Real money (and real tax consequences) in the virtual world — Wacky Tax Wednesday

Sales of digital land and digital art generate real money — and real tax consequences.

You may have seen the headlines. From the Wall Street Journal (WSJ): “NFTs Are Spurring a Digital Land Grab — in Videogame Worlds.” From the New York Times (NYT): “JPG File Sells for $69 Million, as ‘NFT Mania’ Gathers Pace.” And like me, you may find yourself wondering how we got to this point.

As first, gamers bought virtual weapons, tools, and other enhancements to up their game. A dollar here, a dollar there, the kind of money I could understand a person spending on a hobby (though altogether it amounts to billions, according to the WSJ). People spend a lot of money on boats, books, cars, music, and all sorts of sports, after all.

Once players got involved in building worlds, the scale of purchases grew. As the WSJ reports (and I admit to having no firsthand experience in this area), “players can buy digital deeds for real estate,” and “rent out their land to other gamers, charge others for using it or even sell it — either within the game or on a third-party exchange.”

As in my corner of the real world, virtual real estate can be surprisingly spendy. Earlier this year, a group of people purchased a virtual kingdom, the Citadel of the Stars, for $1.6 million. Mirandus, the game in which the kingdom exists, is still “in development.”

“Land” in other virtual worlds is going for astronomical prices, too. In March, the virtual reality The Sandbox valued its digital properties at roughly $37 million after two pieces of virtual property sold for about $2.8 million.

Real money may not change hands in virtual worlds, but cryptocurrency does. And cryptocurrency can be converted to cash.

I guess it’s a new twist on the old game of land speculation. Back in the day, people lured west by promises of open space and fertile land didn’t know what they were getting into either. Some ended up losing everything thanks to summer droughts and winter temperatures cold enough to freeze cattle. At least virtual worlds don’t come with those hazards, though spending hour after hour in a chair may involve other risks.

Gamers and “land” developers aren’t the only people being swept up in the virtual craze. Last spring, Christie’s sold the first “purely digital artwork (NFT)” for $69,346,250, the highest price paid for something of its kind. In another first, Christie’s said bidders could pay with the cryptocurrency Ether. A non-fungible token (the NFT from the headline) issued by the digital marketplace MakersPlace guarantees the authenticity of the piece.

All this is extremely interesting. But I of course want to know where tax fits in with virtual transactions.

The Internal Revenue Service explained “how existing general tax principles apply to transactions using virtual currency” back in 2014. According to Notice 2014-21, “the sale or exchange of convertible virtual currency, or the use of convertible virtual currency to pay for goods or services in a real-world economy transaction, has tax consequences that may result in a tax liability.” However, this may not be true for other types of virtual currencies (e.g., non-convertible).

The IRS treats virtual currency as property. As such, “general tax principles applicable to property transactions apply to transactions using virtual currency.” Thus, taxpayers who receive virtual currency as income must report its fair market value.

Another IRS notice explains, “The sale or other exchange of virtual currencies, or the use of virtual currencies to pay for goods or services, or holding virtual currencies as an investment, generally has tax consequences that could result in tax liability.”

“Mining” virtual currency may constitute a trade or business, according to IRS Notice 2014-21. If it does, net earnings resulting from those activities “constitute self-employment income and are subject to the self-employment tax.” Basically, making money out of nothing makes real tax obligations.

A married couple is challenging this and seeking a refund of taxes paid on the cryptocurrency tokens they created. In a complaint file in a U.S. District Court on May 26, 2021, they assert “they did not receive the tokens at issue as compensation, but rather created them, like a baker who bakes a cake.” Thus, they believe, “they should not be taxed immediately on the creation of new property.”

The taxpayers say tax should apply only after they realize income from the virtual coins they mined, by selling or exchanging them. This contradicts the IRS guidance in Notice 2014-21. It will be interesting to see what the court has to say about it.

The Washington Department of Revenue is one of a handful of states that explains how sales tax applies when “bitcoin is tendered in an amount equal to the amount invoiced for goods or services and the related retail sales tax.” If a seller immediately converts a bitcoin payment into U.S. dollars, tax is computed on the converted amount as it is with more traditional types of transactions. Sellers must document the time of sale, the value of the converted amount, and the transaction.

Determining taxable value becomes more complicated if bitcoin isn’t immediately converted to U.S. dollars at the time of sale, and the value of the bitcoin is greater or less than the amount invoiced when it is converted. In this case, “the value may be determined via a reliable cryptocurrency pricing index,” and tax may be computed on this value.

The department invites taxpayers to contact the department for more guidance in the event “sellers accept payment in bitcoin that is greater or less than the amount invoiced for goods or service and the related retail sales tax.”

Washington state doesn’t accept bitcoin or other virtual currencies for tax payments. Ohio does — or rather it did for a short time. Less than a year after announcing taxpayers could pay taxes with bitcoin, Ohio suspended cryptocurrency tax payments, and it has yet to resume the program.

States do recognize a need to regulate, and tax, virtual transactions. On June 30, 2021, Delaware adopted an express reporting requirement for virtual currency, with an exemption for game-related digital content with minimal or no value. It requires virtual currency to be converted to U.S. dollars prior to reporting and remitting to the state. Texas recently passed a law relating to the control of virtual currency and the rights of purchasers. And a new Wyoming law specifies how commercial law applies to specific types of digital assets.

Some years back, a friend who sold 3D printers told me he’s seen customers tear up when a printer spits out their avatars. It may not be my thing, but I understand life in the virtual world has real significance. It has real tax consequences, too.

For more wacky tax tales, and other tax-related stories, check out the Avalara blog.