The IRS could start taxing virtual environments like Second Life and World of Warcraft to get a cut of the real dollars that are spent on potions, armor and weapons in the online gaming world.

National Taxpayer Advocate Nina Olson suggested the IRS should proactively look into issuing guidance for taxpayers who are already concerned the taxman might one day audit these transactions.

In her recently issued annual report to Congress, Olson noted that in 2005, about $1 billion in real money changed hands in virtual worlds, and that some businesses now accept virtual dollars, such as the Linden dollars used in Linden Lab's Second Life, in exchange for real property and services. In 2006, about 3,100 virtual residents of Second Life had average revenues of $20,000 in real dollars.

"Economic activities with virtual worlds may present an emerging area of noncompliance, in part because the IRS has not issued guidance about whether and how taxpayers should report such activities," she wrote.

While the IRS has not yet issued any specific guidance on the subject, Olson believes the time is ripe to answer some nagging questions. Among them is the perplexing matter of whether a person is subject to tax each time he or she acquires virtual property, or when a person exchanges one virtual property for another or for virtual currency.

For example, what if you happened to slay a dragon and won its hoard of gold and jewels? Would you be required to pay taxes on it? The IRS might decide one day that the answer is yes.

Indeed, accountants are already starting to set up shop in virtual worlds. For instance, the Maryland Association of CPAs set up CPA Island on Second Life in 2007 (see CPAs Find an Island on Second Life). While not too many firms have relocated to the island yet, CPA Island might one day become a sanctuary for Second Lifers seeking help on their taxes.

The IRS told Olson that it recognizes the need to address the tax aspects of new e-business activities and in 2003 set up an E-Business and Emerging Issues policy group to address similar issues. The IRS pointed out that it has released guidance related to online auctions, bartering and electronic businesses. That guidance states that if taxpayers spend more money on an activity than they receive, they cannot claim a loss on their tax return. Conversely, if a taxpayer receives more money than is spent, then the taxpayer may be required to report taxable income.

Olson said this kind of guidance is helpful, but she isn't letting the IRS off the hook. She still wants the IRS to issue specific guidance on transactions involving virtual items. Whether the guidance needs to be specifically about issues involving virtual swords and wands will have to wait for another day, and maybe for a virtual avatar of an IRS commissioner to decide.

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