Most people play video games for entertainment. They play in a virtual world by themselves or with others where they rescue a princess or play in the virtual Super Bowl. But some people have made real money from their online activities, usually from selling virtual items.
Most video games do not have a mechanism to convert game currency into real money because they don’t create wealth. But many online games allow players to exchange real money for in-game currency which can be used to purchase virtual goods and services. For developers, it is a business model that serves as an alternative to charging a monthly subscription fee to its players. As I mentioned in a previous column, the IRS will not tax in-game activities in these closed virtual worlds.
But a few of these online massively multiplayer online games allow a two-way conversion of currencies. Not only can players convert real money into in-game virtual currency, but they can also convert it back to real money. There are two online games that do this: Second Life and Entropia Universe. Second Life has a currency called Lindens while Entropia Universe’s currency is called Project Entropia Dollars, or PEDs. The developers have no issues with players earning income from their platforms. And there have been stories of some people earning large amounts of money from selling virtual real estate or from their virtual businesses.
These virtual worlds with two-way convertible currencies produced a tax conundrum. If these currencies are cash equivalents, like foreign currencies, should they be taxed at receipt, even if the players do not cash them out? Most would agree that those who play for real world profit should report their virtual income. The problem is that most people play for fun and not to make money. If they spend the money only in the virtual world, it would be absurd to have to pay real world taxes on their virtual income.
Seven years ago, the Internal Revenue Service tried to address this when they issued Notice 2014-21. It was issued at a time when cryptocurrencies like Bitcoin started to rise in value. It stated that the sale or exchange of convertible virtual currency to pay for goods or services in a real-world economy transaction could result in a real-world tax liability. It also suggested that those who received virtual currencies would have to report its fair market value as taxable income. For example, those who received Bitcoin as a result of mining would have to report the receipt on their tax returns.
This could suggest that transactions involving in-game virtual currencies can result in real-world tax consequences. On the other hand, there are reasons why the notice should not apply to these currencies. The notice only uses Bitcoin as an example of convertible virtual currency. It does not mention Entropia Universe, Second Life, or any other virtual world based games with convertible currencies.
While both in-game currencies and Bitcoin can be converted to real world currency and vice versa, they operate differently. Bitcoin and similar cryptocurrencies operate in the real world as
securities investment vehicles or as substitute currencies to obtain real world goods and services. On the other hand, game currencies like PEDs only exist in the Entropia Universe virtual world and they are mainly used to purchase in-game items. While it is possible to exchange PEDs for a large pizza, these transactions are rare. This is because most real-world stores do not accept PEDs since they cannot be used as a currency in the real world nor is there a large demand for them outside of the game. The only people who would engage in these types of transactions are Entropia Universe players.
Second, the game currencies are controlled by its developers while most cryptocurrencies are supposedly decentralized. Generally, the developers will tweak their currencies as needed to maximize revenue from its players and ensure that the in-game economy is not disrupted to the point where the game becomes unplayable. For example, one day, the developers might change the exchange rate so that one dollar can purchase five PEDs instead of ten. Or they can make PEDs easier or harder to get in the game. They can ban real-world transactions using PEDs (although enforcing this is probably easier said than done). So even though PEDs can be converted into real world money, the real world value is uncertain while it is in the game since the developers can change how the currency functions. Accordingly, the value should only be realized when the currency is cashed out.
Notice 2014-21 did not create a distinction between those who play online games for fun as opposed to those who play for profit. On one end of the spectrum, there is the person who plays for fun and uses their game currency exclusively in the game. These people should not be taxed on their in-game activities and should only pay taxes when they cash out. On the other, there are those who play for profit who will cash out their currency as often as they can and will only keep in-game currency to pay in-game costs. These people arguably should be taxed on the receipt of game currency since they see them as no different than real money.
But what about those in the middle? Where should the line between fun and profit be drawn? For example, someone who withdraws money only twice per year and puts the money back in the game later in the same year? Or someone who saves a large amount of game currency in order to purchase an expensive in-game item but later decides to quit the game and cash out instead? The potential scenarios are endless.
Drawing the line will be difficult because most, if audited, will argue that the taxable event occurs when they cash out, not when they receive the virtual currency. While some may be telling the truth about playing for fun, others won’t.
Until guidance is issued, these audits will be no different than a typical audit. The problem is that most older tax auditors are likely not familiar with online gaming and so will have a difficult time understanding every transaction that goes on in an online game. They only thing they will look at is the cash deposits. Also, most who play for fun are not likely to keep records of their online transactions, will not understand that there were tax consequences. Finally, they probably won’t be able to pay the tax due since the IRS does not accept tax payments in the form of Lindens and PEDs.
It is uncertain whether there will be more online games with two-way convertible currencies. But before the intricacies of the tax laws are applied to online game activities, there must be a way to separate out those who play for fun compared to those who play with a real world profit motive. The IRS’s Notice 2014-21 should only apply to cryptocurrency transactions and not to in-game currencies because the currencies behave differently. Those who play for fun are easy to spot as they do not cash out their virtual cash. Also, auditing them will be difficult and may result in an unfair outcome. In a future column, I will look at some proposed solutions to this tax conundrum.
This column is also available at Above The Law.