The treatment of cryptocurrency is a complex, often mysterious, area of taxation. The proper treatment of non-fungible tokens, or NFTs, has perhaps generated even more controversy and confusion. Now, the IRS has stepped in to provide some guidance on issues that clients who invest in NFTs must understand.
As investment in cryptocurrency and NFTs continues to become more mainstream, clients must also understand that holding these types of investments in tax-preferred retirement accounts can possibly have significant consequences given the content of the IRS' guidance. It's now critical that clients know the rules to avoid potentially significant negative tax consequences based on holding NFT investments within IRAs and other tax-qualified retirement planning vehicles.
Collectibles as IRA Investments
IRA investments are not subject to the same strict regulations that govern the investment options for Employee Retirement Income Security Act plans. However, under IRC Section 408(m), IRAs cannot hold collectibles as investments without adverse tax consequences.
Generally speaking, collectibles are defined to include works of art, rugs or antiques, metals or gems, stamps or coins and alcoholic beverages. Limited exceptions exist for certain coins and bullion.
An IRA's acquisition of a collectible as an IRA investment will be treated as a distribution from the IRA. The amount of the distribution is the amount of the cost of acquiring the collectible. These distributions are taxed to the owner as ordinary income. They may also subject the owner to the 10% early withdrawal penalty if the owner has not yet reached age 59.5 when the collectible investment is acquired.
Notably, these deemed distributions are subject to ordinary income tax rates — not the more favorable 28% rate that applies with respect to gain on the sale of collectibles in general.
NFTs: The Basics
Unlike cash or bitcoin, no two NFTs are exactly alike — although an NFT can take the form of multiple replicas of the same actual content. Ownership in an NFT can represent an ownership interest in virtually anything.
In the NFT world, the NFT is actually a type of digital "token" that represents ownership in some type of underlying asset. The NFT itself is akin to the certificate of stock ownership the client would receive when purchasing stock in a corporation.
