NFTs in an IRA can be risky
You should be extremely careful if you are considering holding nonfungible tokens (NFTs) in an IRA.
In March, the IRS issued guidance (Notice 2023-27) regarding taxes and penalties associated with NFTs 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 law and 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. The U.S Tax 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 individuals who hold 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” from the IRA. (This is known as a deemed distribution.) There would 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 expert Ed Slott, it is not clear how the IRS plans to apply this rule for an NFT in 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. When the NFT is 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 cost was treated as being distributed.
Example: Joe, 45, invested $100,000 in a NFT that is linked to ownership rights to a collectible. The NFT becomes 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: Investors who expect an NFT to increase in value could consider adding an NFT to a Roth account. If the Roth IRA NFT is deemed to be a collectible, the investment would not be taxable if the distribution is considered to be “qualified.” In order to be qualified, the Roth IRA account would 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 his Roth account was established three years ago. He invests $100,000 in a NFT that is deemed a collectible. Because the distribution is not qualified yet, the $100,000 is considered a deemed transaction, with a taxable distribution. If Edward waits until the Roth account has been opened for five years, no income tax would be due even if the transaction is considered a deemed transaction.
The IRS indicates that if an NFT in an IRA is deemed to be a collectible, the IRA NFT can result in a “prohibited transaction” as well as a deemed distribution. This situation would result if the IRA owner uses the property for his own interest. 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 owner was under 59 ½, there would be a 10% early distribution penalty.
Bottom line: Holding an NFT in your IRA is a complex and risky matter, and can be expensive. Make sure you or your adviser understands IRS Notice 2023-27 before you hold an NFT in your IRA.