The mixed characteristics of non-fungible tokens (NFTs) have made them a tricky subject for state taxation. This fact, coupled with the lack of guidance from state tax administrators, leaves NFT sellers, purchasers, and their tax advisors on their own to guess at how to report the purchase and sale of NFTs. This article will cover the ambiguous tax treatment of transactions involving NFTs and how some states are currently approaching the issue.
What is an NFT?
NFTs are unique digital assets/files that are linked to a certificate of authenticity stored on a blockchain. These assets can take the form of artwork, music, tweets, domain names, club memberships, video game characters, virtual land, and more. Because the certificate of authenticity exists on a blockchain, it is possible to indisputably verify who owns the original of the digital asset, certify its uniqueness, and facilitate its exchange. Tokenized or anonymous identity makes markets more private and more secure, which could explain the reason behind their growing popularity.
NFTs began entering the mainstream in 2017 with the sale of images of digital punks or virtual cats that could be traded in an online game. The market for NFTs has since evolved and grown to an estimated $25 billion in sales by the end of 2021. Some analysts expect global sales of NFTs to reach $80 billion by 2025.
The Hurdles of NFT State Taxation
All states with sales taxes levy them on sales of tangible personal property. Many states also tax sales of certain services. However, the sale of intangibles, or non-physical property, have not historically been treated as taxable. As digital products, services, software, and now NFTs have become more popular, states have found creative ways to tax these electronic transactions which would be considered by most to be intangible in nature.
Given NFT’s intangible nature, the question has arisen as to whether their sale fits within a particular state’s taxable categories. However, because ownership of an NFT essentially represents virtual ownership of a digital asset, it is imperative to consider the nature of what the underlying asset represents when determining taxability of its exchange.
Some NFTs have connections to traditional tangible assets as well. Popular high-end brands like Burberry and Louis Vuitton have released clothing lines made for digital avatars and video game characters. NFTs are currently being used in the real estate industry to facilitate transactions through title validation, enable smart contracts for properties that automate the escrow and transfer of currency, and even create decentralized home rentals services that protect sensitive data like credit card details.
The variety of forms that an NFT can take makes identifying the nature of their exchange challenging. From a sales tax perspective, the absence of existing guidance from the states creates a considerable amount of ambiguity as it relates to their tax treatment.
Latest State Tax Developments
Although states have largely been silent regarding the taxation of NFTs, as of July 2022, there are two states that have released guidance regarding the taxation of NFT transactions.
Pennsylvania
The Pennsylvania Department of Revenue was the first to formally issue guidance regarding NFTs when it added them to the taxability matrix it publishes online. However, the state hasn’t issued guidance or provided a definition for NFTs other than specifying that the tokens are taxable.
Due to the complexities associated with the wide variety of both digital and non-digital assets that encompass NFTs, this state issued guidance is limited in its application to transactions involving their exchange.
Washington
On July 1st, 2022, the Washington Department of Revenue issued an interim statement regarding the taxability of NFTs. The statement includes legal definitions, as well as specific examples which, unlike Pennsylvania, provide more factually specific, and less ambiguous, guidance. Because Washington has enacted a comprehensive set of rules regarding the taxation of digital goods and services, the treatment of the sale of NFTs depends on whether the NFT is considered a digital good or contains some element of a taxable digital service (so-called “digital automated services” or “DAS”). The Washington Department of Revenue indicated it has plans to develop more permanent and comprehensive guidance in the future.
The interim statement details that the selling price of an NFT is measured by the amount of consideration received in exchange for it, and in cases where cryptocurrency is received as consideration, the value of the cryptocurrency will be determined in U.S. dollars at the time the sale occurred. Taxpayers will be responsible for retaining documentation that describes the nature and character of each sale.
More Taxation Hurdles
As previously mentioned, the broad definitions of “digital products” in several states arguably could encompass NFT transactions. However, it may also be necessary to investigate what the underlying asset(s) secured by the NFT is/are to determine whether their exchange is subject to sales tax. NFTs may include both tangible and intangible components, and since both state definitions and laws regarding the taxability differ, uncertainty is likely to abound in this new frontier.
Another issue arises around the privacy and anonymity that are coveted values of blockchain transactions. Blockchain transactions are indisputably verifiable, yet the parties involved in the transaction are typically unknown. However, for sales tax purposes, most states source transactions to the location where the product is delivered to or first accessed by the buyer. Sourcing determines the state or locality with jurisdiction to tax the transaction. The buyer’s location is therefore an essential piece of information for sourcing purposes.
Without the ability to determine the buyer’s location, it is not possible to source the transaction to a physical location. As a result, states may consider requiring NFT marketplaces to collect key information on the location of buyers based on their IP address. It’s unclear if this type of regulatory oversight would affect the popularity of the NFTs in the market.
Conclusion
The future popularity and taxability of NFTs is uncertain. Although their exchange has rapidly expanded over the past couple of bull-market years, whether their popularity will continue to expand is unclear given the numerous complexities and issues raised in this article.
One thing we can expect is that, if the potential tax revenue from their exchange continues to be material, then eventually the tax man will cometh. Before he comes knocking, make sure you’re prepared to answer by reaching out to a member of the Clark Nuber state and local tax team to discuss the taxation of your NFTs.
Cecilia Palli is a senior in Clark Nuber’s SALT Services Group.
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