December 13, 2006
It started quietly in 2001 when economist Edward Castronova published an analysis of the burgeoning virtual economy of online gameworlds, which he calculated to have a gross domestic product of about $135 million. It gained national attention in early 2006 when writer and gamer Julian Dibbell posed a fascinating question -- are my virtual assets taxable? -- and put his money where his mouth his: Dibbell sold a collection of his own virtual assets from the massively multiplayer online game (MMOG) Ultima Online on eBay and reported the income to the IRS.
Dibbell claimed income in the amount of $11,000 earned from the sale of assets that don't actually exist in any concrete way. But the more intriguing part came next: After filing with the IRS, he tried to find out from various IRS employees if he was supposed to claim his castles and gold and other online assets that he hadn't converted to real-world dollars -- items that had never left the virtual world of Ultima Online. Some of the IRS representatives found the question amusing; others gave it serious thought and could not offer Dibbel a definite response. His telling of it was funny. But that story and other reports of people making their living auctioning off World of Warcraft and EverQuest characters and assets for real money spread like wildfire through online news sites and the blogosphere. And now, the once-laughable question of taxing virtual transactions that never even leave the vitual world has landed right in middle of a real-life, real-money tax debate. Where does the virtual economy meet the real-world one? And gamers with a theoretical treasure trove of online assets aren't chuckling anymore. The U.S. Congress is actually looking into the taxability of Mighty Rage Potion and Shrouds of Provocation.
The issue of taxing virtual assets is a complicated one, but the primary point of justification offered by many economists, even if they're only talking "in theory," is the fact that these virtual assets have an established real-world value. When gamers started selling their virtual armor and horses and castles for real-world cash, which began long before Dibbell wrote a great story about the extended tax implications of those sales, they established an exchange rate. For instance, since we know what a suit of armor sells for in Everquest or World of Warcraft gold, and we know what the same type of suit of armor sells for on eBay in U.S. dollars, we have a way to establish the an exchange rate between game dollars and U.S. dollars. And theoretically speaking, for tax purposes, anything that has a real dollar value is taxable once it changes hands. So if you sell a suit of armor to another player for a certain amount of gold, it's possible for the IRS to tax that transaction as income earned in the converted U.S. dollar amount of that gold. The MMOG Second Life has established the exchange rate of Linden dollars to U.S. dollars within the gameworld itself.
And when you die, if your virtual assets are worth a total of more than, say, $2 million, your heirs would theoretically have to pay an estate tax on all of the stuff you collected in your years of online home-building, monster-killing, sword-crafting and ore-collecting. As long as it has a real-world value, it can be taxed for that real-world amount just like your sale of a car or a house can be taxed.
It may seem absurd, but there's an easy precedent for this kind of taxed, cashless transaction. When a barter economy sprang up in many cities in the 1970s, the IRS didn't notice. But within a decade, that barter economy was doing serious business, and transactions were said to be in the area of $200 million a year. In the mid-1980s, the IRS added barters to its list of taxable transactions. Again, the issue was cash value. If you trade someone two hours of your window-washing services, which might run, say, $30 an hour in the cash-based world, for a swamp cooler he no longer uses -- cash value about $40 used -- you've earned $20 of taxable income. It doesn't matter that you never saw a $20 bill.
On an interesting side note, if you decide to steal that swamp cooler instead, you need to report that $40 of income in the taxes you file for the year in which you stole it, according to IRS tax code part 525.
As of December 2006, the Congressional Joint Economic Committee (JEC) is examining the issues involved in imposing real-world taxes on virtual transactions that don't leave the virtual world. Two big arguments against it are that such taxation, while theoretically viable, would go against common sense -- these "assets" are a bunch of ones and zeroes; and it could potentially cripple online gaming with unmanageable amounts of paperwork and record-keeping. One way the online gaming industry hopes to thwart what some consider to be the inevitable is through the retention of ownership rights, which most companies have established in their contracts. In most MMOG rules, the company, not the player, owns the Castle. Second Life is a notable exception to this rule.
The JEC's report is expected to be released early in 2008.
For more information on virtual assets, taxable income and related topics, check out the following links:
- CNET News: Are virtual assets taxable? - Jan. 17, 2006
- Legal Affairs: Dragon Slayers or Tax Evaders
- Reuters: US Congress launches probe into virtual economies - Oct. 15, 2006
- "Can the IRS Tax Virtual Profits in On-Line Gaming?" TaxProf Blog. Jan. 10, 2006.
- Chamberlain, Andrew. "Taxing the Video Game Economy." The Tax Foundation: Tax Policy Blog. Jan. 10, 2006.
- Dibbell, Julian. "Dragon Slayers or Tax Evaders." Legal Affairs. January/February 2006.
- "JEC Warns IRS: Do Not Tax Virtual Economies." TaxProf Blog. Oct. 19, 2006.
- Terdiman, Daniel. "Are virtual assets taxable?" CNET News. Jan. 17, 2006.
- Terdiman, Daniel. "IRS taxation of online game virtual assets inevitable." CNET News. Dec. 3, 2006.
- "US Congress launches probe into virtual economies." Reuters. Oct. 15, 2006.