Virtual Money, Real Pizza

A recent news story reports that Second Life residents will soon be able to order -- from within SL -- real pizza for delivery to their home. (This ability was once available for players of Everquest, but has been discontinued.) More importantly, residents can pay for the pizza with Linden dollars.

Now, in and of itself, this is not a major development that will dramatically change the nature of virtual worlds. Nonetheless, this service does cross a meaningful line that opens the door for much more complex treatment of virtual worlds: using virtual currency for the purchase of real goods or services.

Suppose I have a Second Life business that generates Linden dollar income for me. Suppose also that I cash out all my profit into US$, and dutifully report that income on my tax return. Now, however, if I spend $20 on this virtual pizza service, does that $20 escape tax-free because it never gets converted to US$. In the real world, with a traditional salary, I could also spend $20, but that $20 is still reported as part of my AGI. (Obviously, the tax on $20 is pretty trivial, but the underlying principle is what’s important. What if I buy a car with Linden dollars?)

What is the proper tax treatment of real-world purchases using virtual currency? Should I report $20 as ordinary income? As barter income? If I do, that could raise my compliance costs since I have to file Schedule C. What about horizontal equity – the tax treatment of individuals in similar economic circumstances? If I don’t report the $20, but my buddy who spends $20 on pizza using salary income does, then I will end up paying less in taxes, even if he and I make exactly the same amount of income.