NFT Investments through IRAs and Roths

In March, the IRS released a notice that highlighted the potential for unexpected taxes and penalties when holding nonfungible tokens (NFTs) in an individual retirement account (IRA). IRAs offer a wide range of investment opportunities but there are certain prohibited investments, including collectibles, life insurance, and S Corp. stock.

The IRS has now focused its guidance on whether NFTs are considered collectibles, which have always been prohibited IRA investments. According to Tax Code § 408(m)(2), the definition of “collectible” includes works of art, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages, and other tangible personal property specified by the IRS.

It’s worth noting that while NFTs are considered a prohibited investment for IRAs, there are some exceptions. Coins issued under state law and certain types of gold, silver, platinum, or palladium bullion are not considered collectibles and therefore can be included in an IRA investment. However, they must still be held by an IRA custodian, and not by the IRA owner at home or elsewhere.

In a U.S. Tax Court case from November 2021, it was demonstrated just how risky it can be to hold gold coins at home as part of a self-directed IRA. The case involved Donna McNulty, a nurse from Rhode Island, who suffered a significant loss when the Tax Court deemed her investment in gold coins held at home to be a taxable distribution. This resulted in over $300,000 in taxes and penalties for McNulty, highlighting the importance of following the rules and guidelines when it comes to IRA investments.

Although NFTs are not specifically listed as collectibles, the IRS has indicated that certain NFTs may be considered as such if they are linked to a collectible. This could lead to significant and costly tax implications for IRA owners who hold NFTs in their accounts.

If a collectible (or any other prohibited investment) is held in an IRA, the original cost of the investment is treated as a taxable distribution from the IRA. Additionally, a 10% early distribution penalty is applied if the IRA owner is under 59½ years old. It’s important to note that the distribution amount is based on the original cost, even if the value of the asset has decreased. However, it’s not entirely clear how the IRS will apply this rule for an NFT in an IRA that is considered a collectible under the new guidance but was purchased prior to the issuance of the notice.

According to the IRS Publication 590-A, a collectible doesn’t need to be withdrawn from the IRA once a deemed distribution occurs. The publication explains that when the NFT is distributed from the IRA, any amounts that were already included in income as a result of the deemed distribution won’t be included again in income. Essentially, the IRA owner will receive credit for the original cost to the extent that it was treated as distributed.

Example: Mike, who is 47 years old, invested $300,000 from his traditional IRA in an NFT when they were highly popular. The NFT is linked to ownership rights to a collectible, but it has now become worthless. Joe will owe tax on the entire $300,000 (along with a 10% penalty) even though the asset’s value is zero. This can be a painful double blow, first losing the funds, and then having to pay taxes on value that no longer exists.

ROTH IRA Effect

It is possible that NFTs in Roth IRAs may become more common, especially among investors who anticipate a significant increase in value of their NFTs and want to avoid paying income tax on those gains.

If the NFT held in a Roth IRA is considered a collectible, the investment in the NFT would not be subject to a taxable distribution if the distribution meets the criteria for being “qualified.” This means that the investment was made after any of the owner’s Roth IRAs have been held for at least five years and the IRA owner is at least 59 ½ years old.

Example: Mike’s 62-year-old sister, Mary, chose to invest her $200,000 Roth IRA funds in an NFT that is classified as a collectible. Although Mary will still be subject to a deemed distribution on her investment, she won’t have to pay any income tax on it because the deemed distribution pertains to a Roth IRA NFT investment, as long as the distribution is considered qualified.

Suppose the value of the NFT in which Mary invested her Roth IRA funds increases to $1 million by the time she distributes it from the account. In that case, Mary may not have to pay taxes on the $800,000 gain she earned. This means that even though the Roth IRA is invested in a prohibited investment, the typical tax advantages of a Roth IRA are not lost.

NFT Look-through Rules

NFTs can offer their owners rights to a diverse range of digital files, including images, music, trading cards, or digital sports moments. Alternatively, NFTs may grant the holder permission to attend a concert or prove ownership of a particular item.

However, not all NFTs held in IRAs will necessarily trigger a deemed distribution. According to the IRS guidance, it is essential to examine the NFT to determine whether the right or asset it represents is linked to a collectible item.

The IRS guidance provides examples of when an NFT would be deemed a collectible and considered a prohibited investment in an IRA, resulting in a deemed distribution based on the initial cost. This is true when the NFT is associated with rights or ownership of collectible items like gems or works of art. However, the guidance also includes an example where an NFT that provides a right to use or develop a plot of land is not considered a collectible. Since land is an acceptable IRA investment, owning such an NFT won’t cause a tax issue.

Prohibited Transaction Risk

The tax implications could become even more severe if an NFT held in an IRA is considered a collectible by the IRS. In such cases, the NFT can lead to a prohibited transaction and a deemed distribution on the investment, particularly if the IRA owner uses the asset for personal gain. If this happens, the tax consequences could be much worse, as the entire IRA could become disqualified and deemed distributed as of the first day of the year the prohibited transaction took place. This is a more severe outcome than if only the cost of the NFT were subject to deemed distribution.

Example: Suppose James invests $500,000 of his $3 million IRA in an NFT that certifies ownership of a rare gem, which is considered a prohibited investment in an IRA. Because the NFT is a collectible, the $500,000 investment will be subject to a taxable deemed distribution in the year of the investment. Later, James lends the gem to a museum and receives compensation for it. However, this transaction is considered prohibited since James is using the gem for his own benefit. Consequently, the entire $3 million IRA becomes disqualified and taxable to James as a distribution from his IRA, with the exception of the $500,000 basis from the deemed distribution on the original investment. Moreover, if James was below the age of 59½ at the time the transaction occurred, she would also face a 10% early distribution penalty in addition to the tax on the prohibited transaction.

The tax consequences of investing in NFTs as part of an IRA can be severe and should not be taken lightly. Although NFTs are a recent phenomenon, the IRS has already taken steps to regulate their use as IRA investments.

It’s worth noting that the recent IRS notice on NFTs is just the beginning of its regulatory efforts in this area. The notice also invites comments on the issue and signals that further guidance is forthcoming. Nevertheless, the rules outlined in the notice should be adhered to for the time being.