On June 18, 2023, the New York State Bar Association Tax Section submitted a report (the "Report") in response to the IRS’s request for comments in Notice 2023-27.  As previously discussed here, Notice 2023-27 (the "Notice") announces the government’s intention to treat certain non-fungible tokens ("NFTs") as “collectibles” under Section 408(m) of the Internal Revenue Code and potentially subject certain sales or exchanges of NFTs to increased long-term capital gains rates of 28% as well as restrict acquisitions of collectibles by individual retirement accounts. The  Notice states that ownership of an NFT “may provide the holder a right with respect to a digital file” as well as certify ownership in physical items and proposes a “look-through rule” examining whether an NFT’s associated rights in underlying property may be characterized as collectibles on a look-through basis.

As defined in the Notice, NFTs are unique digital identifiers, which may be used to certify ownership of distinct rights or assets (either physical or digital) where such ownership is recorded on a distributed ledger. In this regard, the Report discusses the inherent difficulties in identifying the particular rights associated with an NFT. The Report distinguishes between the NFT itself, which may not, absent additional legal arrangements occurring outside of the distributed ledger, transfer rights in an asset referenced by the NFT and the bundle of rights associated with the underlying asset. The Report further notes that NFTs generally cannot convey legal rights to physical assets independently without additional off-blockchain contracts.  

The Report makes the following recommendations to Treasury and the IRS:

• A separate definition for NFTs is unnecessary in order to issue guidance under Section 408(m), and guidance on the application of Section 408(m) to digital assets should not be limited to non-fungible digital assets. If NFTs are defined, the definition should not imply that transferring an NFT (or other digital asset) also transfers the rights to off-blockchain assets or services associated therewith.   
• Guidance should be issued clarifying whether an intangible can be a “work-of-art” for purposes of Section 408(m), and if so, replacing the Notice’s look-through rule with specific criteria to determine if an NFT referencing a digital asset is classified as a collectible (e.g., (a) the NFT is minted by the creator of the digital file’s content, (b) the digital asset would be considered a Section 408(m) “work-of-art” in its physical form, and (c) the NFT holder possesses display rights akin to physical art).

• NFTs referencing rights in physical assets (e.g., paintings, gems, or metals) should be classified as Section 408(m) collectibles based on existing concepts of tax ownership (i.e., an NFT holder possesses the benefits and burdens of ownership substantially equivalent to an owner of the physical asset, and a holder of the assets is contractually required to deliver the assets to the NFT holder).
• Treasury or the IRS may wish to request that Congress evaluate whether to expand Section 408(m) to include some or all digital assets.
• Guidance should be issued describing whether and when airdrops of NFTs are included in gross income, and if so, treating NFTs and fungible digital assets consistently.
• Guidance should be issued providing that NFTs may be classified as digital assets under Section 6045’s broker reporting rules (even if the NFT references a non-digital asset).
• Additionally, the Report requests that Treasury or the IRS issue specific NFT guidance outside of the context of Section 408(m) on the following areas: (a) characterizing income derived from self-created NFTs, (b) characterizing and sourcing NFT royalty income, (c) characterizing and sourcing NFT income under the specific Treasury regulations related to computer programs, and (d) treatment of NFTs participating in underlying algorithmic activity.