Is Your Bored Ape NFT a Work of Art? IRS Will Have to Decide

The IRS in the coming months will have to decide if your Bored Ape non-fungible token is a work of art or a membership card to an exclusive “yacht club.”

These kinds of decisions made by a federal agency are causing concern among tax practitioners who say determining the use of an NFT is often subjective and could expose their clients to a 28% capital gains tax.

The IRS released Notice 2023-27 in March, announcing plans to issue guidance about the treatment of NFTs as collectibles under Section 408(m) of the tax code.

The notice lays out how the agency is thinking about assessing a digital asset as a collectible, using what is calls a “look-through analysis.” It also asks for feedback from the public about what makes a digital file a “work of art” for tax purposes.

“Is Bored Ape a collectible?” said Jordan Bass, CPA, tax attorney, and founder of Taxing Cryptocurrency. “Is it just an NFT that grants them rights to gain access to this membership? Maybe, maybe not. There’s a lot of different considerations that come into it.”

Experts say an NFT’s ability to serve several purposes at once for an investor will complicate the IRS’s task of writing clear guidance, and tax preparers say they’d like an established set of criteria to classify an NFT as a collectible.

“That’s the beauty of an NFT, right? It’s the multi-use case,” said Gabriel Brin, vice president of tax and accounting at Ledgible. “And that’s where there’s going to be a little bit of tension, a little growing pains there.”

‘Look-Through Analysis’

The look-through rule analyzes whether an NFT is an “associated right or asset” for an underlying physical collectible under Tax code Section 408.

Tax code Section 408(m)(2) defines a collectible as any work of art, rug, antique, metal, gem, or alcoholic beverage; the sale of a collectible that’s held for more than a year is subject to a 28% capital gains tax.

If an NFT certifies ownership of an asset such as a Persian rug, the NFT is a collectible. If an NFT is used to develop a land plot in a virtual space—such as the metaverse—it is not a collectible, according to the IRS.

Sahel A. Assar, international tax counsel and chair of Buchanan Ingersoll and Rooney’s Blockchain and Digital Assets Practice Group, said the look-through rule is “simplistic,” the most “fundamental,” and “probably the most correct way” to figure out if an NFT is a collectible.

“I applaud the IRS because I think it’s a good first step,” Assar said. “I mean, the alternative is it just puts out guidance that says this is not collectible, or this is not collectible, that would be very elementary and sort of silly, right?”

She acknowledged the first iteration of guidance will most likely not be perfect.

Multiple Purposes

NFTs can serve multiple purposes, including as a piece of digital art, proof of ownership for a tangible asset, membership for entrance into a club, ticket to an event, or even a mechanism to gather and record data.

For example, auto manufacturer Alfa Romeo announced last year it would release a compact SUV with a function allowing maintenance data to be recorded on an NFT.

Brin said in this case, a decision would have to be made to determine if the NFT has value, or if it’s used solely for the purpose of tracking.

The Bored Ape Collection gained popularity and value after promotion by celebrities such as Jimmy Fallon, Paris Hilton, Eminem, Snoop Dogg, and Justin Bieber.

The images are used as profile pictures on social media platforms. They also serve as a means of entrance into a community of other Bored Ape NFT owners, or the “yacht club,” who receive special perks as owners of these NFTs.

Treasury and IRS requested comments from the public in their notice about the “burdens” the look-through analysis may impose and instances in which there may be concerns about applying the look-through rule.

The department is also considering the extent to which a digital file constitutes a work of art—a task tax professionals say may be tricky considering opinions of art differ from person to person.

“The art is in the eye of the beholder,” Brin said. “How much it’s worth is really in the eye of the beholder.”

Omri Marian, a law professor specializing in taxation and the blockchain at the University of California, Irvine, said he hopes the IRS will not have to define the term.

Though he says he doesn’t think it will be a big issue in the long run, he added, “Every time we’re asking the IRS to do something that is not squarely within its expertise of administering and collecting taxes, I get nervous.”

Safe Harbors

To avoid complications, tax professionals say they want to see clear examples or a list of criteria that would allow them to easily determine whether an NFT is a collectible.

Assar said she’d like to see some flexibility in the guidance that comes out and rules that “could be applied practically.”

“So, I as a practitioner would like the IRS to provide me a rule that’s not rigid,” Assar said. “That’s not inflexible. That allows me maybe four or five criteria that says, ‘OK, if the NFT meets these four or five criteria, then more likely than not, it’s collectible.”

Tom Shea, financial services crypto tax leader at Ernst & Young, said the first thing he looks at in guidance to resolve a technical issue is the examples laid out by the IRS that “sketch out” the treatment of assets held by a taxpayer.

“If they could sketch out some of these examples like Bored Apes, without naming them directly, providing those practical examples and the applications of such, I think, would be incredibly helpful,” he said.