Blockchain-Based Digital Real Estate
In June 2021, Sotheby’s launched a new gallery space in the digital metaverse Decentraland, modelled after its London Headquarters on Bond Street. Digital art and NFT exhibitions were on display throughout the space’s five floors, and a digital avatar of its London commissioner Hans Lomulder greeted guests at the door. Michael Bouhanna, Sotheby’s Head of Sales, expressed that the company sees spaces like Decentraland as “the next frontier of digital art.” However, what exactly are these new spaces? And how are they being developed?
Digital Metaverses
“Metaverses” are created by blockchain developers as immersive digital experiences designed to mimic the real world and foster authentic social interaction between users. Decentraland is one of the most popular metaverses and gained a lot of traction with the public following its release in February 2020. Decentraland offers users the opportunity to explore spaces such as art galleries, museums, movie theaters, malls, and even casinos using custom-designed avatars. Users can listen to live music at various venues, participate in games, or even give pitches to Silicon Valley investors in Decentraland’s very own, “Crypto Valley.”
Perhaps one of Decentraland’s more interesting features is that users can buy deeds to digital plots of land (LAND) in the platform’s finite, 3D space. The users purchase LAND using Decentraland’s cryptocurrency (MANA). The platform’s real estate market has experienced a boom – the cheapest plots are currently selling for over $11,000. Likewise, MANA’s market capitalization is at over $4 billion, seeing an over 300% increase in prices in its first year.
Digital Real Estate
Much like in the traditional real estate market, many metaverse users have bought digital real estate as an investment. However, since it is such a new concept, the valuation of land that only exists virtually is hard to determine. Some have suggested it be based on location. For instance, the plots near Genesis City (Decentraland’s first city) and Crypto Valley have higher price points than those on the fringes of the metaverse. But, in a world where users only need to plug in a set of coordinates into their computer to visit a location, this traditional method of assessment is tenuous at best. Virtual real estate companies have emerged that help users buy, sell, evaluate, and develop properties across various metaverses. These companies also offer opportunities for clients to rent out their properties to other metaverse users.
Traditional property tax laws do not apply to properties in the metaverse. Digital properties are typically sold as NFTs and considered assets by the IRS. Thus, owners of digital property are subject to capital gains taxes. Decentraland notes in its Terms of Use that users are solely responsible for determining what, if any, taxes apply to their LAND parcel-related transactions, and any other transaction conducted on the platform. For some investors, these taxes could end up being quite significant considering that in June 2021 a parcel of LAND sold for a record-breaking $900,000 on the platform.
Lack of central control
Sam Hamilton, Decentraland Foundation’s head of community and events, stated that “the underlying philosophy of Decentraland is for the people to take back control of the internet and decide in which directions it goes in.” Although, the Decentraland Foundation makes the tools and the site available to users, it does not own or control the platform. True to its name, Decentraland is a decentralized virtual reality platform that runs on the Ethereum blockchain, allowing users to conduct immutable and verifiable transactions without a central authority. The platform has limited central governance or oversight system and was set up so that users could develop, modify, and monetize their own content and applications as they wish.
The Decentraland foundation also lacks a clear structure. Although it claims to be a non-profit organization, there are no financial statements or founding documents on Decentraland’s website or readily available online to allow users to verify its non-profit status.
Potential Liability
Metaverses like Decentraland could become a hub for illicit online activities because of the unfettered control given to users. For example, the casinos in Decentraland function much like casinos in the “real world” – patrons use crypto to gamble on various games and virtual slot machines. However, there is no way to verify the age of the people participating in these games, allowing underage players to unlawfully engage in such activities.
The virtual real estate market is also ripe for illicit schemes involving money laundering, fraud and sanctions violations. Anyone with access to cryptocurrency can buy land in the metaverse. Parties may unwittingly engage in a transaction with sanctioned individuals and/or users in sanctioned jurisdictions because they do not always know who their buyers/sellers are or where the money is coming from. This makes it difficult to comply with the myriad of US and global trade laws and regulations, including conspiracy laws.
U.S. government agencies continue to monitor and engage in enforcement actions regarding the use of cryptocurrency. In October 2021, the Department of Treasury, Office of Foreign Assets Control (OFAC) issued guidance tailored for the virtual currency industry. The guidance included a reminder that U.S. entities and individuals “may be held civilly liable for sanctions violations even without having knowledge or reason to know it was engaging in such a violation.” OFAC outlined that these entities dealing with cryptocurrency (such as Decentraland) “are encouraged to develop, implement, and routinely update, a tailored, risk-based sanctions compliance program” to prevent transactions with sanctioned individuals and users in sanctioned jurisdictions.
Platforms serving as a marketplace for virtual real estate need to prioritize compliance programs to prevent running afoul of these trade laws. Investors also should be wary of unknowingly engaging in unlawful conduct and carefully review their transactions through these platforms. Without a strong compliance program and due diligence, including transaction monitoring and screening of platform users, companies and individuals risk potential liability (including hefty fines and jail time) for these prohibited activities.
Conclusion
Metaverses offer users the chance to enhance their online presence in creative and engaging ways. However, because of their novelty, the value of their LAND as an investment strategy and the tax implications of these investments is still unclear. Furthermore, the de-regulated nature of the spaces means that individuals and corporations must proceed with caution when navigating these platforms to avoid violating US and global trade laws.
Teresa Taylor
202.454.2885
taylortn@butzel.com
Jude Nwaokobia
202.454.2856
nwaokobia@butzel.com
