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Fantasy Taxes, or How Much is that Pixie in the Window?

WARNING: This post contains a long and abstruse discussion of two of the geekiest subjects on the planet: taxation law and massively multiplayer online roleplaying games (MMORPGs). It's quite possible that this much pure geekdom in one place may cause aberrations in the laws of physics or adverse health consequences. The management expressly disclaims all liability for any and all such events. Further (as if this isn't obvious), this post does not constitute tax advice. If you begin to play the highly addictive game Kingdom of Loathing as a result of this post, don't blame me. So far as I know, no support group is available.

(If it's not obvious from the extended discussion, I find tax law fascinating.)

For the last month or so, Heidi Bond and I have been discussing a curious question of tax and online gaming, centering around her fascination with Kingdom of Loathing. It's old news that online games have spawned their own economies, that players sell virtual property online for real cash and even that some Chinese players organize in "gold factories", getting paid to do virtual drudgework so that the resulting booty can be sold to real-world aristocrats with less time on their hands.

I'll admit that I have only a passing acquaintance with Kingdom of Loathing, although the combination of Dungeons and Dragons with Douglas Adams never fails to make me smile. Unsurprisingly given that we're law students, Heidi and I both wondered at a question that has now been raised in the illustrious online pages of Legal Affairs. Given that people are getting rich, how much will the IRS tax you for a Sword of OrcMeat Sandwichmaking +1?

Oddly, this doesn't come up in your standard Federal Tax class. The Legal Affairs article mentions the possibility of getting a private letter ruling from the IRS, and I'm very tempted to try to write one. After all, literally millions could be riding on the answers. [1]

Simple Simon: Trades for Cash
Let's start with the uncontroversial. As Julian Dibbell relates in his article:

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.

Unsurprisingly, the fact that Dibbell sold magic swords doesn't stop the IRS from taking a cut. There might be some questions as to his basis and the best way of structuring the transaction (and whether it violates Ultima Online's terms of service), but once money has changed hands it's fairly obvious that a gain has been realized.

More Complex: In-Game Trades
Heidi makes the question more interesting: does earning items within the game constitute income that should be declared on one's tax return? As she describes the scenario:

If I [received a very valuable game item, a Talisman of Baio] and sold the Baio on eBay, I'd obviously have to pay taxes on the sale. And if I found a valuable diamond ring while walking through the woods, I'd have to pay taxes on my windfall. So is finding the Baio itself, in the game, a realization event? If I choose to keep the incredibly-useful Baio for myself, without selling it, do I have to pay taxes on the find? What about if I sell the Baio for meat [the KoL currency] in the Mall of Loathing? Is that a realization event?

The answer is not that we can't value the Baio; there's a pretty robust in-game player economy, and regular out-of-game meat sales on eBay. An in-game Baio is worth 98 million meat, and meat goes for about 700K per dollar, so Baios are probably worth about $140. This isn't a difficult valuation problem . . . .

The Legal Affairs article chronicles the author's quest to get an answer from the IRS, but ultimately reaches no conclusion, largely because the author doesn't want to pay to get a definitive answer from the Service.

My guess--and this is very much not legal advice, so if you're currently holding a Wand of Tax Enforcement +8 don't report me to the IRS--is that an in-game transaction cannot result in a realization event. Heidi's example implicitly relies upon treating currencies within a game ("meat" in Kingdom of Loathing) as the equivalent of currencies in the real world. I disagree. To oversimplify, nothing in a MMORPG is actually more than a piece of a mathematical equation that in some sense alters a storyline. For instance, if Player A buys a magical sword or even his own magical castle, he's really purchased a higher likelihood that the calculation involved in his beating up an orc will succeed, or a lower likelihood that someone else will steal his stuff. (That stuff is, in turn, just another set of alterations in specific equations. In a graphical MMORPG, he's also buying the right to look at the graphics that go with the item, I suppose, but let's leave that aside for a bit.) Online "currency" is sort of like a very flexible magical item: with enough of it, you can turn one set of equation-altering objects into another.

