NFTs: The Basics And How To Tax Them

Robert Goulder and Roxanne Bland of Tax Notes discuss non-fungible tokens, their ownership rights, and how the IRS plans to tax them.

This transcript has been edited for length and clarity.

Robert Goulder: Hello everyone. I'm Bob Goulder, a contributing editor with Tax Notes. Welcome to the latest edition of In the Pages.

Our featured article for June was written by Roxanne Bland, a contributing editor with Tax Notes, who specializes in state and local issues.

Her article addresses NFTs, which of course stands for non-fungible tokens. There are people making fortunes buying and selling these things. Although to be perfectly honest, I still struggle to appreciate the value proposition behind them. But hey, that's just me. Pay no attention to my personal skepticism.

The fact is that in a short amount of time, NFTs have gone from the obscure backwaters of the global investment community to becoming relatively mainstream, so much so that tax authorities need to figure out what to do with them. And Roxanne's article is an excellent starting point.

That article is titled “New Taxable Kid on the Block: NFTs,” and we're delighted to have the author join us.

Roxanne, welcome to In the Pages.

Roxanne Bland: Thank you Bob. It's a pleasure to be here.

Robert Goulder: So for the benefit of any viewers who might not be familiar with NFTs, could you tell us what they are?

Roxanne Bland: Well, as you mentioned, NFTs are non-fungible, which means they are not interchangeable. A real world example of a non-fungible asset would be your house, your car, your furniture, something like that.

What makes an NFT non-fungible? I'm going to use ethereum as an example, because I think that's the biggest platform for minting NFTs.

Each NFT is unique because it has an identifier that is linked to one ethereum address, which no other token can replicate. So an NFT can only have one owner and that uniqueness serves an important function because it is proof of ownership.

Now, there's a whole list of things that proof of ownership means, but it's really just your private key. That's what most people will understand.

Just like with crypto, you have a private key to your wallet in order to access your crypto. It's the same thing with NFTs.

What can an NFT be? Well, it could be anything that can be represented in the digital world. For example, art, music, videos, or collectables like baseball cards. Cars or real-world items like the deed to your house can be an NFT. Your car registration, or other legal documents.

The importance of having a real-world item like that on an NFT is because it can't be counterfeit or tampered with. Like I said, it's the owner's private key that proves that is the proof of ownership.

Robert Goulder: Your article mentions that smart contracts are involved. Can you explain?

Roxanne Bland: Sure. A smart contract is really just a software app. And what it does, when you mint an NFT it generates a code that underlies it. That code is created whenever an NFT is minted. What a smart contract does is it verifies ownership and handles the transferability of the NFT.

Now, smart contracts can do all kinds of things, but that's basically what it does. It can do things like handle royalty payments, which otherwise you would have to have a person to do. It can just do that automatically. Other payments too.

Say that I bought X, and once the app decides that all of the contract terms have been fulfilled, it executes itself, done deal.

That is its real advantage over a paper contract. Again, it can't be counterfeited, can't be tampered with or anything like that. So the people who enter into the contract are safe in the knowledge that this contract is what it says.

Robert Goulder: You compare NFTs to the bundle of ownership rights that a person acquires when they go to an art gallery and buy a work of art. You get the item itself, you don't necessarily get the intellectual property behind it.

How does that play out with NFTs? You have the token, but not necessarily anything more?

Roxanne Bland: Actually, it's the same way. It's the same thing.

Let's just say that you buy a token. You have the right to display it, but you can't make any derivative works from it. You can't license it to anybody else. So it's just like buying a painting from an art gallery.

Now the NFT seller could give you licensing rights, allowing you to reproduce and sell these things for yourself, as long as you own the NFT and as long as you're doing it for yourself. And usually those contracts come with a stipulation that you can't make more than X dollars a year off of what you're doing.

But it also doesn't give you the kind of commercial license. Like you can't license the piece to a third party, like a movie theater or something like that. But otherwise it's pretty much like buying a real world art.

Robert Goulder: There are all sorts of tax implications here. As far as I know, the government hasn’t issued any tax guidance specific to NFTs.

But your article does mention an IRS notice that's already several years old now, but it relates to cryptocurrency, right?

Roxanne Bland: Correct. As you say, the IRS has issued nothing on point, but I think considering what they have done with crypto, saying that it is property for tax purposes, I think it's almost a foregone conclusion that the IRS would do the same with NFTs.

NFTs are even more property-like than crypto.

I say almost a foregone conclusion because it's my personal policy not to say anything definitive, because that way, if I don't, then I'm never wrong.

Robert Goulder: Assuming that NFTs are going to be treated as property for tax purposes, how are the states going to deal with that? Aren't there implications as to retail sales taxes?

Roxanne Bland: Yes, very much so. I want to add that the states have issued, as far as I know, no guidance on how to treat NFTs. But, if a state has a statute on the books that deals with digital products, it is no brainer to put an NFT into that statute. It will be subject to sales tax and the tax will be collected just like any other tax, the seller will collect and remit to the state. Now that's interesting.

We're going to just concentrate on intrastate right now. If the state doesn't have as broad a statute, then they may have to enact a statutory change. But I can't imagine that that would be all that difficult, to make NFTs taxable, specifically taxable in a state.

Robert Goulder: Of the 50 states, what are there . . . 46 sales tax jurisdictions?

Roxanne Bland: I think it's 45 states, not counting the District of Columbia.

