Self-Directed IRAs and NFTs: Prohibited Collectible or The Future of Alternative?

This digital asset has seen a boom over the entire year of 2021, so what’s the fuss about? What is an NFT, how does it compare to cryptocurrency, how will the IRS treat the asset, and more. 

What is an NFT?

Non-fungible token.

NFTs (or “non-fungible tokens”) are a special kind of crypto asset in which each token is unique — as opposed to “fungible” assets like Bitcoin and dollar bills, which are all worth exactly the same amount. Because every NFT is unique, they can be used to authenticate ownership of digital assets like artworks, recordings, videos, and virtual real estate or pets.

What does “non-fungible” mean?

Every bitcoin is worth as much as every other bitcoin. NFTs, on the other hand, are all unique. “Fungibility” refers to goods or assets that are all the same and can be swapped interchangeably. A dollar bill is another perfect example — each is worth exactly one dollar. 

Concert tickets, by contrast, are non-fungible. Even if every concert ticket is the same price, they aren’t directly exchangeable. Each represents a specific seat and a specific date — no other ticket will have those exact characteristics.

How do NFTs work?

At a very high level, most NFTs are part of the Ethereum blockchain. Ethereum is a cryptocurrency, like bitcoin or dogecoin, but its blockchain also supports these NFTs, which store extra information that makes them work differently from, say, an ETH coin. It is worth noting that other blockchains can implement their own versions of NFTs. 

What is a self-directed IRA?

A self-directed individual retirement account is unique from a traditional retirement savings account in that the account owner has control of the assets it is invested in. Unlike a traditional retirement savings account hosted by an employer, a self-directed IRA can invest in assets outside of stocks, bonds, or mutual funds.

Assets like commercial real estate, rental property, private loans, gold and silver, or even farmland are among popular choices. 

The list of assets that are prohibited by IRS law is shorter, mainly focusing on collectibles like certain coins, stamps, antiques, and artwork, which is where NFTs come in.

The reason that self-directed IRAs and NFTs come up is the SDIRAs ability to invest in the alternative. The last decade of self-directed investing has seen a boom in interest in cryptocurrency and digital assets, understandably so. Both NFTs and any digital currency are hosted on the same marketplace, but are arguably very different assets. 

One reason experts warn against investing in NFTs through a self-directed IRA is because they’re not widely available and don’t make sense for most investors. Generally, they can be both risky and expensive to maintain.

There are also strict rules in place from the Internal Revenue Service regarding which investments are prohibited in IRAs. With a self-directed IRA, you manage all the investments yourself, so you’re personally on the hook if any rules are broken.

IRS stance on NFTs

So far, none. The IRS has yet to rule on an official stance on how NFTs are taxed and overall handled by the Internal Revenue Service. The digital asset is seen as a collectible and will most likely be taxed and treated as such.

IRS definition of a collectible

Collectibles under IRC Section 408(m)(2) include:

  • Any work of art
  • Rugs or antiques
  • Any metal or gem
  • Stamp or coins
  • Alcoholic beverages

The consequence of investing in collectibles

According to the IRS, a “plan participant whose account acquires a collectible is deemed to receive a distribution in the year the collectible is acquired. The amount of the distribution is the cost of the collectible at the time it is acquired. The amount should be reported to the participant on Form 1099-R. The distribution is generally taxed as ordinary income and the 10% additional tax on early withdrawals may apply if the participant is under age 59½, pursuant to IRC Section 72(t).”

‘When the collectible is actually distributed by the plan, the amount previously reported as a taxable distribution is not included in income again (the participant has basis in the amount of the distribution). “

Prohibited transactions

Acquiring a collectible may also be a prohibited transaction under IRC Section 4975(c). For example, the purchase of a collectible with plan funds for the personal use of a disqualified person could be a prohibited transaction.

How are NFTs changing the investment landscape?

The NFT marketplace is experiencing enormous month-over-month growth in trading volume. NFTs went up by more than 900% in trading volume from $300 million in July to an all-time high of $3 billion in August this year. In fact, one NFT-gaming project similar to Pokemon, called Axie Infinity, generated over $800 million in revenue between August and November this year.

NFTs redefine the business models of various industries such as art, gaming, music and sports. These new use cases give the opportunity to retail and institutional investors to explore this space with a new angle. That said, NFTs should be approached just like any other investment: Conduct research, understand the associated risks and proceed with a healthy dose of caution.

How does investing in NFTs compare to investing in cryptocurrency directly?

There are several differences when comparing investing in NFTs to investing in cryptocurrency directly. Like other forms of art, an NFT’s value is based entirely on what someone else is willing to pay for it. As a result, demand dictates the sale price rather than fundamental, technical or economic indicators.

While NFTs are subject to capital gains taxes, just like when you sell stocks at a profit because they’re considered collectibles, they may not receive the preferential long-term capital gains rates stocks do and may even be taxed at a higher collectibles tax rate.

Additionally, it is worth noting that the cryptocurrencies used to purchase the NFT, and as such sell them, may also be taxed if they’ve increased in value, thus highlighting the importance of checking in with a tax professional when considering adding NFTs to a portfolio.