A plot of virtual real estate in the Decentraland metaverse sold for a record $2.43 million to Metaverse Group in November 2021. The virtual real estate business plans to develop the virtual land to facilitate fashion shows and commerce within the nascent digital fashion industry, presumably turning its land holdings into revenue-generating assets.
The skyrocketing popularity and value of metaverse land beg the question: How do taxes work on virtual real estate?
Virtual real estate has become a multi-million dollar market, but taxes can quickly become overwhelming. Here's how the IRS treats metaverse land and how to minimize your tax exposure.
What is the Metaverse?
Metaverse land is real estate that exists in a digital world, including buildings or plots of land. For example, anyone can use MANA to purchase Decentraland land or ETH to purchase TheSandbox LAND. And depending on the metaverse platform, you can walk around, build structures, harvest resources, or use the land in different ways.
The most popular metaverse platforms offering land sales include:
- Decentraland
- The Sandbox
- Somnium Space
- CryptoVoxels
- Upland
- ERTHA
- Zepeto
Many investors acquire metaverse land to generate rental income or organize profit-driven events. For example, you could build an NFT art gallery and lease space to artists that want to display their art. In addition, metaverse land could appreciate in the same way as physical real estate, creating an opportunity for HODLers.
Of course, there are also differences between the metaverse and physical real estate markets. In particular, physical real estate has more scarcity and higher building costs that drive value. In theory, the metaverse real estate market could be limitless, although proximity to population centers could create some level of scarcity.
Tax on Metaverse Land
The IRS' 2022 tax instructions explicitly state that non-fungible tokens are subject to the same tax rules as other digital assets. In particular, taxpayers that dispose of digital assets through a sale, exchange, gift, or transfer must report and pay capital gains tax. And anyone that receives crypto assets as compensation must declare them as income.
To eliminate any potential ambiguity, the agency further clarified that if "a particular asset has the characteristics of a digital asset, it will be treated as a digital asset for federal income tax purposes." As a result, there's little doubt that most individual taxpayers will owe capital gains taxes on any profits upon the sale or exchange of metaverse crypto assets.
In addition to paying taxes on the sale of metaverse land, individuals that generate income from their metaverse properties must declare and pay taxes on that income. For example, if you have metaverse land that you rent out for Ethereum-based income, you owe ordinary income tax on the U.S. dollar value of the Ethereum upon receipt.
The picture becomes a little less clear for individuals operating as businesses. For example, you could argue that purchasing and renting metaverse land is a business activity to deduct expenses (e.g., gas) and reduce your taxable income. However, it would be tough to substantiate these deductions to your accountant and the IRS.
If you wish to operate as a business, you may consider utilizing a separate business wallet and documenting the details of each business expense transaction. And even then, the IRS could fail to validate that the deduction is valid in the event of an audit. As a result, discussing these dynamics with a crypto-friendly accountant is a good idea!
Tips to Reduce Taxes
- Hold land for more than a year. Digital assets you purchase and sell within one year are classified as short-term capital gains subject to your marginal income tax rate. On the other hand, if you wait more than a year to sell, they're classified as long-term capital gains and subject to a lower tax rate.
- Record your transaction and gas fees. The IRS permits taxpayers to deduct any commissions or gas fees from the proceeds of a digital asset sale, lowering your potential tax burden. However, you need to accurately document these transaction costs and gas fees to defend the deductions in the event of an audit.
- Harvest tax losses to offset income. Crypto assets aren't subject to the same tax loss harvesting rules as stocks (e.g., the Wash Sale Rule), meaning you have a lot more flexibility when selling losing positions to realize the losses in the current tax year and offset your income or other capital gains.
- Choose the right accounting method. The IRS lets you choose between several different accounting methods when preparing your crypto taxes. While most people use last in, first out (LIFO), you could realize a benefit by using other methods in specific cases. You may want to discuss these with your accountant.
- Use crypto tax software. Crypto tax software, such as ZenLedger, can help you avoid overpaying taxes and provide a clear audit trail to defend your decisions to the IRS. In addition, these tools can help you choose the best accounting method, maximize your deductions, and even identify tax loss harvesting opportunities.
The Bottom Line
The metaverse is quickly becoming an instrumental part of the digital economy, enabling anyone to own land and generate income. However, while the IRS recently issued new tax guidance for NFTs, individuals hoping to treat their metaverse activities as businesses may still have difficulty claiming expense deductions unless careful.
Of course, taxes are just one of the wrinkles facing individuals and businesses in the metaverse. In a previous article, we discussed the potential legal issues facing the metaverse and how they might play out as these platforms become more ubiquitous.
If you trade crypto assets, ZenLedger can help organize your assets in one place, aggregate transactions across wallets and exchanges, and compute your capital gain or loss each year. In addition, we can help you identify ways to harvest tax losses to offset your income while ensuring that you're not overpaying (or underpaying) your taxes.
