Paying Real Taxes for Virtual Loot?

So you just got done doing some awesome instance in your mmorpg of choice and the mob dropped an item worth $100 bucks on eBay.  Now how much less uber would that drop be if you had to pay taxes on it when you picked it up?  Technically it is an asset and it’s worth real money, but can the IRS actually tax you for that item?  At the moment the laws are very unclear on virtual items and people that make a living selling virtual items. 

I have a lot of experience in this because i sell virtual trading cards for a living for Magic the Gathering Online.  I do pay taxes on my actual income that I make from buying and selling the cards, but so far I have not had to pay taxes on the value of my inventory.  If such a law was passed all users of every MMORPG or any other virtual type game would be forced to pay taxes on the value of their character and his items.  This would basically ruin the MMORPG world and would shutdown a lot of the games.  This is all somewhat speculation, but could be very real since the IRS takes notice of any business moving a lot of “virtual items” into real world currency.

More information after the jump…

So you just got done doing some awesome instance in your mmorpg of choice and the mob dropped an item worth $100 bucks on eBay.  Now how much less uber would that drop be if you had to pay taxes on it when you picked it up?  Technically it is an asset and it’s worth real money, but can the IRS actually tax you for that item?  At the moment the laws are very unclear on virtual items and people that make a living selling virtual items. 

I have a lot of experience in this because I sell virtual trading cards for a living for Magic the Gathering Online.  I do pay taxes on my actual income that I make from buying and selling the cards, but so far I have not had to pay taxes on the value of my inventory.  If such a law was passed all users of every MMORPG or any other virtual type game would be forced to pay taxes on the value of their character and his items.  This would basically ruin the MMORPG world and would shutdown a lot of the games.  This is all somewhat speculation, but could be very real since the IRS takes notice of any business moving a lot of “virtual items” into real world currency.

IF YOU HAVEN’T MISSPENT HOURS battling an Arctic Ogre Lord near an Ice Dungeon or been equally profligate spending time reading the published works of the Internal Revenue Service, you probably haven’t wondered whether the United States government will someday tax your virtual winnings from games played over the Internet. The real question is, Why hasn’t it happened already?

Gamers who play EverQuest, an online game with 450,000 subscribers—playing parts that range from Frogloks, a race of sentient amphibians, to Vah Shir, a regal feline race—generate in their virtual world the kind of imaginary economic activity that can be measured in real-world terms like “gross domestic product.” According to Indiana University economist Edward Castronova, EverQuest’s annual GDP—the total wealth in goods and services an economy creates—is about $135 million, or around half the GDP of the Caribbean island nation of Dominica. Castronova sized up the virtual economy (in a widely read 2001 paper that launched his career as the Adam Smith of video games) in part to mock the pomposity of traditional econometrics. But the finding of the paper was no joke. EverQuest’s subscribers are playing a game, to be sure, yet like all massively multiplayer online games, often called MMOs, it’s one with remarkable economic potential.

To play an MMO is to engage in a quest. You take a character into a virtual world to hunt monsters, seek treasure, and enjoy the thrill of slowly rising from humble beginnings to imaginary wealth and stature. The rub, however, is that you can rise only so far without finding treasures placed in the virtual world by the game’s creators or acquiring those items from other players. There are various ways to convince your playmates to surrender their weapons, magic spells, and mineral ores. Killing their characters is one way and befriending them another, but the quickest method is to offer fellow gamers real money. This is rarely approved by official rules of MMOs, but the practice is so widespread that if you look on online marketplaces like eBay today, you will find a thriving, multimillion-dollar market in Golden Runic Hammers, Ethereal Mounts, and similarly exotic items—all of them won (and anything found or wrested from another player is “won” in the context of a game) or bartered for in this or that MMO quest, and many of them fetching prices in the hundreds, even thousands of dollars.

JUNE 2003. I SET MYSELF THE FOLLOWING CHALLENGE, posting it on my web log for the world to see: “On April 15, 2004, I will truthfully report to the IRS that my primary source of income is the sale of imaginary goods—and that I earn more from it, on a monthly basis, than I have ever earned as a professional writer.”

In the course of this project, I made a total of $11,000 selling on eBay the items I won playing a game called Ultima Online, $3,900 of which was in the final, most profitable month. I reported my profit to the IRS, and I paid the requisite taxes. But after I did so, a troublesome set of questions continued to nag at me—for which even IRS publication 525, entitled “Taxable and Nontaxable Income,” couldn’t provide answers.

This was remarkable, for publication 525 would appear to contain every conceivable form of income known to accounting. To read it once is to realize that you know nothing about income. Here you’ll find a description of gains, ill-gotten and otherwise, so irregular that they can be taxed only according to that form of guesswork known as fair market value. Here are stocks, options, retirement watches, and stolen goods (“If you steal property, you must report its fair market value in your income in the year you steal it unless in the same year, you return it to its rightful owner”).

Most significant for my purposes, here too are items acquired either through barter or as prizes in a game. The rules make clear the IRS’s fundamental point: Goods taken in trade or won at play are taxable the moment they fall into somebody’s hands, even if they are not sold for money. The more I read, the more I wondered whether reporting the amount I had brought home from selling virtual items on eBay was enough to satisfy the IRS.

What about the assets I bartered for or won in the game but never sold in the real world, the suits of armor stashed here and there with their easily established fair market value? What if I traded those assets for their value in Ultima Online’s official currency, the Britannian gold piece, rather than for dollars? Wouldn’t it be easy to establish their value in dollars nonetheless and, if I owed American taxes on the exchange, put a number on the deal that the IRS could grasp and love? And what about all the other MMO players out there—how long could the IRS be expected in good conscience to leave the resulting millions of dollars in wealth untouched?

