Earlier this month, the Treasury released a study in which it examined how transactions in “high-value art” may facilitate the laundering of illicit proceeds.[i] The study also considered efforts that be undertaken by government and the private sector to mitigate money laundering through the high-value art market.
The Treasury’s study explained there are several qualities inherent to high-value art that make the market for such art attractive for money laundering; among those listed in the study are “the high dollar value of transactions, transportability of goods, and a longstanding culture of privacy and use of intermediaries (for example, shell companies).
Then there is the increasing use of “high-value art as an investment class.” Indeed, I have spoken with many owners and families that, having sold their business, meet with a private banker to determine how to best invest the proceeds from the sale. Often enough, these folks are advised to take a “holistic” approach, which they are told should include art and real estate in addition to more conventional investments in securities.
According to the study, the participants most vulnerable to money laundering in the high-value art market are businesses that are not subject to comprehensive anti-money laundering obligations, but that offer financial services, such as art- collateralized loans.[ii] Asset-based lending, the study concluded, can be used to disguise the original source of funds, and provide liquidity to criminals.
(Non sequitur? Maybe, but here it goes. How many of you recall the Metropolitan Opera’s putting up its Chagall murals as collateral for an existing loan as the economy – and the Opera’s endowment – tanked in 2009 in the wake of the financial crisis?)
The study noted that entities having larger annual sales turnover and that regularly transact in high-value art in the ordinary course of business may present more opportunities for cleaning dirty money.
Finally, the Treasury’s report observed that the emerging digital art market, including the use of non-fungible tokens (“NFTs”), may present new risks and challenges to law enforcement.
NFTs as Art?
Digital art? Seriously? Apparently so.[iii]
After a lot of reading, and a not insignificant amount of antacid, I concluded that a simple – perhaps simplistic – but workable definition of “digital art” (at least for me[iv]) is any image: (i) that is skillfully made by an individual (the talented artist) (ii) using software and computers (instead of a brush and paints, a palette knife, or other “traditional” tools), (iii) that a hypothetical “beholder” would viscerally describe as art.[v]
All well and good, but what is an NFT?
Following still more reading, and several doses of non-aspirin pain relievers, I abandoned my efforts to master (at least for purposes of this post) the lingua franca of the digital world. Instead, I arrived at the following, concededly oversimplified, definition for an NFT: it is an “electronic medium” by which one may securely purchase, own, and transfer digital art on the internet.[vi]
Which brings us to the term, “non-fungible token.” A “token” may be described as a digital representation of certain rights – in this case, the rights to a specific work of art – that may be bought and sold. Although there is a valuable right in itself, the real value of an NFT is in the fact that each NFT is uniquely coded (think of it as a certificate of authenticity[vii] or, even better, as a fingerprint); thus, as the name indicates, one NFT is not interchangeable with another NFT in the way that a dollar bill is intrinsically identical to every other dollar bill – an NFT is not fungible because not all NFTs are the same. Moreover, an NFT cannot be broken down into smaller parts; you cannot exchange it for “fractional shares” of itself as one may exchange a five-dollar bill for five one-dollar bills.[viii]
However, NFTs are exchangeable; that is to say, one may exchange an NFT for a different NFT, much the same way that those who hold art for investment may exchange one work of art for another.[ix]
Which raises the question of provenance, or the history of the NFT’s ownership – its chain of title, as a dirt lawyer would say. This goes not only to a person’s ability to convey good title to an object (such as a painting), but also to the authenticity of the object.
According to the literature (which is voluminous[x]), the unique coding of an NFT (its “fingerprint”) enables a prospective purchaser to determine the authenticity of a work of digital art and, in theory, even its point of origin (the artist); these characteristics, in turn, help to secure one’s ownership of the NFT. What’s more, these authors explain, because NFT-related transactions occur on a so-called “blockchain” that is very difficult to breach – basically, a shared database in which “blocks” of information that are strung together (chronologically, if I understood correctly) in a way the authors claim is “irreversible,” which should facilitate (at least in theory) the establishment of an NFT’s provenance.
“Minting” a Market?
But how does art become an NFT?
