A popular new game has emerged online based on the Ethereum platform: CryptoKitties. Players can buy and sell virtual cats which they can breed and create new unique virtual cats in return. Virtual cats may sound like a joke, but the business surrounding this new craze is no laughing matter: according to CNBC, players have spent the equivalent of $6.7 million on CryptoKitties since the game was launched one week ago, and some are already selling for 6 figures.
As a virtual farmer, you may be tempted to claim your breeding stock as assets which you can depreciate over time, allowing you to reduce your taxable income. Afterall you’ve worked hard to hand select the cats you want to breed, so why not reap the rewards of a tax deduction?
Unfortunately, breeding of CryptoKitties is breeding in name only. In the eyes of the IRS, CryptoKitty players are buying and selling capital assets. As a capital asset, the capital gain or loss is the difference between your basis and the amount you get when you sell.
If for instance you purchase a CryptoKitty for 0.5 Ethereum and sell for 0.7 Ethereum, you will need to report the USD equivalent of the 0.2 Ethereum difference at the time of sale. If on the other hand your CryptoKitty turns out to be less popular than you envisioned and you sell at a loss, you can write off the USD equivalent of the loss as a tax deduction. You will need to report your capital gains or losses on Schedule D.
If instead you breed a virtual cat by “siring” with another player’s virtual cat, the cost basis of your new cat will be your breeding cost. Subtract the total gain when you sell your cat from your breeding cost to calculate the capital gain, then again, report on Schedule D the USD equivalent of this gain at the time of the transaction.
What if instead you decide to barter with another player and trade your CryptoKitty without the exchange of cash? If two players give each other cats, technically tax filers should report the fair market value (FMV) of the items exchanged and the difference would be taxed as a capital gain or loss.
However we now enter a gray area of tax law since the fair market value of CryptoKitties is entirely subjective and these virtual pets hold no inherent value. It would be up to the player in this case to appraise the value of his or her CryptoKitty based on the market value of similar virtual cats (same CryptoKitty “cooldown” breeding period for instance). The tax laws surrounding cryptocollectibles are uncharted territory, and it remains to be seen how the IRS will deal with CryptoKitty transactions in the future.