The Taxonomy of NFTs
August 31, 2022
In this, the latest installment in our series about non-fungible tokens (NFTs), we’re looking at a topic that always demands (but does not always deliver) absolute clarity: U.S. federal income tax law.
To recap, an NFT is a unique blockchain token, not replaceable and not interchangeable, and designed to prove ownership of a unique digital or physical asset. Despite the recent downturn in digital assets generally, the interest in NFTs has only grown. In addition to the popularity of NFT marketplaces, including OpenSea and Rarible, and the soaring prices of some high-profile collections (looking at you Bored Ape Yacht Club), businesses from Tiffany & Co. to AMC Theatres have created and distributed NFTs to their customers. As buyers grow more interested in NFTs, tax lawyers, CPAs, and the IRS—and everyone else—will be wondering how these assets should be taxed.
How Are NFTs Taxed? Like Collectibles? Digital Assets? Something Else?
Like everything else in the digital economy, the tax law is struggling to keep up with the explosive pace of the creation and exchange of NFTs. As you know from the previous alerts in this series, an NFT could be digital art or some other intangible asset, or it could be a digital representation of the holder’s ownership of a traditional asset like an acre of land or an oil painting. Understanding what an NFT represents is critical for determining how transactions involving NFTs are taxed.
NFT Gratia Artis
The IRS has issued at least some guidance about digital currency like Bitcoin, indicating that, for tax purposes, digital currency is simply a form of property‒not currency. So, the basics of buying and selling digital currency are well understood: Someone who sells Bitcoin held for investment purposes will generally recognize capital gain or loss equal to the difference between the price they sold the Bitcoin for and the price they paid for it originally. If the seller is a U.S. individual taxpayer who has held the Bitcoin for more than one year, that capital gain will be a long-term capital gain, which is generally eligible for a reduced maximum 23.8% federal tax rate, plus applicable state taxes. A U.S. individual taxpayer who creates a new digital asset will generally recognize ordinary income or loss on the sale of that asset at a maximum 37% federal tax rate.
Although the details of taxing any form of property can be complex, there are not yet many special rules that apply only to taxing digital assets—as opposed to other forms of property—and there is not yet any guidance on NFTs specifically. That said, at a high level, NFTs are likely to be treated as property, i.e., subject to rules like those for digital currency.
There is, of course, an important difference between digital currency and NFTs. Bitcoin and other digital currencies are fundamentally fungible, while NFTs, by definition, are not (it’s right there in the name!). In many cases, the NFT is an asset in itself—the ownership of the NFT is the point. Some of the better known NFTs, including the Board Apes Yacht Club, fit this definition. Because of its non-fungibility, an NFT is a unique asset, like a sculpture or one of a limited series of postage stamps. For tax purposes, art, stamps, and other similar assets are often treated as “collectibles.” If an NFT is considered a collectible, a U.S. individual seller’s federal income tax on gain from its sale increases from a maximum of 23.8% to 31.8% or more (depending on household income or possible adjustments under Section 199A and the alternative minimum tax).
Current law defines “collectibles” as a set of very specific assets, including “any work of art,” stamps, or coins, among other items, as well as a catch-all category that permits regulations to list other “tangible personal property” as collectibles. Although NFTs are not tangible property, which would allow the IRS to treat them and regulate them as collectibles, the IRS could reasonably view at least some NFTs as being works of art.
"Paper" and "Shrinkwrap" NFTs
Sometimes assets are transferred through other “assets.” For example, a real property owner could subdivide their land, sell the plots, and issue a physical deed to each purchaser, showing that the purchaser owns the plot. The piece of paper the deed is printed on has no value—it merely is a means of transfer, and an indication of ownership, of a valuable asset. The IRS does not tax the transaction as a transfer of paper; it taxes the transfer of real property. If City Hall were to implement a digital deed program, with all deeds recorded electronically, there is no reason to believe that would change the tax treatment of a real estate transfer, so why should a transfer of a digital asset?
