July 25, 2022 – The “Salvator Mundi” by Leonard da Vinci, a painting that was created more than 600 years ago by one of the most famous artists of all time, sold for $450 million in 2016. The prices obtained for classics and the endless desire to possess them have created a very lucrative marketplace for a limited number of artworks.
But during the past few years, artworks linked to blockchain technology, particularly Non-Fungible Tokens (NFTs), have completely upended valuations and demand and created a level of volatility never seen before by art collectors. For example, “The Merge,” by digital artist Pak, sold for $91.8 million in December of 2021. But, at the time of this writing, NFTs have seen their values plummet, wrecking their valuations.
This article explores issues relating to charitable contributions of NFTs and includes a brief primer on charitable deductions.
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Charitable deduction limitations
In general, individual taxpayers can claim charitable deductions of up to 60% of their adjusted gross income (AGI) for cash donations to public charities. Cash gifts made to private foundations are limited to 30% of AGI for cash gifts or 20% for appreciated securities. Unused charitable deductions can generally be carried forward for five years.
Generally, for gifts of non-cash property (e.g., artwork), the donor may deduct up to 30% of the asset’s fair market value provided that such property is related to the charity’s exempt purpose. This is often known as the “related use requirement.” For example, donation of artwork displayed at an art museum would satisfy this requirement. However, if a donor gives artwork to a charity whose mission is to reduce child poverty, the donor may only deduct the lesser of cost basis or 30% of the asset’s fair market value. Notwithstanding these limitations, contributions of non-cash items to charity avoid capital gains tax and potentially reduce the gift and estate tax liability.
Non-cash contributions must satisfy certain substantiation requirements to secure a charitable deduction.
In the case of artwork worth $5,000 or more, the following requirements should be met:
•A contemporaneous written acknowledgment from the charity;
•A “qualified appraisal” of the donated property; and
•A completed IRS Form 8283 attached to the tax return.
A donor must file Form 8283 with the donor’s tax return for the year the donor contributes the property and first claim a deduction and any carryover year described in section 170(d) of the Internal Revenue Code of 1986, as amended.
A qualified appraisal must follow the Uniform Standards of Professional Appraisal Practice, as developed by the Appraisal Standards Board of the Appraisal Foundation, and include, without limitation, the information described in Treasury Regulation Section 1.170A-17(a)(3):
•a description in sufficient detail under the circumstances, taking into account the value of the property, for a person who is not generally familiar with the type of property to ascertain that the appraised property is the contributed property;
•the condition of the property;
•the valuation effective date;
•the property’s fair market value; and
•information regarding the appraiser, including the appraiser’s (i) name, address, and taxpayer identification number, and (ii) qualifications to value the type of property being valued, including the appraiser’s education and experience.
In determining fair market value, the appraisal must show the valuation method used to determine the fair market value (e.g., the income approach, market-data approach, or the replacement-cost-less-depreciation approach), and the specific basis for the valuation (e.g., specific comparable sales transactions or statistical sampling).
The qualified appraisal’s appraisal report date must be no earlier than 60 days before the charitable contribution date, and no later than the return due date (including extensions) on which the deduction is first claimed by the donor.
Not just any appraiser can be retained to perform an appraisal. A qualified appraiser should have earned an appraisal designation from a recognized organization, and meet certain education and experience requirements. This includes being certified for the property in question, with college or professional-level coursework relevant to the property being valued. The appraiser must work regularly and cannot have been prohibited from practicing before the IRS under section 330(c) of title 31 of the United States Code.
If a tax return that reports a contribution of artwork to charity gets selected for audit, the artwork may be subject to review by the Art Advisory Panel of the Internal Revenue Service (the IRS). Per the IRS website, “[a]ll taxpayer cases selected for examination that include an item of art with a claimed value of $50,000 or more must be referred to Art Appraisal Services for possible review by the Commissioner’s Art Advisory Panel.” Since the panel meets only twice a year, the audit process can be delayed if reviewed by the panel.
An NFT is a digital asset backed by blockchain technology, typically representing a file containing a visual image, but also could be an audio file or a moving image. Some NFTs are designed to be static while others are dynamic, allowing them to be updated from time to time with new features, colors, etc.
Art collectors purchasing NFTs do not receive any physical property (and often not even the copyrights) to the works purchased, but only a digital receipt linked to the work: a token. The token is registered to the owner on the applicable blockchain platform.
Unlike owners of traditional forms of artwork, NFTs do not require any storage space, maintenance, or restoration costs. More importantly, the ability to establish the provenance of an NFT is protected through blockchain technology, which serves as a living ledger that is immutable and forever tracks ownership.
The IRS currently treats NFTs and all digital currencies, such as bitcoin, as property or commodities, not as currency, but Congress and other authorities have considered whether they should be regulated and classified differently.
If NFTs are ultimately classified as non-cash contributions, then the donation of NFTs will need to consider the substantiation requirements applicable to non-cash contributions, which may prove problematic as follows:
•Lack of qualified appraisers. The art world is filled with professionals who have extensive training in traditional forms of art, where decades of sales data under different economic conditions are available to the appraisers, most of whom satisfy the IRS requirements for a qualified appraiser. The same cannot be said for appraisers of NFTs. Since the technology and marketplace for NFTs are so new, it will likely be difficult to identify an individual who would meet the minimum requirements to serve as an expert and provide a qualified appraisal acceptable to the IRS.
•Inaccurate valuations. The combination of a lack of market data and extreme volatility will produce valuations that may be unreliable and easier for the IRS to challenge. The IRS has the benefit of a longer time frame to review past data to test the accuracy of prior appraisals. Audits can be an expensive, time-consuming process, and gross misstatements of value may result in interest and late payment penalties.
•Transferring ownership. Donors should also be increasingly careful about the process of transfer of any NFT to charity. Donors must ensure that the recipient has an established process for accepting and managing digital assets, as the transfer of NFTs is irreversible. If the receiving organization does not properly accept ownership of the NFT, the IRS could argue that the transfer was incomplete and deny the charitable deduction. While uncommon, it is also important to determine if the donor owns the copyright to the NFT, which if attached, should be considered when assigning ownership.
•Satisfying the related use requirement. It is anticipated that as NFTs grow in popularity, art museums will accept and display NFTs, thereby satisfying the related use requirements described above and yielding higher charitable deductions. However, with little guidance on this topic, it is still too early to confirm whether donating to art institutions will meet the related use exception. It is worth nothing that some museums have started minting their own NFTs for works they own the copyright to or for which the copyrights have long expired, so there is certainly a developing institutional awareness. Until the donation of NFTs becomes a more widely accepted practice, it is imperative that a donor reach out to each potential donee museum and determine whether the gifted NFTs will be accepted and displayed.
For now, most NFT owners are simplifying the donation process and minimizing the issues raised above by selling their NFTs on auction sites and then donating the proceeds to charity. This simplified approach might be the preferred path for now until the IRS and other regulatory agencies provide better clarity in this space. However, this approach does come with a cost as a sale may result in capital gains tax, which would be avoided if the NFT were donated directly to charity.
Blockchain technology has created a new property class for charitable donations. While their value is uncertain and charitable institutions are slowly adopting them, practitioners and philanthropists should be prepared to adapt to the ever-changing reporting requirements of NFT donations.
Eric N. Mann is a regular contributing columnist on trusts and estates law for Reuters Legal News and Westlaw Today.
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Opinions expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence, and freedom from bias. Westlaw Today is owned by Thomson Reuters and operates independently of Reuters News.