The Hidden Dangers of Holding NFTs in Your IRA

Before investing in NFTs, it’s crucial to carefully evaluate the source of your investment funds. This is particularly important if you use your IRA funds for NFT investments. The taxation of cryptocurrency can be complex and mysterious, and the treatment of NFTs is no exception.

Recently, the IRS has provided some guidance on the tax implications of investing in NFTs, and retirement account holders must understand these rules to avoid potential negative consequences.

As cryptocurrency and NFT investments gain popularity, it’s important to be aware that holding such assets in tax-preferred retirement accounts could have significant repercussions based on the IRS’ guidance. This is especially relevant regarding Individual Retirement Accounts (IRAs) and other tax-qualified retirement planning vehicles.

When it comes to IRAs, they have more flexibility in investment options compared to Employee Retirement Income Security Act plans. However, there are restrictions outlined in IRC Section 408(m), which prevent IRAs from holding collectibles as investments without facing adverse tax consequences. Collectibles include various items such as art, antiques, metals, gems, coins, and alcoholic beverages, with limited exceptions for certain coins and bullion.

If an IRA acquires a collectible as an investment, it will be treated as a distribution from the account, and the amount used to acquire the collectible will be taxed as ordinary income. If the account holder is under 59.5 years old when obtaining a collectible, they may face a 10% penalty for withdrawing the distribution early. Even more importantly, the taxation on these is deemed as distributions, and ordinary income tax rates will apply, not the more favorable 28% rate that applies to the general sale of collectibles.

NFTs

NFTs are unique digital tokens representing ownership. Because the digital item can translate to an actual cash value, it has come under scrutiny by the IRS. Unlike cash or bitcoin, each NFT is distinct, even if the underlying content is replicated. NFT ownership can represent a stake in anything imaginable, from original creations to digital representations or even certain rights like concert attendance or land development. Moreover, an NFT can grant ownership of physical assets like paintings, gems, or antiques. Like real estate or a commodity, it is possible to sell the stuff and keep the digital art token. Also, interestingly enough, the artist of the NFT usually gets a percentage of the sale each time the art or token is sold.

The IRS recently announced its intention to clarify that NFTs may be taxed as collectibles in Notice 2024-27. While formal guidance is pending, the IRS will apply a look-through analysis to determine whether an NFT should be taxed as a collectible. This means that if the asset associated with the NFT qualifies as a collectible, the NFT itself will be treated as one for taxation purposes, including potential ordinary income taxation and early withdrawal penalties if held within an IRA.

It’s essential for owners of retirement accounts considering NFTs as retirement investments to be aware of the current IRS guidance. While the matter is not entirely settled, it’s wise for IRA owners to review their retirement plans’ terms carefully and stay informed about ongoing IRS guidance to understand how NFT investments will be taxed in the interim.