Selling goods in a virtual world can have real tax implications

A lot of us will soon be spending an hour of each day in the metaverse, or maybe more. We’ll attend classes and work events, explore exotic locales, visit with friends who live far and wide. And we’ll buy and sell stuff, because that’s what people do.

The technology research firm Gartner predicts 30% of the world’s organizations will be selling goods and services in the metaverse by 2026: “The metaverse will impact every business that consumers interact with every day.” It will likely consist of “a single environment” that’s “created by the convergence of virtually enhanced physical and digital reality.”

It’s not hard to imagine. I’m tethered to a computer for work, often Zooming with colleagues who live across an ocean or just down the street. I Wordle and Duolingo during my free time, when I’m not listening to an Audible book — which I do while my phone tracks the steps I take.

I also regularly FaceTime with my daughter. If I thought we’d feel more connected by “meeting for coffee” in a virtual cafe, I’d probably jump at the chance. Of course, I’d want my avatar to look good. (Younger, with better hair.)

I’m not alone. According to Vogue, “what we look like online is becoming just as important as our IRL (in real life) appearance.”

People are certainly spending real money to enhance their virtual selves. “Kitting yourself out, even virtually, is an expensive endeavor,” notes Leah Dolan of CNN, who attended Decentraland’s Metaverse Fashion Week in March. “Printed bucket hats and puffer jackets, as well as a glowing winged tuxedo … ranged anywhere from $1,670 to $2,740 a piece.”

Browsing myself, the Platinum $urfer (15,000€) caught my eye. If I understand the FAQs, I’d be the only person (avatar?) able to don the Platinum $urfer in Decentraland were I to purchase the full body outfit (skin). Of course, I’d actually be purchasing a non-fungible token (NFT), a “unique and irreplaceable” piece of data stored in a blockchain.

All this sounds very Tron to me, truthfully, and not particularly relevant to my life. But though NFTs exist in a virtual world, they’re affecting sales in the physical world. And that piques my interest.

According to Vogue Business, “there’s already a measurable knock-on effect for physical sales.” Searches for the brand Roksanda on Lyst reportedly jumped 76% after Roksanda created NFTs with the Institute of Digital Fashion during London Fashion Week. Likewise, brand searches for Diesel increased 41% after it announced at Milan Fashion Week that it would release NFTs in addition to physical clothes.

In fact, it would be “a mistake” to try to separate the digital and physical world, says Giovanna Graziosi Casimiro, the head of Metaverse Fashion Week (MVFW). “They are two elements composing the same story.”

Alex Lambert, creative director of content production studio Happy Finish, agrees. “Once you’re able to buy a virtual Chanel jacket and then wear that item in the real world, that’s when things will really start to change.” Turning that idea on its head, Philipp Plein is developing a way for consumers to “upgrade a physical purchase with its digital twin, for less than it would cost to buy the wearable alone.”

StockX, a multibillion-dollar sneaker and streetwear resale company, is also “bridging the physical and digital worlds.” Purchase an Air Jordan 4 Retro White Oreo NFT from StockX and you’ll get ownership of an actual pair of Air Jordan 4 Retro White Oreos too. The real shoes will be stored in a climate-controlled StockX facility until the buyer either wants them in hand or decides to resell both the NFT and the real shoes.

So, what does all this mean for sales tax? What happens when the sale of a digital good results in ownership of a physical good, or vice versa?

Many states haven’t yet addressed the taxability of goods sold in the metaverse. Most states provide guidance on how to tax digital goods, but do those policies govern the sale of a fashionable hat in Decentraland? Maybe. Maybe not. It depends on who you ask.

According to David Lingerfelt, senior director of North America Tax Content at Avalara, “If you don’t know what something is, you can’t know how to approach taxing it.” Is an NFT a digital product? Software? Something else? Lingerfelt isn’t sure many tax and government officials understand the metaverse or NFTs.

Of course, members of the Streamlined Sales and Use Tax Agreement (SSUTA) have specified how they tax digital codes, products, and services, notes Scott Peterson, vice president of Government Relations at Avalara. They’d likely say they’ve provided all the guidance needed to determine taxability of a virtual skin.

