NFTs in an IRA can be risky | Business

You should be extremely careful if you are considering holding nonfungible tokens (NFTs) in an IRA.

InMarch, the IRS issued guidance (Notice 2023-27) regarding taxes and penalties associated withNFTs held in IRA accounts.

In general, collectibles are considered a “prohibited” investment and not allowed in IRAs. However, there are exceptions for coins under state lawand certain gold, silver, platinum or palladium bullion.

These coins are not considered collectibles, so they are not a prohibited IRA investment. However, they must be held by an IRA custodian and can’t be held at home. TheU.STax Court has ruled that individuals holding gold coins at home were subject to taxes and penalties.

Following is a list of collectibles that are considered prohibited investments: any work of art; any rug or antique; any metal or gem; any stamp or coin; and any beverage, alcoholic or otherwise.

The IRS has indicated that certain NFTs may be considered collectibles “if the NFT’s associated right or asset falls under the definition of collectible in the tax code.”

There are potential serious and expensive tax issues for individualswhohold these items in their IRAs. For example, if a collectible or any other prohibited investment is held in an IRA, the original cost will be treated as a “taxable distribution” fromthe IRA. (This is knownas a deemed distribution.) Therewould be a 10% early distribution penalty if the IRA owner is under 59 ½ . The distribution amount is based on the original cost, even if the asset has decreased in value. (According to IRA expertEd Slott, it is not clear howthe IRS plans to apply this rule for anNFTin an IRA that is considered a collectible but was purchased prior to the issuance of the March notice.)

According to IRS Publication 590-A, a collectible doesn’t need to be taken out of an IRA once a deemed distribution occurs. WhentheNFTis distributed from the IRA, any amounts included in income as a result of the “deemed transaction” won’t be included again in income. So the IRA owner will get credit for the basis to the extent that original costwas treated as being distributed.

Example: Joe, 45, invested $100,000 in aNFTthat is linked to ownership rights to a collectible. TheNFTbecomes worthless. The IRS will rule that Joe owes tax on the $100,000 investment and a 10% penalty of $10,000 even though the investment has no value.

Roth exception: Investorswho expect anNFTto increase in value could consider adding anNFTto aRoth account. If theRoth IRANFTis deemed to be a collectible, the investmentwould not be taxable if the distribution is considered to be “qualified.” In order to be qualified, theRoth IRA accountwould have to be already opened for five years, and the owner had already reached at least age 59

½ . Because the distribution is qualified, no tax is due even if the transaction is considered a deemed distribution.

Example: Edward is 60, and hisRoth accountwas established three years ago. He invests $100,000 in aNFTthat is deemed a collectible. Because the distribution is not qualified yet, the $100,000 is considered a deemed transaction, with a taxable distribution. IfEdwardwaits until theRoth account has been opened for five years, no income taxwould be due even if the transaction is considered a deemed transaction.

The IRS indicates that if anNFTin an IRA is deemed to be a collectible, the IRA NFTcan result in a “prohibited transaction” aswell as a deemed distribution. This situationwould result if the IRA owner uses the property for his owninterest. In this situation, the tax consequences are disastrous. The “entire” IRA will be disqualified and be deemed distributed as of the first day of the year the prohibited transaction occurred. In addition, if the ownerwas under 59 ½ , therewould be a 10% early distribution penalty.

Bottom line: Holding anNFTin your IRA is a complex and risky matter, and can be expensive. Make sure you or your adviser understands IRSNotice 2023-27 before you hold anNFTin your IRA. ElliotRaphaelson welcomes your questions and comments at raphelliot@gmail.com.

DREAMSTIME

Elliot Raphaelson

The Savings Game