If you slay an online dragon and receive virtual treasure that has "real world" value, the Internal Revenue Service might decide that you owe the government taxes on your "profit".
So if virtual loot can be sold for real money and therefore has real value, what's to stop the government from concluding that every time a fallen virtual monster gives up its prize, or a fistful of Linden dollars is traded for a virtual hair weave, a taxable event has occurred?Don't ask the IRS. Pressed for an official opinion on the taxability of virtual trades, IRS spokesperson Nancy Mathis would say, via e-mail, only that "whether exchanges constitute bartering depends on the facts and circumstances of each case." As to whether that magic helmet won from a slain dragon is a taxable prize, the answer was similarly noncommittal. "[The] bottom line," Mathis wrote, "is this: You can receive income in the form of money, property, or services. Generally, your income is taxable unless it is specifically exempted by law."
Translation: The IRS is keeping its options open. And according to former IRS lawyer Bryan Camp, now a professor of tax law at Texas Tech, those options definitely include taxing virtual gold. "Section 61 of the Internal Revenue Code says that gross income is any income received from any source," says Camp. "And if someone in the IRS thinks that a [virtual-world] transaction represents the receipt of either cash or services or property, and that has a fair market value, then yes, that's going to be income."
I guess what would make the taxability of virtual "profit" strange is that the context within which this "wealth" is created is completely artificial and self-contained. Unlike, say, ore mined out of the ground, a virtual magic sword has no intrinsic usefulness aside from the virtual context in which it was won. The game company that controls that context could manipulate the scarcity or properties of that treasure at will, or even shut down the entire game overnight.
The value is illusory... but is it any more illusory than value attached to rare baseball cards? Those at least can't be as easily manipulated by their creators as can virtual items. Furthermore, when it comes to baseball cards at least the holders of the cards actually own them. Virtual treasure exists only within a game company's computer database, so who really owns that virtual magic sword? The player whose character currently controls its in-game use, or the game company that owns the database that holds the bytes that constitute the sword's material existence?
"The value is illusory..."
All value is "illusory". Anything is only worth as much as people think it's worth. You can spend a lot of money/effort/time/resources making something and then fail to convince me that I should buy it for as much as you're charging me. And on the opposite end of that spectrum, you could sell your video-game gold on eBay and make real money. So the difference between virtual goods and real goods is only the fact that the environment in which the virtual goods exist is under the control of a game company:
"Virtual treasure exists only within a game company's computer database, so who really owns that virtual magic sword?"
Read the Terms Of Use - the contract that the game company agrees with, that sets the terms of who owns what, who has what duties towards whom, who can expect what, etc.
Just because something "only" exists within a database, doesn't mean that the owner of the database does not have a duty to me to preserve that thing. My bank accounts exist "only" within databases, but the contract I have signed with my banks allow me to not be afraid of my bank accounts disappearing. The banks have a duty to me to preserve their value (in dollars). Some game companies are better at taking on this duty than others. Second Life is quite exemplary - it even lets you keep Intellectual Property rights to things you create in-game, and allows you to sell your creations, and to copy-protect them so that only you can make copies of them. So, depending on the User Agreement / Terms Of Service, sometimes you do own that magic sword. And sometimes you don't. You might argue that the IRS should take this into consideration when deciding whether to tax you, or the game company, for the generation of this value. But in the end (and the IRS would agree), the sword effectively belongs to whomever can sell it on eBay. (Or, being more strict, to whomever can go on eBay and charge for then going into the game and giving the sword to another person's avatar).
The IRS is right. If you do some work and get money back, then that's taxable income. The only real question is how liquid of a market you need before the IRS is willing to wait to find out whether you will actually turn your in-game stuff into cash. But if you turn it into cash, then I can't see any decent argument that it isn't taxable income. Though I would also deduct against that income the cost of the game and any monthly fees for playing.