How do you tax NFTs? States are in a quandary.

• But the fact that NFTs can take many forms — physical and digital — and be sold in nontraditional ways place them outside the scope of current tax codes.
• So states are losing out: "At least 31 states apply sales taxes to digital products and services, but few if any tax dollars are flowing to them from the hottest commodity in the digital economy," NFTs, reports Bloomberg Tax.

Driving the news: Washington state and Puerto Rico are poised to become the first two jurisdictions to issue guidance on how NFTs should be taxed.

• Both take the position that NFTs are subject to sales taxes, despite the sometimes nebulous nature of a token's underlying product.
• Other jurisdictions are likely to eye the rules they lay down for guidance.
• “Puerto Rico’s regulation gives me hope that even states with a really broad definition of digital goods will acknowledge that NFTs may not fit squarely into the existing rules,” Grace Kyne, a senior tax manager in the Boston office of EY LLP, tells Bloomberg Tax.

Where it stands: The IRS hasn't addressed the taxation of NFTs in any of its guidance on cryptocurrency (or elsewhere). This has left state tax officials — not to mention private accountants — at a loss.

• "The problem is, NFTs act like tax code shapeshifters," says Route Fifty, a news website that reports on state and local government issues. "Sometimes it’s tangible property, sometimes it’s a video, other times it’s admission to a private event. And sometimes it’s a combination of things."
• A spokeswoman for Washington state’s Department of Revenue told Route Fifty that its advisory on NFTs "will address sales and use tax and business and occupation taxes, and that it may later address capital gains taxes."

Between the lines: NFTs confound the tax code for many reasons, including the fact that they're based on a system (the blockchain) where transactions are anonymous or pseudonymous.

• Plus: The tax code relies on the knowledge of people's physical location — but parties to an NFT sale don't necessarily exchange that information.

There's also the complicated question of the nature of an NFT, which can be both an entry on a blockchain (intangible) and a work of art or other token (tangible).

• "Sales tax does not generally apply to the sale of intangible property, such as stocks or bonds, or to revenues received from royalties from intellectual property," according to an article in Tax Notes, a trade publication, by Jeff Cook, Madeleine Smith and Harley Duncan of KPMG.
• But "because NFTs represent ownership of another asset ... an NFT transaction would likely be considered by states to be the sale of the underlying asset," the KPMG authors conclude.
• "In other words, the taxability of the transaction would follow the underlying asset rather than the intangible token on the blockchain."

Bonus: There's also the thorny issue of what "owning" an NFT really means — since it doesn't include, for example, the copyright to a work of art.

What they're saying: “It would be very helpful for the IRS and state tax authorities to clarify how gains and sales of NFTs should be treated,” Lawrence Zlatkin, the vice president of tax at the crypto exchange Coinbase, tells Politico.

The bottom line: By the time the tax authorities figure out how to regulate it, the entire NFT market may already be in a state of collapse.