Annette Nellen
Annette Nellen
Real taxes in the virtual economy

When does virtual currency have real-world tax consequences?

August 15, 2013
by Annette Nellen, Esq., CPA

The internet allows people to engage in traditional transactions, such as buying and selling goods, in a different format. Ordering equipment online, for example, is similar to using a paper invoice. But the online format offers efficiency, such as quicker processing and immediate payment. The internet also allows people to engage in transactions that exist only in the virtual world. For example, you can play a game with strangers without any need to even know their locations. You can create an avatar that can interact with other avatars and use virtual currency to buy virtual property.

The infinitude of virtual transactions raises real-world tax issues. For example, if your avatar sells its virtual land for more virtual money than it purchased the virtual land for, is there a taxable gain? Does it only matter if that virtual money can be converted into real currency (the same type used to pay taxes)? What if the virtual currency, such as Linden dollars (used in Second Life, an online virtual world where users create avatars and participate in a virtual society) can be converted into Bitcoin or some other recognized virtual currency that is used in real-world transactions?

While the tax issues of virtual economies are not new, specific tax guidance does not exist, and new tax questions can arise as virtual economies become more intricate. This article provides a background on virtual economies, some government actions, and key tax issues.


In a May 2013 report, the U.S. Government Accountability Office (GAO) noted the lack of legal definitions for a virtual economy or currency (GAO Report, Virtual Economies and Currencies: Additional IRS Guidance Could Reduce Tax Compliance Risks, GAO-13-516, May 2013, page 3). Guidance released in March 2013 from the Financial Crimes Enforcement Network (FinCEN) of the Treasury Department also offers insights into the virtual world (FIN-2013-G001 (3/18/13)). These two sources yield the following definitions:

  • Virtual economy: “Economic activities among a community of entities that interact within a virtual setting, such as an online, multi-user game” (GAO-13-516, page 3). A “closed” virtual economy does not interact with the “real” economy. That is, the currency or medium of exchange used in the virtual economy cannot be converted into real dollars or real goods and services or vice versa. This would be similar to playing a board game, such as Monopoly, with “play money.” Alternatively, an “open” virtual economy allows virtual currency or items to be exchanged for real currency or items.
  • Virtual currency: Per the FinCEN release, “virtual” currency can be defined as a “medium of exchange” without the “attributes of real currency” in that it is not legal tender. FinCEN’s 2013 guidance addresses “convertible virtual currency” that “either has an equivalent value in real currency, or acts as a substitute for real currency.” An example of a virtual currency is Bitcoin, defined in the GAO report as “a decentralized digital currency that uses a peer-to-peer computer network to move bitcoins around the world” (page 5). And while a virtual currency is not legal tender, last week a federal district court held that for purposes of defining an investment contract under the securities law, “Bitcoin is a currency or form of money” (Securities and Exchange Comm'n v. Shavers, No. 4:13-CV-416 (E.D. Tex. 8/6/13), slip op. at 3).

Government actions

Several government agencies have addressed some aspect of virtual currency. A statement by FinCEN Director Jennifer Shasky Calvery discusses the regulatory and promotional roles federal agencies might have:

I will not deny that there are some troublesome providers out there. But, that is balanced by a recognition of the innovation these virtual currencies provide, and the financial inclusion that they might offer society. A whole host of emerging technologies in the financial sector have proven their capacity to empower customers, encourage the development of innovative financial products, and expand access to financial services. And we want these advances to continue. However, equally important is the need to ensure integrity and transparency. [Remarks delivered June 13, 2013, “The Virtual Economy: Potential, Perplexities and Promises.”]

A brief summary of selected government actions provides an overview of issues that can exist with any virtual economy or currency.

  • Joint Economic Committee: In October 2006, the congressional Joint Economic Committee issued a press release, “Virtual Economies Need Clarification, Not More Taxes.” It noted that online games were growing in popularity and that they raised both tax and intellectual property rights issues. It indicated that the committee had started an examination of the policy issues in virtual economies such as Second Life or World of Warcraft. No report was released.
  • IRS national taxpayer advocate (NTA): The 2008 Annual Report to Congress from the NTA included a section titled, “The IRS Should Proactively Address Emerging Issues Such as Those Arising From ‘Virtual Worlds’” (pages 213–226). This report provided background and data on the size and nature of virtual worlds, as well as tax issues in need of guidance. Tax issues included when an online game player’s winnings would be taxable, treatment of the receipt of hard-to-value property, and reporting obligations.
  • IRS: The IRS has a webpage titled “Tax Consequences of Virtual World Transactions.” It provides little information, referring visitors only to IRS general information on bartering, gambling, business and hobby income, and online auctions. Letter Ruling 200532025 explains Form 1099 rules (Sec. 6041 reporting requirements) for an operator of a website offering game tournaments where players pay entry fees and can win cash or in-kind prizes. The IRS concluded that the activity did not involve wagering and the operator was required to issue Form 1099-MISC, Miscellaneous Income, to any player who was paid $600 or more in a year, after deducting the fee charged to play the games won (but not the fees paid for games lost).
  • Treasury Department/FinCEN: In March 2013, FinCEN issued interpretive guidance on how the Bank Secrecy Act applies to “users,” “administrators,” and “exchangers”—terms defined in the guidance depending on the role each plays in a virtual currency transaction (FIN-2013-G001).
  • Criminal enforcement: A July 22, 2008, press release from the U.S. Secret Service describes an investigation involving digital currency, money laundering, and illegal money transmitting that led to a criminal conviction. A May 28, 2013, press release from the Department of Justice describes a vast money-laundering scheme involving virtual currency on a global scale. Over $6 billion was laundered by more than 1 million users worldwide in about 55 million transactions, “virtually all of which were illegal.” The company’s founders and officers were arrested in Spain and Costa Rica, as well as in the United States. The scheme was uncovered through efforts of the Secret Service, Homeland Security, and the IRS. These money-laundering schemes illustrate a downside of virtual currency, which allow anonymous transactions and make it difficult to track the flow of money.
  • SEC: In July 2013, the SEC issued an “investor alert” on Ponzi schemes involving virtual currency. This alert likely was in response to an earlier press release about the SEC charging someone with promoting a Ponzi scheme involving “Bitcoin-denominated investments” (SEC Press Release 2013-132 (7/23/13)).

