CryptoKitties are Collectible, Breedable, Adorable and ... TAXABLE!

You may have heard cats have nine lives, but in the end they do not escape the certainty of death and taxes.

Many of us have indulged in the game of CryptoKittens. Some of us may even have been lucky enough to turn a real profit breeding and selling them. In the U.S., this profit could be taxable.

Background

CryptoKitties is coined as "Beanie Babies" of the blockchain. The cute, cuddly game is also famous for being one of the first distributed applications on Ethereum that significant clogged the network.

Each CryptoKitten is a Smart Contract that runs on the Ethereum network. Each kitten can be bought, sold, leased out for breeding through "siring", gifted or bred into new kittens. But the story starts with the initial genesis block of CryptoKitties:

Using Smart Contract technology, in late 2017, a group of generation zero kittens were released on the decentralized application. Once the generation zero kittens were released, they were available to be purchased by users of the application. Every 15 minutes, new generation zero kittens are released into the wild until 50,000 total kittens in total are released.

The combination of generation zero kittens through "breeding" results in the creation of new kittens ("Generation 1, 2, 3 etc."). Each kitten resulting from the breeding is a unique Smart Contract with unique traits. The unique traits of each smart contract are represented/materialized through a unique pictorial avatar of each kitten, as well as a bio & description of unique "Cattributes" underneath the avatar.

More information is provided in the terms of use: https://www.cryptokitties.co/terms-of-use

Tax Law

The IRS in 2014 determined that virtual currencies are subject to income tax if they can be:

• (1) Traded among users
• (2) Exchange for U.S. dollars or other currencies (including taxable virtual currencies).

https://www.irs.gov/pub/irs-drop/n-14-21.pdf

Impact of IRS Guidance on CryptoKitties

Because each kitten is a Smart Contract, below are some general considerations for CryptoKitty users in the U.S.:

• CryptoKitties ("Kitties or Kitten for short") can be traded among users and bought/sold for Ethereum. As Ethereum can be bought/sold for U.S. dollars or for Bitcoin, and is also traded among users, Ethereum is a convertible virtual currency. Therefore, CryptoKitties smart contracts are convertible virtual currencies.
• A gain/loss on the sale of a Kitten for Ethereum is based on the U.S. dollar value of Ethereum on the date of sale, minus the U.S. taxpayer's cost basis in the CryptoKitten, and minus the exchange listing fee.
• The U.S. dollar value of Ethereum spent to acquire a CryptoKitty, on the date of purchase, is the tax basis in the original Kitten. Also, the U.S. dollar value of the Ethereum spent on listing fees is a reduction in the gain. However, please note these two uses of Ethereum also create at taxable gain on the sale of the Ethereum to fund a Kitten purchase or listing fee.
• When two CryptoKitties are bred to create a new kitty, that new Kitty is a smart contract. The taxpayer will need to determine whether to allocate a portion of the cost basis of the two original kitties to the new kitty; or whether to treat the newly bred kitty as having "$0 tax basis." Contact a tax advisor to determine how you should do this.
• If a gain is realized on the sale of a kitten, there is a chance the gain is treated as ordinary income if the user is routinely selling kittens. This is because the cryptocurrency is possibly treated as "inventory" for U.S. tax purposes (the IRS's 2014-21 notice alluded to this as a possibility). This would mean that the favorable lower capital gain rates are unavailable. However, please note this depends on the nature of a person's involvement in CryptoKitties. Also, the income could also be subject to self-employment income tax and state income taxes. Contact a tax advisor to determine how you should handle this!
• If you are like me, you bought CryptoKitties during the hype and can only sell the CryptoKittens at a loss. The loss would potentially be considered a nondeductible "hobby loss" or nondeductible "personal loss" unless the taxpayer can substantiate this activity was an investment with the intention for the production of income, or if CryptoKitten trading is their trade/business which might be a stretch. Personally, I am not going to try and take any loss if I eventually sell my cryptokittens at a loss as I got involved in the game for fun, a personal nature. However, I will report a gain if I ever have one (my gen 8/11 cats aren't very valuable though and haven't sold!)

Example

On January 1, Jon bought 1 Ethereum for $500. On January 15th, when Ethereum was worth $800, she used 0.25 Ethereum to buy a Generation 1 kitty (Kitten A) with poor traits, 0.75 Ethereum on a Generation 1 kitty (Kitten B) with rare traits.

• Jon has a gain on the sale of her Ethereum of $300 ($800 value of 1 Ethereum spent on kittens less cost basis of $500). This ignores small transaction costs which would reduce his gain.
• Jon's tax basis in Kitten A is $200 (0.25 X $800) and Jon's tax basis in Kitten B is $600 (0.75 X $800).

Jon shortly after breeds 3 kittens in the month of January (Kittens C, D, and E). On February 1, 2017, Jon sells Kitten C for 0.4 Eth (when 1 Eth = $1,000), Kitten D for 0.2 Eth (when 1 Eth = $1,000) and Kitten E for 5 Eth (when 1 Eth = $1,100). Jon does not sell Kittens A or B. The transaction fee for each sale is $15 worth of ETH.

• Jon has a total selling price of $400 for Kitten C (0.4 x $1,000); $200 for Kitten D (0.2 X $1,000); and $5,500 for Kitten E (5 x $1,100) - total of $6,100.
• Jon's listing cost are $45 ($15 cost x 3 sales). Jon bought the Eth used on listing fees on the same day he listed the kittens; so his gain/loss on sale of his Eth to pay $45 in transaction fees is ignored for this example as it expected to be small.
• Jon's tax advisor determines he has zero tax basis in these kittens as they have been created out of thin air. It's not 100% certain, however this example will roll with the assumption the basis = $0.
• Jon's gain is $6,055 ($6,100 - $45). Jon plans to report this gain on his tax return, but he is contacting a tax advisor to help him determine if the gain is ordinary or capital, and also if it is subject to self employment and state taxes, etc.
• Jon continue to have $800 total basis in Kittens A and B. This could create a loss if Kitten A and B are sold. If a sale occurs in 2018, potentially Jon could use the loss from Kittens A/B to offset his $6,055 gain from the sale of Kittens C, D and E.

Takeaway

CryptoKitten taxation uncertainty is just another reason for anyone involved in crypto to contact a tax advisor.

Picture Credit
https://pixabay.com/en/users/Ty_Swartz-617282/ (white cat)
https://pixabay.com/en/users/stevepb-282134/ (paper)
https://pixabay.com/en/users/Alexas_Fotos-686414/ (rolled over cat)
https://pixabay.com/en/users/Jan-Mallander-615621/ (multiple kittens)

Disclaimer: This series contains general discussion of U.S. taxes in a developing and unclear area of tax law. As always, you should consult your own tax advisor in your jurisdiction to determine your specific situation as this is not personal advice; and consider any future guidance by the Congress/IRS after the date of this article. Under Circular 230 to the extent it applies, this article cannot be used or relied on to avoid any tax or penalties in the U.S., its States or any other jurisdictions. This post/book does not create a client relationship between the author and the reader. I hold a few CryptoKitten smart contracts through my account, however my understanding is the trademarks/copyrights are all solely the property of Launch Labs, Inc. d/b/a Axiom Zen (For information on the trademarks and copyrights see: https://www.cryptokitties.co/terms-of-use). Therefore, I have not included pictures of my kittens.