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

in #cryptokitties3 years ago (edited)

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.

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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

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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

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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!)

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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.

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I kinda thought this, but didn't want to be Gloomy Gus, publican edition. Plus it would only be speculation on my part.

The issue is sort of like MTG cards (or any other kind of trading card, really). This layman is reasonably certain that trading said cards is a taxable event, even if one that is generally ignored. The difference here is that everyone, including the IRS, has an indestructible virtual paper trail of every crypto-collectible interaction.

This is, among other reasons, why I never involved myself with CryptoKitties. Hopefully some reasonable Congress will pass some reasonable de minimis crypto exception to allow this sort of thing to flourish without having to worry about the taxes of it all.

This is, among other reasons, why I never involved myself with CryptoKitties.

Everyone with a steemit account is in for a world of hurt by any stretch of the imagination. I probably have hundreds of taxable events a week easily on my steemit account. Cryptokitties is nothing compared to that.

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

Well, this means that gaming in general may begin to come into tax law. For example, that guy who recently got a CS:GO weapon skin worth 61 grand...

Correct - great points. I have a plan for a digital currencies - gaming edition that will center around WoW and Diablo (can cover the topic of skins too). Some great discussion with @not-a-bird in this thread:

https://steemit.com/taxes/@jesta/steem-rewards-history-csv-exporter-via-steemdata-com

I really like that first kitten picture.

The Pilgrims were the first to introduce cats to North America.

Cat memes are welcome in this thread.

The Amur leopard is one of the most endangered animals in the world.

Cats are the world's most popular pets, outnumbering dogs by as many as three to one

The earliest ancestor of the modern cat lived about 30 million years ago. Scientists called it the Proailurus, which means “first cat” in Greek. The group of animals that pet cats belong to emerged around 12 million years ago.

A domestic cat can run at speeds of 30 mph.

With passage of time many things exchanges have changed same goes for money From Barter to Crypto-currency this transition will go on till advancement continues. Well Cryptro kitties I have heard or seen but after reading your article , I will be now searching for it. Thanks for sharing it

This post has received a 2.12 % upvote from @booster thanks to: @cryptotax.

This post has received a 4.93 % upvote from @boomerang thanks to: @cryptotax

A cat’s jaw can’t move sideways, so a cat can’t chew large chunks of food.

That sucks, but that's the U.S. government for ya. :/

I believe that even though this is an article for which you MIGHT receive compensation, you are still ok to post pictures of CryptoKitties. I think the Fair Use Doctrine has you covered, even though you agreed to the terms of service:

"For the sake of clarity, you understand and agree: (i) that your “purchase” of a CryptoKitty, whether via the App or otherwise, does not give you any rights or licenses in or to the Axiom Materials (including, without limitation, our copyright in and to the art and drawings associated with that CrytpoKitty) other than those expressly contained in these Terms; and (ii) that you do not have the right to reproduce, distribute, or otherwise commercialize any elements of the Axiom Materials (including, without limitation, our copyright in and to the art and drawings associated with that CrytpoKitty) in any way without our prior written consent in each case, which consent we may withhold in our sole and absolute discretion."

I read that section of the agreement to mean you are good to go to post pictures in a Steemit article.

Show us the kitties!

I would like to clarify one thing. If you were looking to add photos of GrumpyCat to an article, then I would say tread lightly. GrumpyCat scares me sometimes.

Interesting. I will have to check this rule out for the future. I am typically cautious.

Since you purchased your CryptoKitty, also check out the First Sale Doctrine.

Since my first reply, I see other Steem writers posting images of CryotoKitties. If Steemit.com were receiving takedown notices from the CryptoKitty copyright holders, I feel we would have heard about that by now.

I am not an attorney, but if someone ever messes with you about posting an image of your Kitty, or other item that you have purchased, then feel free to contact me. I am rusty, but have a strong background in takedown notices, and the DMCA.

Your article made me realize that I need to add CryptoKitty representation to my business card, and in my advertising. Here is a rough draft of the new card:

CryptoTaxAdvisor - Enrolled Agent licensed to practice before the IRS. Specializing in the representation of:

Exotic Dancers
Actors
Marijuana Distributors
Twinks
Hodlers
Steemits
and
Cryptokitties

This is going to be my year!

You got a 1.00% upvote from @postpromoter courtesy of @cryptotax!

Want to promote your posts too? Check out the Steem Bot Tracker website for more info. If you would like to support the development of @postpromoter and the bot tracker please vote for @yabapmatt for witness!

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