Tax issues

Sec. 61 provides that “gross income means all income from whatever source derived.” Regs. Sec. 1.61-1(a) provides that income may be in any form—money, property, or services. In Glenshaw Glass Co., 348 U.S. 426 (1955), the Supreme Court defined gross income as “accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” “Generally, taxpayers realize income upon the occurrence of a specific realization event and are not otherwise taxed merely for the appreciation in value of assets. See, e.g., Eisner v. Macomber, 252 U.S. 189 (1919)” (Letter Ruling 201122007). Generally, a realization event occurs when property is converted into cash or other property via a sale or other disposition (see Sec. 1001 and regulations).

Some examples of realized income in a virtual setting:

  • Selling virtual currency or goods (such as an avatar or game piece) for cash or other property. These sales may be permitted on auction sites, such as eBay, depending on the terms of service agreements for the virtual economy and the auction site.
  • Mining Bitcoins (users’ computers solve complex mathematical equations and then are awarded Bitcoins). Because this virtual currency can be converted into cash or other property and used to buy goods and services, receiving them is an accession to wealth (income).
  • Using virtual currency to play games or buy and sell virtual goods and services and later converting the virtual currency to cash or other property with a value greater than the amount originally invested.
  • Providing consulting services and allowing customers to pay you with a virtual currency that can either be used to purchase other goods or services or converted into cash (similar to bartering).

Some tax issues in need of guidance:

  • When does a taxpayer realize income from transactions in virtual currency or goods? For example, on July 1, 2011, Sarah paid $50 to play in virtual economy X, receiving 100 Playcoins. Sarah used these Playcoins over the next two years to buy and sell virtual goods and play games. Sarah left X in August 2013, cashing in her Playcoins for $140. Per the income rules cited earlier, Sarah appears to have $90 of income for 2013. Guidance is needed to address any exception to this treatment as well as requirements to track income if Sarah had been buying and selling Playcoins periodically while playing in X.
  • The reporting obligations of operators of virtual worlds, such as X in the above example.
  • The reporting obligations of businesses that pay others using a virtual currency. For example, how and when should the transaction be valued?
  • The reporting obligations for entities that exchange virtual currencies for real currency.
  • Valuation guidelines for transfers of virtual currencies and goods, including by gift or bequest.

The GAO report suggests that the IRS also provide general information on its website to help taxpayers who are trying to understand the tax obligations of their virtual economy activities. The GAO report (pages 4–5) describes the virtual economy and currency transactions as follows:

  • Closed-flow: The virtual currency can be exchanged only for virtual goods and services (not for cash or real goods or services). This is similar to playing Monopoly where no real currency is involved and your play money only yields you play properties and pretend rent payments. There should be no tax consequences in a closed-flow system.
  • Open-flow: Virtual currency can be exchanged for real currency, real goods and services, and virtual goods and services. Virtual economy X in the earlier example is an open-flow system.
  • Hybrid: It may be possible to purchase virtual currency with real currency, but not to reverse that transaction. The virtual currency can be used to purchase virtual goods and services and perhaps even real goods and services. A third-party exchange might be usable to convert virtual items into real currency.

The GAO framework should serve as a useful one to enable the IRS to provide guidance on the tax consequences for the operators, players, buyers, and sellers using virtual currency, goods, and services in the hybrid and open-flow systems.

Looking forward

Virtual economies and currencies are more likely to expand than go away. There are tax issues that need clarification or guidance to enable all parties involved with a virtual economy and its currency and goods to comply with the tax laws. These issues are not just problems for the IRS; they will exist for state income taxes as well. In addition, states may need to issue guidance regarding valuation, timing, and reporting for sales taxes as well as property taxes. Tax agencies might even find it beneficial to provide this guidance not only in the real world, but also by setting up locations in virtual economies or worlds.

For further information


Other virtual currencies and related information (not a complete list):

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Annette Nellen, CPA, Esq., is a tax professor and Director of the MST Program at San José State University. Nellen is an active member of the tax sections of the AICPA, ABA, and California State Bar. She is the immediate past chair of the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax policy and reform and a blog.