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Can the IRS tax virtual money?


From Bartering to Bitcoins
When online sales of virtual assets for hundreds and thousands of dollars became commonplace, the U.S. government took notice.
When online sales of virtual assets for hundreds and thousands of dollars became commonplace, the U.S. government took notice.

When the GAO issued its report in May 2013, it began by comparing virtual currency transactions to another type of cashless transaction, bartering. Bartering is the exchange of goods and services for other goods and services without any actual money changing hands. In the 1970s, small bartering economies sprung up across the U.S. At first, the IRS didn't take notice, but within a decade, the alternative barter economy was doing serious business with transactions valuing in the area of $200 million a year. In the mid-1980s, the IRS decided to add bartering income to its list of taxable transactions. Again, the issue was cash value. If you trade someone an old TV (cash value about $40) for two hours of their window-washing services (worth $60 in the cash-based world), then you've technically earned $20 of taxable income. It doesn't matter that you never saw a $20 bill.

If income from bartering is taxable by the IRS, argues the GAO, then income from certain virtual currency transactions should be taxable, too. The GAO divides virtual currency systems into three different categories, each with its own tax implications:

Closed-flow System: There is no interplay or exchange between virtual goods and services and real money. An example is a MMORPG in which players earn virtual "gold" by performing certain tasks within the game, then use that gold to buy virtual clothing and weapons. Since none of those items have cash value in the real world, any income or assets earned from the game cannot be taxed.

Hybrid System: Some transactions are taxable and others are not. "World of Warcraft" (WoW) is a good example of a hybrid system. In "WoW," a player can choose to keep all transactions within the virtual world using only "WoW" gold as currency. Those transactions don't produce taxable income. But there are also third-party exchanges outside of "WoW" where players can buy and sell "WoW" assets for real money. In that case, when a virtual sale results in real profit, the income may be taxable [source: GAO].

Open-flow System: Most transactions are taxable. "Second Life" is a good example of an open-flow system, because the game itself allows players to freely exchange real U.S. dollars for virtual Linden dollars. Since Linden dollars have an established cash value, the IRS can easily determine the real-world value of virtual transactions. For example, if you sell a property in "Second Life" for 2 million Linden dollars, the IRS can argue that you realized a real-world profit of $7,905. That's taxable income.

For all the talk of online role-playing games, the biggest player in the virtual currency world -- and the most worrisome to the IRS and the U.S. Securities and Exchange Commission (SEC) -- is" Bitcoin, an untraceable peer-to-peer currency. As the GAO explained in its report, Bitcoin is the ultimate open-flow system. There is no virtual world, like "Second Life or "World of Warcraft," within which Bitcoin transactions are confined. Once you acquire bitcoins -- through a convoluted "virtual mining" operation -- you can spend them on anything you want: cars, clothes or candy bars. The GAO report said that money earned through Bitcoin transactions may also be taxable -- the final decision on that matter being up to the IRS.

As of May 1, 2013, there were 11 million bitcoins in circulation. In August 2013, a single bitcoin traded for $120, which amounted to $1.3 billion of untaxed virtual income in circulation [source: Leonard]. On March 25, 2014, the IRS announced that it would be taxing bitcoin as property, following the same tax guidelines as other transactions involving property. This means people will have to report the fair market value of earned bitcoins -- and any other virtual currencies -- to the IRS [source: IRS].