You might think that I was letting my imagination run away with me—I certainly hoped I was. I thought that a glance at past IRS practices would assure me that the feds would never dream of taxing assets that had not been turned into money. I thought wrong.

The IRS has taxed barter transactions that are remarkably similar to the ones that online players engage in every day. In the late 1970s, for example, dozens of so-called barter clubs sprang up around the U.S., said Deborah Schenk, a tax professor at New York University School of Law. The clubs put out directories in which members listed themselves as providing accounting, window washing, or other types of services. Any member could buy those services with “trade dollars,” a virtual currency like Britannian gold pieces, and a member could earn trade dollars by offering his own services. By 1980 these clubs were handling an estimated $200 million worth of transactions every year, and the IRS took notice. In a 1980 ruling, the agency said that barter club transactions produced taxable income, even though no actual money changed hands. A 1982 law made enforcement of the ruling easier by requiring the clubs to provide the IRS with information about every transaction.

Swapping a financial audit for a dental checkup seems different from trading a Runic Hammer for an Ethereal Mount, if only because audits and checkups are real. But what does “real” mean for tax purposes? Richard Schmalbeck, a tax professor at Duke University School of Law, said the IRS determines that something has “real” value when a similar good or service trades on a market for actual money. Transactions involving items with real value are taxable. He acknowledged, though, that not every situation is clear.

Schmalbeck described the case of David Zarin, a gambler who spent close to a year playing craps in a casino, essentially without leaving the casino. Zarin lost $3.4 million worth of chips he acquired on house credit and he converted few, if any, into actual money. Unable to collect, the casino wrote off all but $500,000 of his debt, arguably presenting Zarin with a gift of $2.9 million. Was that taxable, as the IRS claimed? Schmalbeck said that several courts reached different conclusions, unable to agree on whether the gambling debt or the gift (or, perhaps, the gambler’s year in the casino) was real in any meaningful sense, even though the chips had fallen where they did and had a monetary value.

In any case, with virtual goods from Internet games being traded every day for actual money on eBay, wouldn’t Schmalbeck’s theory about similar goods trading on actual markets mean that trades occurring exclusively in a game are taxable? I set out for my local tax office in South Bend, Ind., to find out.

Arriving near the end of the workday, I took a chair until my number was called, and then approached the help desk, where a tax official named John Knight looked up at me with a mix of weariness and curiosity. I took a deep breath and proceeded to describe my business and the economy that sustained it. I cited publication 525. I inquired about barter income, specifically the difference, if any, between a painting for which the owner paid $6,000 bartered for half a year’s rent and a virtual castle with a value of $1,200 established on eBay bartered for 10 million pieces of virtual gold. If John Knight’s response was typical, the IRS hasn’t done much thinking about the matter.

“O.K., so I got a fake jewel that’s worth 80 million points, gives me all kinds of invincibility,” said Knight, striving doggedly to nail down what I was talking about. “But I got two of them, or don’t want to play [anymore]. And I can go on eBay and sell my jewel to some other character?”

“Uh, yeah,” I confirmed.

Knight considered the facts and offered a nonbinding opinion: “That’s so weird.”

He ventured to say that it was doubtful the IRS would treat virtual items as cash equivalents anytime soon. Until the Britannian gold piece trades on international money markets, or until the value of a virtual amulet is as widely recognized as that of a beer, he suggested, “I don’t think we’re recognizing Dungeon and Dragon [sic] currency as legal tender.”

Because he wasn’t in a position to offer a final word, however, Knight gave me a number for the IRS’s Business and Specialty Tax Line. “Specialty” sounded about right, so I called and told my story to a telereceptionist, who routed me to a small-business specialist, who passed me along to a barter-income specialist, who identified herself as “Mrs. Clardy, badge number 7500416,” and listened in silence to my query about virtual economics—and then put me on hold.

When Mrs. Clardy returned, she was a bureaucrat transformed. “We just had this little discussion,” she said, almost giggling. “And it sounds to us like [the online trades you’ve described] would be—yes—Internet barter.” Here she paused, whether to catch her breath or to let the conclusion sink in, I couldn’t tell. “However,” she went on, “there are no regs, there is no code, there are no rulings, to rely upon. This is our opinion.”

Mrs. Clardy suggested I seek a more authoritative judgment. A “private letter ruling,” she assured me, was the IRS’s definitive opinion, in writing, on a particular taxpayer’s situation. And a letter ruling in my case, she believed, would probably be the closest the IRS had ever come to an opinion on the status of virtual income.

“The ramifications are enormous,” Mrs. Clardy exhorted. “Break new ground!”

WHY NOT? WELL, BECAUSE MRS. CLARDY had neglected to mention the $650 fee stipulated in the letter-ruling request instructions, or the tax lawyer I would have to hire to write the request with any effectiveness, or the six months I would have to wait for a final response. Even if none of these obstacles had stood in the way, I finally had to ask myself: Was this really the kind of ground I wanted to break?

Considering what the IRS had done with barter clubs, it seemed prudent not to be the game player who officially invited the agency to visit the world of MMOs and gave the feds the opening to tax virtual income. That decision might force game companies, as John Knight had put it, “to start sending out 1099s every time somebody gets a gold coin or a bag of grapes or a shiny emerald” in a game’s virtual world.

It would certainly transform the thrill of the online quest into distress for the legions of players who couldn’t afford to pay their new taxes, and would likely doom my fellow Frogloks, Vah Shir, and other characters to appalling fates.