Over the summer, Pennsylvania and Washington quietly became the first US states to list NFTs as digital assets subject to sales and use taxes, opening the way for more states to follow suit. But as authorities attempt to issue uniform guidance on taxing NFTs, collectors, art institutions, and anyone who’s bought, sold or issued NFTs are finding themselves caught in a regulatory quagmire.
That’s because taxing NFTs, unlike cryptocurrencies, is much less straightforward, with the issues of transfer of rights, identity, and location central to the regulations.
For art institutions and museums dipping into the world of NFTs, law experts caution that the rules that apply to individuals are applicable to them as well, with some potential caveats. “Some states do afford sales and use tax exemptions for certain organizations. For instance, Pennsylvania allows nonprofits to obtain a sales tax exemption,” says Jeff Neumeister, partner at accounting firm Neumeister & Associates.
How NFTs differ from crypto, tax-wise
Max Dilendorf, a lawyer specializing in crypto at Dilendorf Law, says that NFTs, like crypto, are seen as property by the Internal Revenue Service, and thus subject to the tax principles applicable to property transactions.
But the similarities stop there.
As NFTs are non-fungible items, just like unique works of art, they could be treated as “collectibles” for tax purposes, according to guidance issued by law firm O’Melveny. This means sellers could face a tax rate of 31.8 percent, up from the ordinary capital gains tax of 23.8 percent.
Of course, NFTs can be more than just collectibles. For example, the Associated Press released NFTs of rich metadata from its photo archive, but those NFTs don’t confer any additional rights to the underlying photographs, instead representing intangible assets separate from the NFTs themselves. This is an important distinction. In AP’s case, O’Malveny says the NFTs are likely to be treated as copyrighted material similar to physical copies of software, which would make them separate assets for tax purposes.
However, if a copyright owner decided to transfer IP rights via an NFT, it is likely that such a transaction would be subject to the current tax rules on copyright transfers, the firm said.
Identifying the buyer
Washington’s guidance makes clear that NFT sellers will be expected to keep a record of the time and location of each transaction, including buyer addresses. “It is possible that marketplaces such as OpenSea will start implementing sales tax charges on transactions in certain states,” says Andrew Gordon, president and tax attorney at Gordon Law Group.
But that might prove tricky to implement in practice. At the moment, few, if any, marketplaces collect this data from buyers — largely because transactions are executed with cryptocurrency, which allows for anonymity.
Some law experts think that the trail blazed by Washington state might push other states to reduce the degree of anonymity afforded to NFT sales. However, NFT marketplaces are likely to resist this push for transparency. This is because anonymity is one of the central tenets of Web3, and a key selling point for many platforms that promise a decentralized market.
Locating the sale
Unlike the clear law surrounding e-commerce taxation across state borders, individual states are all taking different approaches when it comes to NFT taxation, making interstate transactions a maze to navigate. Currently, Washington and Pennsylvania are the only ones to have issued clear guidance on NFT taxation. Others, like Illinois and New York, have recently published guidance that suggests NFTs could be treated and taxed as digital assets, like cryptocurrencies.
Other states are more narrow in their regulation. New Jersey’s recent guidance says that the state won’t tax virtual currencies purchased for investment, while Arizona lets buyers deduct gas fees from their income and only taxes airdropped NFTs if they are resold.
“Until there is clear guidance disseminated by all states, this will remain a nebulous territory. If all NFT activity is limited to just the state they reside in and said state does not have sales and use taxes for NFTs, they shouldn’t have this additional compliance to contend with, yet,” says Neumeister.
The future of NFTs and taxes
The taxability of NFTs might eventually come down to whether their purchase confers any rights to a buyer. Should those rights amount to the transfer of ownership, custody, or possession, then they would likely make the NFT fall under the definition of the sale of a taxable item.
For now, law experts agree on one thing: this is just the beginning of regulation targeted at NFTs. “Traders, miners, art collectors, art institutions, and anyone else delving into the digital asset space should continue to confer with CPAs that specialize in these matters,” Neumeister emphasizes.