Robert Goulder: They already have a sales tax system on the books, and we're thinking they probably don't need to enact any statutory amendment. They can just fit NFTs into the preexisting definition of property.

Now, some of these NFTs go for a lot of money. It makes your jaw drop what these things are being bought and sold for. Are the sellers actually collecting and remitting? Because that's a lot of tax.

Roxanne Bland: Well, that's a really good question. Are we still talking about intrastate sales?

Robert Goulder: Yeah. Just intrastate.

Roxanne Bland: Well then if they are selling NFTs, even for exorbitant sums of money, then yes they should be collecting sales tax.

Robert Goulder: What about the concept of a taxable event? You explain this nicely in the article, some NFTs are structured so that there's a redemption that occurs subsequent to the acquisition.

Is there a possibility that maybe the sale of an NFT isn't the taxable event, instead it's this subsequent triggering event or redemption?

Roxanne Bland: Well, a sale is always a sale. If an NFT dealer sells something, the NFT dealer should collect a tax at the time of the sale. And the redemption doesn't really matter. That's just, that's secondary. The redemption is the actual transfer of ownership in the real world.

Now, something else I tried to explain in the article is that it might be easier in some cases to collect the tax on redemption, because there are people who are not going to redeem whatever it is they bought.

But if, again, if they're in a sales tax state and they purchased the NFT, and the state sales tax statute applies to NFTs, then it doesn't matter if they redeem or not. They're going to pay sales tax.

Robert Goulder: We've discussed the intrastate scenario. Let's shift gears here and look at interstate transactions. If you're in California and I'm in New York, and you're selling me an NFT, what then, especially in the aftermath of Wayfair?

Roxanne Bland: Well, that's a really interesting question. I think every sales-tax-state has enacted a South Dakota-like statute. And if you have a big dealer that meets the monetary threshold as well as the transactional threshold, then they're going to collect and remit.

Smaller dealers, well, you would think that they would fall under the threshold, and they would, except that Wayfair is kind of strange in that it leaves a lot of unanswered questions. The Court talked in terms of, you need to have an economic presence as well as a virtual presence.

But what if you don't? What if that big company has an economic presence because they made X dollars of sales, but they don't advertise or they're not really on the net, or something like that.

Well, if they don't have a virtual presence, how does that work? Is the state's nexus statute still valid?

That's a case that's currently in the petition stage at the U.S. Supreme Court. What exactly does economic presence and virtual presence mean? Do you need to have both, or is one enough?

And the reason, I think, the reason why it's kind of wishy-washy is because in Wayfair, the Court was dealing with three huge retailers that certainly had the economic and the virtual presence in every state. So there was really no need for it to go beyond that. We wish it had, but it didn't.

So these are more questions that are going to have to be litigated. And this one case, it is the first case that I know of that has made it to the U.S. Supreme Court. I do hope they take it because there are, I think, some clarifications they need to make with respect to Wayfair.

Robert Goulder: Your article compares the situation we have today, regarding NFTs, to the situation we had a few years ago with our old friend voice-over-internet-protocol (VoIP). Remember VoIP, which was fascinating because there's authorization to tax phone lines and then they’re trying to tax a phone call that's made over the internet, which is technically not a phone line.

Could you elaborate on the VoIP comparison and how it might influence our thinking about the taxation of NFTs?

Roxanne Bland: Well, until VoIP came along, everything went over wires. And I think what the states did was, they thought, "Well, this is a telephone call. I mean, it has the same function as a telephone call that works with wires." So, it really wasn't unreasonable for the state to say, "This serves the same function, so we're going to tax it like a wired telephone call."

And I don't recall if there was any real pushback from the VoIP providers over that, because it's the functional equivalent and it's hard to argue with that.

Robert Goulder: Now let's talk about capital gains. We mentioned consumption taxes before, but this would be an income tax question. You buy low, you sell high. You make some money on the exchange.

What are the implications for federal and state tax authorities? Are NFTs capital assets?

Roxanne Bland: It could be. It depends on what you do with it. It's the intent behind the purchase. Are you just buying it to put on your virtual wall, or are you actually buying it to serve a purpose in your business or whatever? Or if it's personal, are you treating it as an investment?

I think these are certainly questions that are going to arise, but I think first we have to figure out if it's property. We need to get that on the books and then we can go forward. Like with crypto. OK, it's property.

Well, it's conceivable that NFTs are going to be treated the same way, but we don't know. So, until there's guidance out there, people are just kind of doing what they're doing.

Robert Goulder: Well, that's interesting because if I go and I buy a share of stock in General Electric, my broker is going to know the date that I acquired it, the price I paid, and that matters in terms of your cost basis.

Roxanne Bland: Well, the other thing about buying and selling NFTs, for whatever purpose, you mentioned the basis. What's your basis in the NFT? That's going to be recorded on the blockchain. All of that information is going to be there, and it's all going to be transparent. Meaning that anybody can go look at it. You're going to have your basis, no matter what.

Then you sell it for more than what you paid, you get a gain. And if you sell for less, you get a loss. Assuming that NFTs are going to be treated as property, then it would be no different than the way the IRS treats crypto.

Robert Goulder: Well, there you have it. The lay of the land in terms of state and federal taxation of non-fungible tokens. Again, the author is Roxanne Bland, and the article is called “New Taxable Kid on the Block: NFTs.” You can find it in the state edition of Tax Notes.

Roxanne, thank you for coming on our program.

Roxanne Bland: Thank you for asking me, Bob. I appreciate it.