Not all NFTs are works of art with intrinsic value—instead, property owners or creators may create NFTs that merely indicate ownership of a non-NFT asset. A real property owner could, in theory, issue an NFT that indicates ownership of each subdivided lot. In that case, like the paper a physical deed is printed on, the NFT itself has no value—it only has value in that it represents a valuable asset, i.e., the lot. So, for tax purposes, we would expect that in a sale of an NFT conferring ownership of a plot of land, the existence of the NFT would be disregarded and the transaction would be viewed as a transfer of the land it represents. Any other treatment would be nonsense. For example, non-U.S. individuals are generally not subject to U.S. federal income tax on gains from the sale of investment assets, but one exception is the sale of a U.S. real estate asset. If the real estate is tokenized into an NFT and viewed as an independent asset, a non-U.S. individual, who transferred the NFT, would not be subject to U.S. federal income tax on the transfer, while a non-U.S. individual, whose transfer was by paper deed, would be subject to U.S. tax.
A more complicated question arises when the NFT represents not a tokenized tangible asset like land, but a tokenized intangible asset, separate and apart from the NFT. The key question in that case would be whether the transfer of the NFT has conferred any traditional IP rights in the tokenized intangible asset or whether the NFT is a separate asset for tax purposes. For example, the Associated Press has created a market of official NFTs from its photo library. These NFTs do not confer to their owners any rights to the underlying photographs—what owners receive is, according to AP, “a rich set of original metadata offering collectors awareness of the time, date, location, equipment and technical settings used for the shot.” It seems clear that this type of NFT would be treated as an independent asset (i.e., copyrighted material similar to shrink-wrapped copies of software) rather than as licensed intellectual property rights associated with the photographs.
A copyright owner of a photograph could also actually transfer ownership rights in that copyright via NFT in a manner similar to the NFT real property transfer example. In that case, we expect the tax law to consider a transfer of that NFT to be like a transfer of a traditional copyright and therefore subject to the well-developed tax rules on such transfers. Making that distinction could be difficult and would require a detailed understanding of the precise legal rights conferred. A consultation with a tax lawyer would seem to be in order.
Of course, the existing guidance on the taxation of digital assets is sparse and none of it is specific to NFTs. We strongly encourage creators of NFTs and those who invest in them to seek advice on how to treat transactions. O’Melveny will be closely monitoring all developments surrounding NFTs. Please do not hesitate to reach out to the individuals listed on this alert or your O’Melveny lawyer for assistance, and keep an eye out for the next installment in our NFT series.
As we said, for all the uncertainty in the digital economy, the NFT market is booming. Here are the 10 most expensive NFT art pieces ever sold (keep in mind that this list may be out-of-date by the time you finish this sentence):
10. CryptoPunk #7804: $7.56 million
The pipe-smoking #7804 is one of only nine aliens in existence.
9. CryptoPunk #3100: $7.57 million
The white-and-blue headband–wearing #3100 is another of the nine.
8. CryptoPunk #5577: $7.7 million
One of 24 Ape punks, #5577 wears a cowboy hat. Most people think Robert Leshner, CEO of Compound Finance, bought it because after the sale he tweeted “Yeehaw.” Yeehaw!
7. CryptoPunk #4156: $10.2 million
The ape of #4156 wears a blue bandana.
6. Tpunk #3442: $10.5 million
This “Joker” (green hair, red eyebrows) was purchased by TRON co-founder, Justin Sun.
5. CryptoPunk #7523: $11.7 million
The “COVID Alien”—it wears a surgical mask—was bought by Shalom Meckenzie, largest shareholder of DraftKings.
4. CryptoPunk #5822: $23.7 million
Another one of the nine, this blue bandana–wearing punk was bought by Chain CEO Deepak Thapliyal.
3. Beeple, Human One: $28.9 million
Both the NFT and the electronic sculpture were auctioned as a lot in Christie’s 21st Century Evening Sale.
2. Julian Assange and Pak, Clock: $52.7 million
This depicts a timer that counts the number of days Assange has spent in prison. It was purchased by AssangeDAO, an organization that works to free Assange.
1. Beeple, Everydays: The First 5000 Days: $69.3 million
This sale brought the term “NFT” to the public’s consciousness.
This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Luc Moritz, an O’Melveny partner licensed to practice law in California, William K. Pao, an O’Melveny partner licensed to practice law in California, and Billy Abbott, an O’Melveny counsel licensed to practice law in New York and California, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.
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