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The State of NFTs: Navigating the Taxation of Digital Assets

Posted on Dec. 7, 2022

As states begin releasing tax guidance on sales of non-fungible tokens (NFTs), questions persist on how the digital assets will be sourced and taxed for state and local tax purposes.

A handful of states and the IRS have begun releasing interim guidance on the tax treatment of digital assets, an umbrella term created by the IRS to include cryptocurrency and NFTs.

Meanwhile, state lawmakers, revenue department heads, and practitioners are working to provide taxpayers with specifics on how to report the currency on their tax returns, under what tax category they fall, and how states themselves would source the sales. Such specificity is particularly important since NFTs have exploded in popularity in recent years: According to CNBC, more than 2.5 million crypto wallets traded or held NFTs in 2021, up from 89,000 in 2020.

That said, NFTs have also experienced stark fluctuations in the stock market, raising the question whether the tax revenue that NFTs could generate would justify the process by state revenue departments and lawmakers to establish rules and laws around a rapidly changing asset. Reuters reported October 3 that sales of NFTs fell to $3.4 billion in the third quarter, down from $8.4 billion in the second quarter.

Matt Graham, tax senior manager with Moss Adams LLP, described “the perfect storm” that NFTs navigate when seeking to comply with state sourcing and tax laws.

Graham said that while attending the American Institute of CPAs Blockchain Symposium in June, he heard the NFT state sales tax situation described as “the elephant in the room” for which “no one seems to have a solution.”

What makes sourcing taxes difficult for NFT sellers, Graham said, is that there’s almost no way to know where a buyer or seller is located based on the digital interfaces used for the transactions. While somewhat dubious forms of identifying location exist, such as relying on someone’s IP address, which could be inaccurate if a buyer or seller uses a virtual private network, Graham said sellers are reluctant to require customer information. Buyers who are not willing to provide identifying information could move on to other NFT sellers, he said.

“It’s a tough spot that a lot of NFT marketplaces are in,” Graham said. “How do you comply with sales tax if you don’t know where your buyer is?”

Graham also said that while some sellers or buyers might be taking advantage of states’ lack of NFT guidance, they likely represent a low minority. “There are more good actors than bad actors,” he added.

Regarding the future of NFTs, Graham said he imagines that the bubble propelling their high sales has already burst. But that doesn’t mean NFTs or cryptocurrencies are going away, he added.

Likening the process to the dot-com bust, Graham pointed out that rather than disappearing, the internet evolved into a more structured entity, and he anticipates digital assets will undergo a similar process.

How Do States Tax NFTs?

Three state revenue departments this year have begun developing guidance on NFTs, addressing the categories they fall under and how to report NFT sales on personal or business income tax returns.

In August the Minnesota Department of Revenue updated a sales tax fact sheet on digital products to note that NFTs are subject to sales and use tax if the underlying goods or services are taxable in the state.

For example, NFTs are taxable when associated with tangible personal property such as memorabilia; admissions to concerts or sporting events; prepared foods and beverages; and digital products that include video games, music, and audiovisual works, according to the fact sheet.

The Washington DOR on July 1 issued preliminary guidance on the state tax treatment of NFTs, which depends on the nature of the sale and associated products. For example, NFTs that represent products such as digital artwork or videos are subject to sales and use tax because the state taxes digital products. The NFTs would also be subject to the state’s business and occupation tax. The guidance also addresses sourcing and nexus issues, detailing a statutory five-point hierarchy that describes how retail sales of tangible personal property — including digital goods — are sourced.

In June the Pennsylvania DOR included NFTs in its periodically updated list of items that are subject to sales and use taxation. The tax “applies to any transfer of a digital product where the purchaser pays a consideration, unless that transfer is otherwise exempt,” according to the list.

On the legislative level, Arizona enacted a law in July (H.B. 2204) creating an income tax subtraction for virtual currency and NFTs that are airdropped to taxpayers. The bill defines airdropping as a mass distribution of virtual currency into the ledgers of multiple taxpayers. H.B. 2204 was sponsored by Rep. Jeff Weninger (R), who chairs the House’s Commerce Committee and is vice chair of the Technology Committee.

Weninger told Tax Notes November 14 that the legislation is intended to treat virtual currency in the same way as stocks, which wouldn’t be subject to tax when they are initially gifted. Noting that NFTs and cryptocurrency are still relatively new subjects among lawmakers, he said his goal in introducing the bill was “educating the elected officials, lobbyists, and populace, while doing good legislation at the same time.” He added that while agencies like the IRS have addressed cryptocurrency, he believes elected officials need to enact policy on digital assets and how they would be treated.

