Taxing Income In The Digital World

Although the metaverse as ultimately envisioned by its creators has not yet arrived, its development continues apace. Currently, there are several proprietary platforms that offer games, interactive business experiences, and interactive social experiences. For example, Barbados has been working with several metaverse platforms to declare digital real estate as sovereign land, the first sovereign in the world to do so. The island nation intends to build virtual embassies and consulates, develop services to provide e-visas, and construct a “teleporter” that will allow users to transport their avatars between the various worlds. These kinds of activities in the digital world are only expected to grow, and now is the time for all governments — state, federal, and foreign — to think about if and how such activities should be taxed, be they transaction taxes, income taxes, or any other type of tax.

The Nature of Work in the Metaverse

When it comes to income taxes, the first question that must be asked is what it means to work in the metaverse. For example, consider the digital equivalent of an analog real estate broker. She is hired to select digital land parcels her client may be interested in purchasing. Her client purchases a parcel and pays the broker her commission in cryptocurrency. Like her analog counterpart, the broker’s commission is income. In this case, the broker would report her commission as ordinary income on her federal and state tax returns, determined by the market value of the cryptocurrency on the day she is paid.

Yet payments to others can be made not just in cryptocurrency. Similar questions arise in the case of “play-to-earn” video games — that is, whether a gamer’s earnings count as wages. For example, Axie Infinity is a gaming universe where players purchase, breed, train, and battle non-fungible token critters called Axies. Axie Infinity contains several types of in-game currencies, one of which is “smooth love potion” (SLP), a token players earn for battle victories. Used to assist in breeding new Axies, the number of SLP tokens player earns varies with the strength of her gaming skills. SLP tokens can also be purchased and sold on the open market with either cryptocurrency or fiat money. Since the Axie in-game currency has real-world value, it stands to reason that tokens earned during gameplay should be reported and taxed as ordinary income, determined by the market value of the token on the day the player earned or claimed it. And, as has been well settled, if the gamer converts her SLP token into cryptocurrency or sells it in exchange for fiat money, it qualifies as capital gains income, subject to short- or long-term capital gains tax. The latter is also true for the Axie NFTs, which, like SLP tokens, can be converted to cryptocurrency or sold on the open market.

Thus, the issue whether cryptocurrency payments in exchange for services or the rental of a digital commodity constitute taxable income is settled. The question concerning whether payments consisting solely of NFTs, however, remains open. For example, what if the broker’s client paid her with a Bored Ape NFT? Some Bored Ape NFTs have been sold for millions in the marketplace, while others have been sold for substantially less. How would one go about valuing such an NFT for purposes of determining income?

Another example of income, although not “work” in the traditional sense, is the case of a person who rents digital land. Like the broker, how would the digital landlord determine her rental income for the lease period if paid with an NFT?

Could NFT Payments Be Considered Barter Transactions?

The IRS has issued guidance that cryptocurrency is property, yet it has not issued similar guidance for NFTs, although it is likely that NFTs also qualify as property. Regarding our broker, could the broker’s receipt of an NFT in exchange for her services count as barter? Yes, but only if the broker and her client agreed beforehand that the fair market value of the broker’s services and the FMV of the NFT are equal. This would also be true of the landlord and her renter — if the parties agree that the NFT’s FMV is equal to the FMV lease period, the exchange qualifies as barter, and in both cases, the broker and the landlord would report the value of the exchange as income. The problem, of course, lies in determining the FMV of the NFT.

In the broker’s case, if the FMV of the NFT is determined by comparing the prices of similar NFTs, it is possible that no barter could have occurred. People, businesses, and governments have paid hundreds of thousands of dollars or more for digital land, and it is almost a given that our broker’s commission is but a fraction of what the buyer paid for the digital asset. Of course, the opposite could also be true — the FMV of the NFT offered is less than the FMV of the broker’s services. Overall, in the case of a digital broker, it seems she would be better off to demand compensation either in cryptocurrency or in fiat money.

Sourcing Income From Transactions Involving Digital Land

Expanding on the landlord and renter example to include buyers and sellers of digital land, a knotty question arises regarding the source of the landlord’s and seller’s income arising from the transactions. In the analog world, such income is sourced to the jurisdictions where the real property is located. Of course, in the digital world, that doesn’t make sense. So where should the landlord’s and the seller’s income from their digital land holdings be sourced? One option is to source the income to the jurisdiction where the digital environment’s servers are located. A second option is to treat income from the digital land and the real property in the same manner — that is, to source the income to the jurisdiction where the landlord and seller physically reside. The second option carries greater logic than the first and remains so even if the digital environment is hosted in the cloud.

Similar questions arise when the digital land is purchased from or rented by the platforms themselves. Should the income be sourced to the jurisdiction where the platforms’ servers are located or where the platforms’ owners are physically located? Again, the second option carries greater logic. What if the platform owners are outside the United States? If the platform owner acts as a landlord, and is qualified to do business here, it will have a registered U.S. address, and the rental payments will be sourced to the state where the address is located. The same is true when the platform is acting as the seller of digital land — that is, the purchase price will be sourced accordingly. If neither the landlord nor the seller is doing business in the United States, the rental payments and the payment for the purchase should be sourced to the platform’s home jurisdiction.

Sales and Royalty Income From NFTs and NFT Donations

If a person is actively involved in creating and selling NFTs as a livelihood, there is no question that the proceeds from those sales constitute income. In this case, the NFTs would be considered inventory, and the creator would be subject to self-employment tax on his profits in addition to individual income tax. However, the IRS has not issued guidance on the tax treatment of royalty income from NFTs. In this case, if the person is actively involved in creating NFTs, his royalty income would more than likely be subject to self-employment taxes.

Donating or auctioning off NFTs for charitable purposes is not considered to be a taxable event if three criteria are met. First, the NFT donation is held for over a year; second, the NFT is donated to a section 501(c)(3) organization; and third, the NFT is donated directly to the organization. However, regarding auctions, if the creator auctions the NFT first and then donates the proceeds to the organization, he will incur capital gains income and be taxed accordingly, depending on the length of time the asset was held.

Conclusion

The digital world promises a plethora of new experiences and opportunities to generate income for individuals as well as business entities. However, determining how to tax that income will not necessarily be easy. In the United States, the IRS has issued little taxpayer guidance, meaning that tax professionals, other than what guidance the IRS has provided, have little to rely on other than their own knowledge and experience to fill the holes. Despite these shortcomings, the metaverse, even if it does not come to full realization, promises to be an interesting digital world, nonetheless.