Buying and selling objects using virtual currency is simply making a strategic move in the game itself. This is no different from (say) rolling a six in Sorry! or purchasing a hotel in Monopoly. No one would consider a taxable event, even though it may make the player happy (or even win the game). By contrast, if I sell a game object for cash, I am performing a service within the game that is not contemplated by its rules in exchange for goods or services outside the game. [2]

That's where I'd draw the line, but I'm just a student. As for precedent, there's not a lot out there to analyze. In Legal Affairs, Professor Richard Schmalbeck of Duke University School of Law cites to the old casebook favorite Zarin v. Commissioner, 916 F.2d 110 (3d Cir. 1990). David Zarin, a professional gambler, got in over his head to the tune of some $3.43 million. He'd gambled on credit with the casino, but apparently he had better luck at the negotiating table after his checks bounced, because he settled for a mere $500,000. Any joy at this outcome was crushed when the IRS determined that far from losing, Zarin had gained $2.9 million in discharged indebtedness income. Much of the dispute involved whether the chips Zarin received for his loan constituted cash that he used to purchase chips (and thus were worth $3.4 million) or were a purchase money loan for a given amount of gambling, and were only worth the enforceable debt. Both the tax court and the 3rd Circuit returned divided opinions.

I mention the case at length because Prof. Schmalbeck is described in the article (though not quoted) as suggesting this case could lead to taxation of ingame MMORPG gains. The case itself, however, doesn't primarily deal with transactions in chips during the course of the craps games, but rather their initial purchase. Although it's the closest I can find, it's not really on point. Closer might be Collins v. Commissioner, T.C. Memo 1992-478 (1992), which dealt with pari mutuel racetrack betting slips, but the connection is still tenuous. In each case, the taxable transaction was the exchange of chips or tickets for cash, not purely an in-game transfer of "wealth." They don't seem to counsel against the distinction above.

I quite like my theoretical dividing line, especially as the result is instinctively satisfying. If nothing else, taxing magic items would be an administrative nightmare to enforce. On the other hand, I suppose some auditors would have significantly more fun, particularly if they got to roam the game worlds looking for tax cheats on Service time.[2]

More Complex Still: Between Game Transactions
My house of cards threatens to fall over when I try to support a more complex fact pattern. Suppose that Heidi primarily plays Kingdom of Loathing and I mostly dabble in World of Warcraft, but we each have a presence in both games. She owns the Talisman of Baio and I've crafted a very nice Elvish Sword. Bored with our respective hobbies, we each decide to switch worlds. What are the tax consequences if:

a) Heidi agrees to give my KoL character the Talisman if I give her the Sword?
b) Deciding to drop out of our primary games, I give her the passwords to my WoW character and vice-versa?

According to my analysis above, these would both be taxable events. Although we're playing in both games, the trade is outside the rules of either, and the trade isn't really a game event. Rather than trading in-game strategic advantage like a meat-for-Baio exchange, we've entered into a slightly contracted version of two item-for-money exchanges. Of course, we still have the same administrative nightmare for the taxman: given that I made the sword but Heidi found the Baio, what is our basis for the sale? Given that no real record is available, how will this transaction get audited? But there's nothing in my theory to provide us with a Shield of Tax Relief.

The alternative would be to say that any trade between any two MMORPGs does not constitute a taxable event, but my gut tells me that this is rife for abuse. Indeed, I can quickly see the outlines of a scheme or two for tax evasion, money laundering or other accounting gimmickery, especially if the value of the "currencies" in each realm are subject to considerable fluctuation. (Could one make a living speculating in online currencies, only being taxed on the last "real world" transaction?) Nevertheless, an elegant solution eludes me at the moment, so I think I'll leave any better definition for my readers in the comments.

(Note: The comments may block the word "poker." If you get error messages after referencing it in your comments, please just find a way around this, such as referring to it as P---- or whatever creative means you wish.)

[1]: Sadly, I'm not enough of a player to have anything taxable, and until I'm a lawyer I'm probably only able to request an answer on my behalf. I'd really appreciate it if a bigger KoL player would help me engineer such a transaction, for instance by buying my spooky staff for some insane amount.

[2]: An interesting question would be whether or not buying or selling things in a game that itself contemplated exchange to real dollars would constitute an accession to wealth. Assume, for instance, that Everquest charges $15/month access, but will allow you to trade a certain amount of gold earned in game for free months of service. (That's actually a suicidal business model, of course.) Assuming I'm right, would it be possible to create trades that would constitute realization events once someone had sold enough items to get a free month?

[3]: I've always wondered if tax auditors compete for the most interesting or unique audits. After any number of relatively similar small businesses, would someone really relish trying to find the Everquest tax cheat, or for that matter investigating Nevada brothels or felony rings?


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Well, if there is a robust market in fantasy world gold, then trading a certain amount for free service is actually an event that keeps the price supported (and could support the service selling gold on e-bay). I'm not sure the move is a bad one for a business model, depending on how you arbitrage values.

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