per the information provided on the IRS website, NFTs and cryptocurrency are currently treated as property for federal income tax purposes. 

If you sell an NFT at a price lower than what you initially paid for it, you can utilize those losses to offset any profits you have earned from other investments, which are commonly referred to as capital gains. Additionally, if your losses exceed your annual capital gains, you have the opportunity to reduce your regular income by up to $3,000.

Generally, capital gains are taxed at a lower rate compared to the income you earn from employment or side jobs. The tax rate for long-term capital gains, which applies to assets held for more than a year before being sold, can vary from 0%, 15%, or 20% depending on your income level.

However, when it comes to selling collectibles, the net profits are subject to a higher tax rate of 28%. According to the IRS, collectibles are defined as tangible personal property, including artworks, rugs, or antiques. Consequently, if the IRS classifies NFTs as collectibles for tax purposes, sellers may face a higher tax liability.

How Can We Determine When a Specific NFT is a Collectible?

To determine whether a specific NFT should be classified as a collectible, the IRS intends to utilize a look-through analysis. This analysis helps the agency determine if the NFT represents ownership of an asset that is already considered a collectible according to the IRS’s definition. This is how taxing NFTs start.

For example, if you own an NFT that certifies ownership of a gem, it would be deemed a collectible since gems fall under the IRS’s definition of tangible collectibles, as stated on the agency’s website.

During the current tax season, the IRS plans to employ this analysis to decide when an NFT should be treated as a collectible. The agency will issue further guidance in the coming months regarding this matter.