Well, first an artist needs to create a work of digital art.[xi] The artist’s creation is then “minted” to give the art the unique code (mentioned above) by which it becomes an NFT and by which it will be identified as it changes “hands” (?) through the digital marketplace for collectible and “investment-grade” digital art, with its transactional history being indelibly recorded in the blockchain.
Based upon the foregoing – and assuming a reasonably open mind – would it be too farfetched to suggest that a work of digital art that has been minted into an NFT shares several traits with a physical (i.e., two or three dimensional) work of art?[xii]
Tell me you’re not inspired to spend the next few hours surfing the internet in search of some quality, but reasonably priced, NFT art.[xiii] You wouldn’t be alone.
In fact, last summer Christies sold a digital artwork (by an artist known as “Beeple”) for $69.3 million.[xiv] In addition, there are a number of online sites that cater to the purchase and sale of digital art NFTs.
Yes, the world of art is evolving, as is the public perception of what constitutes “art.” Also in flux is how we view and possess art, meaning at a museum or gallery, on our walls, in a book, and now digitally.
There is one constant, however, something that has adapted to and endured humanity’s vacillating tastes in art. Taxes.[xv] Yes, taxes.
Whatever the form or type of art, regardless of how it is enjoyed, displayed, disposed of, or stored, the gain realized from sale or exchange of art will be taxable, as will the gift or bequest of art.
Taxation of NFT Art
Let’s assume you’ve been smitten after having visited one of the online marketplaces at which NFT art is bought and sold.[xvi] You acquire several works of art that you plan to hold for the long-term as investments; i.e., capital assets.[xvii]
At some point, you decide to dispose of part of your holdings of NFT art. Perhaps you sell it for money, or you exchange it (a swap) for another work of digital art.
To date, the IRS has not specifically addressed the income taxation of NFT art, including the gain realized on its disposition.
However, the IRS has considered the taxation of virtual currency (which is fungible), and it has determined that such “currency” should be treated as property, and that general tax principles applicable to property transactions should also apply to transactions using virtual currency.[xviii]
There is no reason why a transaction in non-fungible digital art should be treated differently than a transaction involving virtual currency; in fact, the case for such treatment is stronger given the non-fungible nature of the artwork.
Thus, a transaction with an art NFT should be treated the same for federal income tax purposes as any other transaction in property.
For example, if the taxpayer sells their digital art for cash, they should recognize and report the gain from the sale on their tax return; if they exchange the digital art for another work of digital art (or for any other property), the taxpayer should be treated as having disposed of the artwork for an amount equal to its the fair market value.[xix]
The amount of gain arising from such a sale or exchange will be equal to the difference between the taxpayer’s basis in the NFT and the amount received in the sale or exchange. The taxpayer’s basis is the amount the taxpayer spent to acquire the NFT, including fees and other acquisition costs in U.S. dollars.[xx]
Assuming the taxpayer has held the NFT for more than one year,[xxi] and assuming the NFT is treated as a “collectible”[xxii] – which includes a “work of art” – then the gain from the sale or exchange will be treated as “collectibles gain” that will be taxed at the federal income tax rate of 28 percent.[xxiii] The collectibles gain will also be subject to the 3.8 percent federal surtax on net investment income.[xxiv]
A gift or bequest of NFT art, whether to a private individual or to a charity, will not require the donor taxpayer to recognize the gain inherent in the NFT (basically, the appreciation following the taxpayer’s purchase of the property). The taxpayer will nevertheless have to determine the fair market value of the NFT (as of the date of its transfer) for purposes of reporting the gift or bequest to an individual on the appropriate federal tax return.[xxv]
Long Way to Go
What about the donation of NFT art to a public charity[xxvi] or to a private operating foundation?[xxvii] Will the NFT be subject to the same requirement as a gift of “conventional” art – i.e., tangible personal property – in order for the donor to claim a fair market value charitable contribution deduction for income tax purposes? Specifically, will it be necessary to demonstrate that the charity’s use of the NFT will be related to the purpose or function constituting the basis for the charity’s tax exemption?[xxviii]
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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] https://home.treasury.gov/news/press-releases/jy0588 . According to the press release, the study was mandated by Congress in the Anti-Money Laundering Act of 2020.
