Can the IRS tax virtual money?

Virtual currency can be really profitable. As of Dec. 31, 2012, there were 9.6 million active users of "World of Warcraft," a massively multiplayer online role-playing game (MMORPG) in which players can earn virtual "gold" that can be exchanged for virtual goods like suits of armor and magic potions. Using third-party currency exchanges, some "World of Warcraft" users buy and sell virtual goods and gold using real U.S. dollars. In "Second Life," another popular MMORPG, players paid each other $150 million worth of Linden dollars, the game's virtual currency, in the third quarter of 2010 alone [source: GAO]. The question is, if people are making real income from virtual currency, should the Internal Revenue Service (IRS) be able to tax it?

It all started in 2001 when economist Edward Castronova published an analysis of the burgeoning virtual economy of online game worlds, 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 MMORPG "Ultima Online" on eBay and reported the income to the IRS [source: Dibbell].

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 Dibbell a definite response.

Dibbell's 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 virtual 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, they established an exchange rate. For instance, if 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 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 MMORPG "Second Life" has established the exchange rate of Linden dollars to U.S. dollars within the game world itself. In August 2013, one U.S. dollar bought 253 Linden dollars.

In 2007, the IRS began to seriously assess the risk of losing tax revenue to unreported virtual income. The issue of taxing virtual currency drew the attention of the Congressional Joint Economic Committee, which asked the Government Accountability Office (GAO) to make recommendations to the IRS on how to proceed. We'll take a look at the GAO's recommendations on the next page.

From Bartering to Bitcoins

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].

Lots More Information

Author's Note: Can the IRS tax virtual money?

The controversy over Bitcoin seems a little irrelevant to the lives of most Americans. What's the likelihood that any of us are going to be buying our groceries or paying our rent with bitcoins anytime soon? What's more interesting is that most of us earn and spend real money as if it's a virtual currency. When was the last time you were paid in cash for doing a job? And how often do you pay with actual dollar bills in a store? Most people I know are paid through direct deposit --or at least a check -- and just about every store and service accepts credit cards. And then there's online shopping; Americans will spend more than $260 billion through Web retailers in 2013, 13 percent higher than 2012. Every day, billions of dollars changes hands in America, but almost all of it is electronic -- 1s and 0s zipping from one virtual bank account to another. How much of a difference is there, really, between a "virtual" dollar and an ingot of "World of Warcraft" gold?

Sources

Chamberlain, Andrew. "Taxing the Video Game Economy." The Tax Foundation: Tax Policy Blog. Jan. 10, 2006. http://taxfoundation.org/blog/taxing-video-game-economy
Caron, Paul. "Can the IRS Tax Virtual Profits in On-Line Gaming?" TaxProf Blog. Jan. 10, 2006. (Aug. 28, 2013).http://taxprof.typepad.com/taxprof_blog/2006/01/can_the_irs_tax.html
Caron, Paul. "JEC Warns IRS: Do Not Tax Virtual Economies." TaxProf Blog. Oct. 19, 2006. (Aug. 28, 2013). http://taxprof.typepad.com/taxprof_blog/2006/10/jec_warns_irs_d.html
Dibbell, Julian. "Dragon Slayers or Tax Evaders." Legal Affairs. January/February 2006. (Aug. 27, 2013). http://www.legalaffairs.org/issues/January-February-2006/feature_dibbell_janfeb06.msp
Leonard, Andrew. "Bitcoin tax time?" Salon. June 19, 2013 (Aug. 22, 2013) http://www.salon.com/2013/06/19/bitcoin_tax_time/
Reuters. "US Congress launches probe into virtual economies." Oct. 15, 2006.
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