“There’s a need for Congress to step in,” Weninger said, adding that federal lawmakers like House Ways and Means Committee member David Schweikert, R-Ariz., who also serves on the Congressional Blockchain Caucus, have demonstrated knowledge on digital assets.

However, Weninger anticipated that upcoming federal regs on digital assets could be more stringent, potentially hampering a growing technology.

Weninger said he also hopes states will pass legislation on crypto and NFTs and said that although his term ends in January 2023, he will be available to provide guidance if lawmakers are interested in introducing such legislation.

Weninger said he hopes for regs that make sense, that aren’t overly stringent on digital assets, and that are approved sooner rather than later. “You don’t want innovation like that held back because of legislators” who are unwilling to learn or embrace new technology, he added.

“I think it’s going to be the future, and people are realizing this,” Weninger said.

State Guidance

In the handful of states beginning to address NFT taxation, DOR officials acknowledge that there’s more work to be done and said they are continuing to develop more comprehensive and detailed regulations.

Washington DOR Tax Policy Specialist Nikki Bizzarri and Interpretation and Technical Advice Assistant Director Timothy Jennrich spoke with Tax Notes, describing their experiences with drafting the department's initial guidance and gathering feedback during an October 20 listening session on NFTs.

Bizzarri said that when the department released initial guidance on cryptocurrency in August 2019 and solicited questions from taxpayers, NFT taxation was becoming a more frequent question among taxpayers. “It became pretty clear” guidance was needed, she said.

Jennrich paralleled the process with the state’s development of cryptocurrency guidance, which similarly became necessary as the DOR received more and more questions about its tax treatment.

Bizzarri said that 89 people attended the DOR’s October 20 listening session. “There were a lot of questions around resell eligibility and sourcing," she said. The session allowed for tax practitioners to broach questions and make suggestions that could be implemented in further guidance, according to Bizzarri and Jennrich.

“We are lucky we have those relationships with these practitioners,” Bizzarri said. “It’s part of why the listening session was so successful.”

In response to a question on whether the DOR would tax NFTs retroactively, Jennrich noted that 2009 legislation subjecting digital products to state taxes isn’t retroactive. However, he said there is a question of how the law applies to NFTs that were sold before the DOR's July 1 initial guidance.

Jennrich said the DOR is accepting comments and feedback from stakeholders and the public and will consider that feedback when developing final guidance on NFTs. Bizzarri added that the DOR is reviewing public comments, including those from the listening session, and will continue to accept comments until December 30.

Bizzarri said that the DOR could release an excise tax advisory — a statement explaining the department’s policy on tax items — on NFTs in the spring. “This isn’t the last guidance we’re going to put out,” she said. “This technology will keep changing, and our updates will reflect that.”

Jeffrey Johnson, communications director with the Pennsylvania DOR, told Tax Notes that the department had "received a number of questions about NFTs, so this addition was timely,” referring to the department's update to the list of taxable and exempt property to include NFTs. State law requires the DOR to update the list every three years.

Notably, officials with both Pennsylvania and Washington said that they couldn’t reliably measure or predict how much revenue NFT taxation could bring to the states.

“We are not planning any retroactive enforcement with regard to taxes owed on NFT sales that occurred prior to the May 2022 issuance of the updated guidance,” Johnson said. “Considering this fact, we do not anticipate that tax revenue stemming from these sales will have a major effect on overall revenue collections in Pennsylvania.”

Johnson added that the DOR is starting an outreach and education program to raise taxpayer awareness of NFT taxation. “We anticipate a dialogue with tax professionals that will result in more definitive guidance on this subject," he said.

Practitioners React

In March Jeff Cook, Madeleine Smith, and Harley T. Duncan of KPMG LLP wrote an analysis on the tax treatment of NFTs, discussing what that guidance should cover, including how assets exchanged as NFTs would be classified, how the state would source sales for tax purposes, and tax responsibilities for NFT exchanges through marketplaces.

Cook, Smith, and Sarah McGahan, state and local tax manager at KPMG, spoke with Tax Notes November 1, describing their responses to recent state guidance and whether it addresses the questions they posed in the analysis.

McGahan said that in her opinion, the Washington DOR’s initial guidance was the most comprehensive, noting that the state is the only one to have addressed sourcing issues related to NFT sales.

Cook said he thinks more states will follow suit, publishing more in-depth information like Washington did. Noting that "some guidance is better than no guidance," he said the initial information from Minnesota, Wisconsin, and Pennsylvania is helpful.

