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The Virtual Taxman Cometh

12/4/06

With the rise of massive virtual worlds like Second Life, EverQuest, World of Warcraft and There, we expect one day to initiate an M&A transaction featuring the sale of virtual assets.

More immediate are the concerns of tax collectors -- and the politicians urging them forward -- who are trying to figure out how to extract their “fair share” of virtual world action. CNET’s recent article on the subject jumpstarts the debate.

We can see why the taxman is concerned. Some virtual world transactions are realized in the form of real-world cash and the values are climbing. And even while most transactions are conducted in virtual dollars (thereby dodging the taxing authority’s definition of income), some players like “real-estate developer” Ailin Graef are rumored to have become the virtual equivalent of real-world millionaires. Tax authorities probably consider virtual assets like hers taxable depending on the player entity (e.g., if she were operating through a corporation) or the circumstances (e.g., estate taxes due upon her death).

Of course, many of these assets have been built by the unbilled and undocumented labors of their owners who spent hours glued to PC’s constructing the components of a virtual castle or trading their way from a scooter to a light-speed spacecraft. A famous example of such an endeavor is that of Kyle MacDonald, a blogger who last Spring began a series of trades commencing with a paperclip and culminating in a real-world house. Should MacDonald later sell this house, the IRS would almost certainly consider the entire proceeds to be taxable. If it cost him nothing but time to acquire the house, then his basis on its sale would be zero.

But that’s just the beginning of the confusion. Even before he sells it or dies, is his receipt of the house considered “income”? What about long- versus short-term capital gains, the appropriate tax treatment when the taxing jurisdictions are on different sides of the globe, and how to value assets when value is expressed in a thinly-traded virtual world’s currency?

We anticipate that there will be serious attempts to impose the impossibly complex US tax code on virtual worlds with most of the attention directed to cases where virtual assets are translated into their real-world equivalents.

But even if one heroically expects virtual entrepreneurs to have the sophistication and motivation to understand and report their tax obligations, good luck on enforcement. Try tracking down the anonymous seller of a virtual mansion through a blind bank account in the Cayman Islands. Such is the difficulty of taxing virtual transactions and assets, it may even throw gasoline on the bonfire of virtual industry growth. And with luck, the industry's rise may eventually force simplification of the tax codes that we real-worlders labor under.

As for real-world lawyers and politicians, they fortunately seem to have been replaced -- at least for the moment -- by benevolent administrators, the virtual world owners.

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Update: See this 1/29/07 PC World article on how Congress looks to be inching closer to figuring out how to get its hands on your virtual largess.


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