Yet as Lingerfelt explains in Will emerging NFTs lead to future sales tax controversies?, the SSUTA definitions preceded NFTs. “Nothing in the SSUTA prevents a member state from imposing sales tax on products other than specified digital products or digital codes,” he states. But he also believes, “Neither an article of digital clothing nor a digital membership NFT is a digital code exchanged for digital property.”

Peterson can’t say for certain whether states presume these transactions to be taxable. “I can say states are talking about NFTs. If they determine NFTs are simply digital codes, then states that have a law taxing digital goods will say that their law automatically taxes NFTs.”

Alternatively, states could determine that NFTs are simply blockchain-based receipts for the thing the NFT represents. “In those states,” says Peterson, “the decision will then just be whether they tax the underlying thing.”

Maybe so. But what happens when a sale of virtual shoes comes with tangible shoes? What happens when the sale of a hat you can put on your head comes with a hat you can put on your avatar? That levels up the tax complexity.

Lingerfelt says that “existing digital property sales tax statutes and regulations may prove inadequate as non-fungible tokens (NFTs) grow in variety and popularity.” Perhaps also as NFTs spill over into the physical world — and vice versa.

Every state with a sales tax taxes most sales of tangible goods, but selling a physical good with a virtual product could complicate tax determination. Would that be a bundled transaction? If so, could taxability be altered by separately stating the virtual and tangible goods?

Peterson says that while states generally don’t tax intangible assets, “they don’t always agree on what is intangible. If they can in any way attach a tangible thing to the purchase of an intangible asset, they will try to tax the sale.”

States will also have to decide the best way to source sales of NFTs, says Richard Cram, director of the Multistate Tax Commission (MTC), “especially since the buyer and seller may not know the location of each other.” And since NFT transactions generally occur through marketplaces like OpenSea, states will need to determine whether their marketplace facilitator laws apply to NFT marketplaces.

In late March, New York Attorney General Letitia James entered the discussion with a notice reminding crypto investors to pay taxes on virtual investments. Two statements in particular stand out:

“Taxpayers must calculate and report any gain or loss when using cryptocurrency to purchase a luxury electric vehicle, a plane ticket, or even a cup of coffee.”

“Retailers and purchasers spending or accepting cryptocurrency need to be aware that … sales tax is owed on transactions involving the use of convertible virtual currency to pay for taxable goods or services delivered in New York state.”

A technical bulletin issued by the New York State Department of Taxation and Finance back in 2014 provides additional details. “The use of convertible virtual currency by a customer to pay for goods or services delivered in New York State is treated as a barter transaction.” Though convertible currency received by a party to a barter transaction isn’t subject to New York sales tax, “if the party that gives convertible virtual currency in trade receives in exchange goods or services that are subject to sales tax, that party owes sales tax based on the market value of the convertible virtual currency at the time of the transaction, converted to U.S. dollars.”

The attorney general is serious about enforcement: “Anyone with information relating to a taxpayer’s willful failure to report income or collect sales tax on transactions involving cryptocurrency are urged to report such failure to the Office of the Attorney General using the online whistleblower portal.”

Until more states come out with concrete guidance, businesses involved in these transactions (and worlds) essentially have two options: Ignore sales tax or try to get in front of it.

The pioneer metaverse platform Second Life has opted for the latter. It started charging U.S. sales tax on recurring billings (e.g., premium subscriptions and land fees) on March 31, 2022. When announcing this new policy, Second Life’s parent company Linden Lab referenced the United States Supreme Court decision in South Dakota v. Wayfair, Inc. (2018), which enabled states to tax remote (aka, out-of-state) sales. Since the Wayfair ruling, Linden Lab states, “we have done our best to shield our residents from these taxes as long as possible.” It just can’t keep doing so indefinitely.

The company explains it will continue to absorb sales taxes on point-of-sale purchases, first-time premium subscriptions, and name changes. However, it admits, “At some point in the future we will need to begin passing those taxes on to you.”

Other companies will eventually follow Second Life’s lead, willingly, or at the behest of a state tax authority.

Read more about this complex issue in Taxing the metaverse: The basics.