[ii] You may recall that, during the last presidential campaign, and well into the debate on the President’s Build Back Better Plan, the progressive wing of the Democratic Party sought to attack the tax-avoidance strategy it described as “buy, borrow, and die,” pursuant to which the ultrarich can avoid income taxes by holding assets until they die (the basis step-up under IRC Sec. 1014). If they need money (go figure), they can borrow against their assets, including valuable works of art.
For a good discussion of art as collateral, see https://artbusinessnews.com/2016/05/borrowing-with-art-as-collateral/.
[iii] I can’t help but recall the following verse from Matthew 15:14: “If a blind man leads a blind man, both will fall into a pit.”
[iv] I am among the most “digitally challenged” individuals I know. Not because I am incapable of understanding, but because I choose to omit many technological “advancements” from my life, in part to keep it relatively simple (to the extent reasonably possible) and in part out of principle. Remember what Jeff Goldblum’s character said in Jurassic Park: “Your scientists were so preoccupied with whether they could, they didn’t stop to think if they should.” There’s a lot of that going on.
[v] There are any number of prejudices to overcome here; this may especially be the case for those among us who are of a certain age.
[vii] I once acquired a Yogi Berra autographed baseball that was offered during a PBS fundraiser. It came with a certificate of authenticity. Am I a “collector”? Hardly. But here was a “token” (pun intended) from a true American philosopher. “Always go to other people’s funerals; otherwise, they won’t go to yours.”
[viii] Yes, there is still a vibrant (some may add underground) cash economy out there.
[ix] Of course, after the Tax Cuts and Jobs Act, in 2017 (P.L. 115-97), such exchanges of art may no longer be effected as part of a like-kind, tax-deferred exchange under IRC Sec. 1031. As a result of this legislation, tax-favored like kind exchanges are now limited to real property. Last year, an earlier version of the Administration’s Build Back Better plan (remember that?) sought to deny “wealthier” taxpayers the tax deferral benefit a like-kind exchange.
[x] Or it would be if it were in physical form.
[xi] Back to that “beauty is in the eye of the beholder” test.
[xii] Do you sense a “Struggle Within”? Do you recognize the title from Metallica? Apropos of our topic, the song begins, “Reaching out for something you’ve got to feel, while clutching to what you had thought was real.”
[xiii] Check out https://opensea.io/explore-collections?tab=art&utm_campaign=category&utm_source=google&utm_medium=cpc&utm_term=art%20nft&gclid=CjwKCAiA9tyQBhAIEiwA6tdCrEtHreqwhl7SLeT00q7xPmqp7oiJ5spGSMkhtzauGzb-MAJjLWx-ahoCIiQQAvD_BwE
“The sale marked the first time a purely digital artwork had ever been offered by a major auction house and, as The New York Times noted, is ‘the strongest indication yet that NFTs, or “non-fungible tokens,” have taken the art market by storm.’”
[xv] In case you’re wondering – you probably aren’t, but I’ll pretend you are – I’m trying to evoke the voice of James Earl Jones (talk about a national treasure) in his “baseball speech” from “Field of Dreams”: “The one constant through all the years, Ray, has been baseball. America has rolled by like an army of steamrollers. It’s been erased like a blackboard, rebuilt, and erased again. But baseball has marked the time.”
Today, we’re in a lockout and opening day is in doubt. Don’t get me started.
[xvii] IRC Sec. 1221.
[xviii] IRS Notice 2014-21. See also the FAQs at https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions
[xix] Reg. Sec. 1.1001-1.
[xx] Not in virtual currency.
[xxi] The period during which one held the NFT begins on the day after one acquired the NFT and ends on the day the NFT is sold or exchanged. IRC Sec. 1223.
[xxii] IRC Sec. 1(h)(5) and IRC Sec. 408(m)(2)(A).
[xxiii] IRC Sec. 1(h)(4). If, for some reason, art NFT is not treated as a collectible, then the 20 percent federal rate for long-term capital gain will apply.
[xxiv] IRC Sec. 1411.
[xxv] IRS Form 709 and Form 706, respectively.
[xxvi] IRC Sec. 509(a).
[xxvii] IRC Sec. 4942(j).
[xxviii] IRC Sec. 170(e)(1)(B).
[xxix] IRC Sec. 170(f).
[xxx] IRC Sec. 170(o).