McGahan agreed, adding that the states’ information is “giving taxpayers awareness that they tax digital assets and NFTs.”

McGahan noted that just because states have been silent on the taxation of NFTs doesn’t mean they aren't subject to tax. She encouraged taxpayers and practitioners to be proactive in learning a state’s rules to ensure they won't be penalized for failing to report a potentially taxable item.

“States generally do tax digital products,” Cook added, mentioning examples like digital music or video sales.

McGahan said she doesn’t think federal guidance on NFT sales would prioritize sales tax treatment because there’s no federal sales tax. However, federal guidance would allow some states to conform to the federal tax treatment, something that Cook speculated that some states may be waiting for. “They don’t want to get ahead of the federal government," Cook said.

Other state tax practitioners are following NFT developments closely, according to Cook. “This will all be very closely watched, we can assure you," he said.

Cryptocurrency and State Tax

The digital asset marketplace can be a turbulent one. Take the recent bankruptcy of crypto exchange company FTX, which had a published valuation at $32 billion in January and experienced more than $6 billion in withdrawals in early November, according to Reuters. Earlier this year, TerraUSD — a so-called stablecoin — collapsed, along with its associated token LUNA.

This turbulence could pose risks for federal, state, and local government entities, the Financial Stability Oversight Council from Treasury said in an October 3 report.

According to the council, accepting cryptocurrency payments could result in “financial risk to these municipalities who would need to convert these assets to dollars to make payments on obligations, which may include debt obligations held by traditional financial institutions.”

In September Colorado became the first state to accept tax payments via cryptocurrency.

Colorado DOR spokesman Daniel Carr told Tax Notes October 31 that the DOR has received three cryptocurrency payments so far. In response to a question on how the DOR would address fluctuating cryptocurrency values when converting the crytpo to U.S. dollars and whether that poses any risk to the state’s tax collection, Carr said, “There is no risk to the state, as we use the PayPal cryptocurrency hub as our vendor to process any such payments, and they adjust for the value of the currency in real time and assume any risk involved.”

Notably, a crypto-related bill (S.B. 25) signed into law June 7 in Colorado directs the state treasurer to examine the feasibility of using security token offerings through a blockchain system to provide an additional capital financing vehicle.

Federal Guidance

At the federal level, a draft version of Form 1040, "U.S. Individual Income Tax Return,” for tax year 2022 asks taxpayers, "At any time during 2022, did you (a) receive (as a reward, award, or compensation); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?” According to a September analysis by Garrett L. Brodeur, an associate at Kostelanetz & Fink LLP, "The change is likely intended to encompass various innovations, such as non-fungible tokens (NFTs) and synthetic assets that do not fall neatly within the IRS’s traditional definition of virtual currency."

The term digital asset was added to the IRC under the Infrastructure Investment and Jobs Act (P.L. 117-58). The act also amended the IRC’s definition of the term "broker" to include anyone providing "any service effectuating transfers of digital assets on behalf of another."

And U.S. Senate Finance Committee Chair Ron Wyden, D-Ore., recently urged Treasury and the IRS to fund greater enforcement measures for cryptocurrency-based tax evasion.

Tracking Digital Asset Taxation

As NFTs and cryptocurrency continue to evolve, and as states create their own tax guidance on digital assets, tax organizations like the Multistate Tax Commission are working to outline considerations that states studying digital asset taxation could implement.

The MTC's work group on sales taxation of digital products, which held its most recent meeting October 27, is developing an outline of a white paper that provides definitions and information for state officials who may be considering imposing sales tax on digital products, according to Uniformity Counsel Helen Hecht.

“We’re still making sure that we have captured the issues that folks think are important,” Hecht told Tax Notes October 28. “Then we will begin to work on developing those issues through research and analysis.”

The work group includes leadership from the Streamlined Sales Tax Governing Board, which has developed its own work group on digital goods. MTC officials have addressed concerns on potential overlap, noting that both organizations have been in close communication.

Hecht added that the work group asked the MTC to focus on describing and categorizing different kinds of digital products, and while NFTs have been included in the outline, “we haven’t gotten much input from the work group that they want us to prioritize addressing that issue.”

Subject Areas / Tax Topics
Magazine Citation
Tax Notes State, Dec. 12, 2022, p. 1011
106 Tax Notes State 1011 (Dec. 12, 2022)
Institutional Authors
Tax Analysts
Tax Analysts Document Number
DOC 2022-38520
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