The Virtual Muse and her Taxman

Calling all investors: How would you like to own artworks that remain in pristine condition, are accessible 24/7, require no storage, no transportation, no insurance costs and trigger no capital gains tax when sold? This fantastical proposition is possible today if you own artwork in virtual reality.

The tax-free bonanza, however, may be short-lived. The US Congress, cognizant of the digital goldmine in sophisticated virtual economies such as Second Life, is currently debating how to tackle virtual taxation. Second Life, the virtual platform with the greatest potential for a full-fledged art market, reports over 340,000 users spending “in world” amounts that exceed USD 35 million during peak months. Simulating the global economy, Second Life has its own currency exchange, the Lindex, where Second Life currency known as Lindens (currently, 270 Lindens = 1 US dollar) can be converted to real currency and vice versa. It also boasts a virtual art industry with at least 1,000 galleries, according to The Art World Market of Second Life, a 2007 study published by the virtual art journal SLART.

While legislators debate how virtual transactions should be taxed, most policy-makers seem to favor “cash out” taxation. In this scenario, Second Life users are only taxed when they convert Lindens to real-world currency. The alternative is “in world” taxation, which would tax on all sales, exchanges and other applicable events in Second Life as they occur, but presents daunting administrative challenges.

One work in particular warrants a second look from both collectors and tax policy-makers. Cao Fei’s ongoing project RMB City (2007–) is a virtual real-estate development loosely based on modern-day Beijing with virtual buildings that resemble Rem Koolhaas’ CCTV Tower, the “bird’s nest” National Stadium and other Beijing landmarks. Exhibited at the 10th Istanbul Biennial and now on view at New York’s Lombard-Fried Projects, RMB City had its “Investors’ World Premiere” at Art Basel Miami Beach in December 2007, where Cao’s gallery reportedly sold a $100,000 stake in the project to an unidentified collector. Advertised as “A Great Real Estate Opportunity in Second Life/A Unique Investment Possibility in First Life,” RMB City is Cao Fei’s overt packaging of art as an investment.

How would tax laws account for the sale, exchange or charitable donation of virtual art such as RMB City? US taxpayers know well that sales of art and other collectibles are subject to a 28 percent long-term capital gains tax, almost double the rate for stocks and bonds.

Under a “cash out” taxation system, a collector of RMB City would incur no tax liability if she sells or exchanges it for other Second Life assets. In theory, controlling for other factors such as demand, supply and liquidity, virtual art would then trade at a discount relative to non-virtual art, as sellers have no taxable gains unless they cash out their profits. Even then, any applicable tax rate lower than the 28 percent on non-virtual works would create a theoretical incentive for lower prices on virtual art.

The “in world” system, by contrast, would tax all virtual transactions of art as and when they occur. However, any short-term practical application of this system is likely to apply a simplified tax rate to gains on all virtual assets. As such, virtual art would still be preferable to non-virtual art if all virtual capital gains are taxed at a flat rate, provided the rate is lower than the real-world 28 percent. As virtual economies become more sophisticated, “in world” taxation may evolve to mirror the complexity of the real-world tax system.

Virtual art poses unique challenges and opportunities for taxpayers who create or deal in art. In a virtual taxation system that is less than comprehensive, opportunities abound for virtual-real “arbitrage.” For example, in an “in world” system wherein capital gains tax rates favor real estate over art, a seller of RMB City could convincingly argue that she is selling a building and not an artwork. In another example, the US tax code permits a “like-kind” exchange that enables investors to defer taxable gain on the sale of property, such as art, that they replace with similar investment property. Could one, then, legitimately enter into a like-kind exchange of virtual for real art? Could a virtual stake in RMB City even be exchanged for real bricks and mortar?

Another issue is property rights. While art collectors in real life own their works, virtual collecting is more complex. In Second Life, for example, artists own the intellectual property rights to their creations but Second Life owns the underlying code that is licensed to users. Hence, collectors of Second Life artwork do not own real property but rather licenses giving them certain rights to that property. 

Congress’ upcoming recommendations should clarify these issues. While virtual taxation seems inevitable, taxing virtual art should not disadvantage its creators or owners relative to other assets. Art and virtual reality are both essential conduits of imagination, expression and progressive ideas; they are also fragile luxuries with little lobbying power. An ideal virtual taxation system, whether “cash out” or “in world,” would foster artistic production, exchange and philanthropy by taxing virtual art at the same rate as other capital assets.