Heroes Pay Taxes: What You Need to Know About the IRS & Online Games

We've been playing games online since the dawn of the Internet. However, making real-world money in non-gambling online games is a relatively recent development. Legitimate practices (like engaging in in-game trade), as well as illegitimate ones (such as gold farming), are helping some players accumulate real-world wealth. But as digital currencies like Bitcoin have begun gaining popularity, virtual transactions of all types — including those in games — are facing more government scrutiny.

Because the IRS has been pretty vague about what we're supposed to do with the millions our orc shaman has accrued for the Horde over the years, we decided to consult an accountant. We were not prepared for the truth: it turns out Uncle Sam doesn't take too kindly to unreported income from hobbies, even virtual ones! Read on to find out how you can avoid such epic tax evasion.

Virtual Worlds, Real Dollars

Two online games in particular, Diablo III and EVE Online, have raised big questions about taxes. When it first launched, online dungeon-crawler Diablo III featured a real-money auction house, where players could purchase in-game items from other players. Blizzard shut down its Diablo III auction system on March 18, but not before the Government Accountability Office (GAO) raised questions about the income generated by these transactions in a report called "Virtual Economies and Currencies."

The Diablo III economy was "considered to have an 'open-flow system' because you [could] easily exchange in-game currency for real-world money," according to WOW Insider. Because it was (theoretically) easy for gamers to generate large amounts of real money in auction house transactions, the GAO warned players that they might be earning taxable income. However, "the report admits that actually calculating the amount of profit you get from playing, especially when there's a monthly subscription fee in the mix, would be 'difficult for the unsophisticated taxpayer.'"

Where Diablo III players might have to worry about reporting income, EVE Online players may want to know if they can report a big loss. This massively multiplayer online role-playing game (MMORPG) made news recently after players lost ships worth around $300,000 during a virtual space battle. EVE allows players to trade an in-game item called PLEX that can be redeemed for playtime. PLEX can also be purchased with cash, so there's a rough PLEX-to-dollar exchange rate, according to Wired. "Currently, $15 to $20 buys one PLEX, which can be sold for about 625 million ISK [the in-game currency], making $1 worth about 35 million ISK. That's how it's possible to lose digital assets worth more than $300,000 in the real world." The PLEX gives EVE Online an open-flow system similar to Diablo III's in which players can apparently lose huge amounts of money. But can they claim those losses on a tax return?

A Profitable Hobby Is a Taxable Hobby

While the IRS does have a page dedicated to helping online gamers understand their tax obligations, we wanted to get some more detailed answers on the intricacies of taxes and gaming. "Offering advice on virtual world transactions (such as those found in MMORPGs) is tricky business, considering the IRS itself has not developed any regulations or rulings that can be directly relied on for tax compliance," said Elisabeth Ashley, a Certified Public Accountant from Valparaiso, Florida. "Instead, the IRS points to existing tax guidance for hobby, business, gambling, and barter income."

According to Ashley, if you're making real money in a game, then that money is taxable income and it should be reported. "In the case of video game transactions, this is usually hobby income and subject only to income taxes, not self-employment taxes," she said. The good news is that if you've lost money in a big space battle, then you might be able to deduct it: "Hobby expenses (up to your total hobby income) can be deducted on Schedule A if you itemize deductions."

When Gamers Become Businessmen

But what if you're a big-time player, handling hundreds or even thousands of dollars worth of in-game transactions? In that case, your gaming could be less of a hobby and more of a business — which means you'd be subject to different tax laws. "If your 'hobby' is regularly generating significant income exceeding expenses, the IRS may reclassify your hobby as a business and begin assessing self-employment taxes of 15.3%," Ashley said. However, "self-employment taxes do not come into play unless you earn over $400 of net profit" after deducting expenses like subscription fees.

That said, treating your online gaming habit as a business could be a boon if you experience a big loss, like the EVE Online players. "If your gaming is a hobby, the loss could only be deducted up to your hobby income," according to Ashley. "If you are gaming as a for-profit business, then the full loss could be taken." However, Ashley warned that "the IRS takes a hard look at businesses that generate regular losses and seem like they are actually hobbies performed for personal pleasure. Take care that the activity is run in a professional, business-like manner."

Whether you're reporting gaming income as a hobbyist or a self-employed businessperson, it's important to protect yourself in case you're audited. Since you're not going to get a W-2 from a game developer, it's up to you to keep track of your income and losses. That's not as daunting as it sounds; Ashley said you should "keep good records, including bank statements and receipts, to justify your income and expense reporting. The burden of proof will be on you to prove whether or not your gaming was a hobby or a business [in the event of an audit]."

While players may have to deal with a certain amount of educated guesswork, Ashley believes that gamers won't be left twisting in the wind for long. "With the rise of Bitcoin, the IRS continues to study virtual currencies and should eventually issue tax guidance on the issue," she said. "That guidance will hopefully address other virtual transactions as well, including in online games."

IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.