NFT games are fun. Filing taxes afterward is a nightmare.

Millions of gamers are in for an unpleasant surprise this tax season.

Little NFT characters with Tax hats and an IRS tree

Play-to-earn games could have tax implications.

Illustration: Sky Mavis and Protocol

In a matter of months, NFT gaming became a multibillion-dollar industry by combining two things people already loved: video games and getting rich from crypto. But it turns out the play-to-earn model also has the incredibly inconvenient side effect of turning even minor actions taken in a video game into taxable events.

Did you sell your cute digital creature on Axie Infinity? That's a taxable event. Did you sell it less than a year after you bought it? (The answer is almost certainly "yes," given the timing of the play-to-earn boom.) Well, then it's a short-term capital gain. If you converted your NFT into a cryptocurrency before cashing out, that counts as two separate investment transactions. Even seemingly trivial in-game item swaps can have tax implications.

Making matters worse, NFT games don't typically keep track of all your transactions for tax documentation purposes. So while there are plenty of services designed to assist with crypto tax filings, it can be difficult to get the raw data that feeds into those products. By contrast, mainstream crypto-trading platforms like Coinbase prepare customer trade data for tax services either in the form of CSVs or direct software integrations.

"Taxes may come as more of an afterthought for a lot of the investors," noted Jen Kim, head of Product at NFTBank.ai. "We're actually getting more questions," she said. "There's quite a number of people reaching out, and I think that is associated with just general mindset toward the end of the year."

Kim also pointed to the added complexity that comes with the "scholarship" model employed within play-to-earn gaming. While the name suggests an altruistic support system, scholarships are all about making money. Thousands of "scholars'' in places like the Philippines and Venezuela play games on behalf of NFT owners ("managers") in exchange for a share of the resultant earnings.

Scholarship managers therefore operate business partnerships within NFT games. That triggers business tax requirements rather than capital gains. It also likely adds overseas tax implications, since many managers live in developed nations and lend to scholars in developing nations. By some estimates, around 40% of players on Axie Infinity are now based in the Philippines.

On the Axie Infinity Discord server, hundreds of messages pour in every day from individuals seeking scholarships in the form of borrowed Axies. The would-be scholars provide details such as their age, gender, marriage status, internet connection and location. They advertise their willingness to dedicate entire days to earn for managers; it's not unusual to see scholars offer to play up to 12 hours a day.

One Filipino player seeking a scholarship wrote: "I'm good with whatever terms or condition[s] you guys have. As long as it isn't a slave contract. This helping hand you'll extend will greatly help me at this time of [the] pandemic."

Protocol spoke with several of the individuals seeking scholarships. They expected to earn around $3 to $5 from a day of playing Axie Infinity. This pales in comparison to the early estimates that scholars made as much as $2,000 an hour playing NFT games. Profit rates have seemingly dropped as the markets matured. One individual noted that a standard full-time job in the Philippines would now provide a higher salary, but that play-to-earn represented an attractive opportunity while unemployed.

Tax scrutiny isn't just on the scholarship managers: In September, the Philippines' Bureau of Internal Revenue announced an investigation of digital influencers that some players interpreted as targeting high-grossing Axie Infinity players, according to Rest of World's reporting.

However, the vast majority of play-to-earn participants in the U.S. won't appear on the IRS' radar this tax cycle. And while filing play-to-earn taxes would be a nightmare, the truth is that many players will choose not to file anything and simply hope for the best.

These individuals benefit from the anonymity afforded by NFT game publishers. Shehan Chandrasekera, the head of Tax Strategy at CoinTracker, said he doesn't think NFT games will add tax enforcement mechanisms unless regulation changes. "Imagine a situation where I have to scan my driver's license and do all the [know your customer] just to play a game — that's a huge friction point for the game," he said. "I don't think anybody will do that because it negatively affects their business model."

Chandrasekera added that intentionally not reporting a taxable event to the IRS would constitute fraud. Even though play-to-earn hasn't been a priority for the IRS, players could draw scrutiny if they cash out in-game earnings through traditional crypto exchanges. The IRS could also retroactively require more stringent reporting measures from game publishers, which could expose players who evaded taxes.

Play-to-earn or earn-to-earn?

Investors see play-to-earn playing a significant role in the future of gaming. Around 20% of the total $9 billion in private gaming investments went to NFT-related projects for the first nine months of 2021, according to Drake Star Partners.

Game developers in the sector are also rewriting the conventional rules of success. Sky Mavis, the Vietnam-based studio behind Axie Infinity, earned a $3 billion valuation with a team of only 40 full-time developers. This occurred just three years after the studio's founding.

But not everyone is sold on the concept. Valve, the company behind the popular PC gaming marketplace Steam, decided in October that it will no longer carry "applications built on blockchain technology that issue or allow exchange of cryptocurrencies or NFTs."

Epic Games, which operates a rival PC gaming marketplace, seized the opportunity to say it remained open to selling NFT games. However, this came only a few weeks after the Epic CEO Tim Sweeney tweeted: "We aren't touching NFTs as the whole field is currently tangled up with an intractable mix of scams, interesting decentralized tech foundations, and scams."

But these digital distribution conflicts are mostly about setting community standards and reducing potential lawsuit exposure. A more important question needs to be asked: If tax laws are ever fully enforced, will anyone want to play NFT games?

Suspension of belief has historically played an essential role in making video games fun. It helps players feel immersed in an alternate reality. Gamers cared about the in-game outcomes because that made playing more fun, not because the outcome would impact their lives.

But play-to-earn developers are now asking players to maintain cognitive dissonance when they play: Gamers are supposed to immerse themselves in a traditional video game environment while still recognizing that everything has tax implications.

That interferes with full immersion, supposing players care about optimizing their earnings. For instance, a player could be in a predicament where they would earn more money in a game by delaying the sale of an item such that the loss would lower taxable long-term capital gains. If that sentence gave you a headache, then imagine having to think about it during a gaming session after a long day at school or work.

The play-to-earn industry has so far resisted confronting this dilemma. It has insisted that it can be both a fun video game and a marketplace for digital assets. The rise of the scholarship model suggests NFTs can thrive even if they don't fully deliver on the "fun video game" front. If this happens, the bright, cartoonish worlds of NFT games will only mask an otherwise straightforward economic engine. Millions of people will flock to NFT worlds — not seeking fun, but because they are showing up for work.

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