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Can a Self-Directed IRA (“SDIRA”) Invest in Cryptocurrency and NFTs?

Self-directed IRAs (“SDIRAs”) can be a powerful investment tool when used the right way. Instead of relying on a bank or brokerage to hold and invest your retirement accounts, the SDIRA gives you direct control over what to invest in for your retirement. Best of all, the SDIRA is not limited to the traditional stock and bond market portfolios. Savvy and knowledgable investors willing to take on high levels of risk can direct their tax-advantaged savings into private companies, debt portfolios, real estate, and other non-traditional assets. While the personalized control and expanded investment opportunities may sound great, SDIRAs are subject to complex tax rules and other pitfalls, including extreme volatility and investment risk. The government rules and regulations ensure that individuals are not abusing the tax advantaged status of their retirement accounts. The Internal Revenue Code (“IRC”) governs what retirement accounts (including SDIRAs) can and cannot invest in.

What about cryptocurrency like Bitcoin? Can an SDIRA invest in cryptocurrency? Yes. In general, the IRC prohibits any IRAs (including self-directed ones) from owning life insurance, S-Corporation stock, and collectables. 26 USC 408. The term “collectable” includes art, antiques, collectable stamps, coins, alcoholic beverages, and “any other tangible personal property” specified by the IRS. Pursuant to Notice 2014-21, the IRS considers cryptocurrency to be intangible property for the purpose of taxation. This means it is treated the same as stocks or bonds – if you sell at a profit, you are paying capital gains tax. Note that cryptocurrency is not treated the same as cash – this also means that if you are paying for a product with Bitcoin, it is a taxable event. For the purposes of an SDIRA and retirement investment, you can certainly buy and hold (or HODL) cryptocurrency. Or sell it for a gain – the tax consequences are the same as they would be with a stock or bond portfolio (depending on whether you have a 401k or Roth-type setup). Remember that any profits that an SDIRA makes go right back into the SDIRA and may only be withdrawn for the benefit of the individual under certain conditions (like being 59 and a half years old) to retain the tax advantage. With cryptocurrency, it is critical to set up an SDIRA-owned LLC to establish and own the cryptowallet in conjunction with a bank account. The LLC structure allows the SDIRA beneficiary to act as a manager and direct investments right from the bank account rather than going back to the SDIRA custodian and waiting for an approval of a particular transaction. However, remember that the manager cannot receive compensation or commingle personal and SDIRA assets, accounts, or cryptowallets.

What about non-fungible tokens or NFTs? Can an SDIRA invest in those? Maybe. NFTs are digital property that exist only online, but unlike “traditional code,” NFTs are unique and cannot be copied. More accurately, they can be copied (like a print of the Mona Lisa can be copied), but there can be only one original. In that sense, they are like real-world property and their non-fungibility creates scarcity, and theoretically value. Although NFTs are based on the Ethereum blockchain (and Ethereum is a cryptocurrency like Bitcoin), cryptocurrency and NFTs are not necessarily treated the same way. As explained above, the IRS treats cryptocurrency the same as intangible property for the purposes of taxation – meaning like stocks, bonds, and mutual funds. Section 408 of the Internal Revenue Code prohibits any IRA from investing in art, antiques, collectable stamps, coins, alcoholic beverages, and “any other tangible personal property” specified by the IRS. 26 USC 408. Will the IRS treat NFTs like cryptocurrency and therefore permitted SDIRA investments? Or will NFTs be treated like restricted collectables?

The IRS has not issued guidance on this matter. Some commentators (including the top search result on Google as of the writing of this article) have concluded that the IRS treats NFTs as collectibles and therefore they subject to a “higher minimum gains tax rate of 28%.” This is simply not true. While the IRS certainly treats NFTs as taxable property, it remains uncertain exactly how the IRS will tax these digital assets.

At its core an NFT is code. Cryptocurrency is also code, which the IRS expressly treats like “property” for the purpose of taxation. It follows that NFTs are also “property” for the purpose of taxes. But what kind of property? Are NFTs always considered art or collectibles? Or are they cryptocurrency and can be owned by an SDIRA? What about NFTs that represent virtual real estate in “worlds” like Decentraland, Cryptovoxels, Somnium Space, Sandbox? What if the NFT is an avatar, a name, a virtual outfit? There are several possible ways for the IRS to treat NFTs:

One, the IRS can take a pragmatic approach and tax them in accordance with what they would represent in the real world. Some NFTs have real-world counterparts – for example, Forbes reported that a digital collectible startup called Ethernity is set to auction limited edition real world baseball bats that include an NFT counterpart. Nike also patented something called “CryptoKicks,” which presumably will tie real sneakers to some sort of digital authentication certificate. If an NFT represents art, then it is treated like art for tax purposes. If an NFT is a trading card, then it is treated like a collectible. If the NFT represents virtual real estate, it is treated and taxed like real estate (which raises a whole different set of questions).

Two, the IRS can take a simple approach and classify NFTs as “property” that is treated exactly like cryptocurrency regardless of what the NFT “represents.” This second approach avoids litigation over what how a particular NFT should be taxed – for example, is an in-game avatar “art”? The second approach also would give SDIRA investors the flexibility to invest in virtual assets, including virtual real estate.

Finally, is the IRS really going after unreported cryptocurrency and NFT transactions? Absolutely. In 2020, the IRS established the Office of Fraud Enforcement and announced in 2021 that a special investigative team was conducting “Operation Hidden Treasure” to identify individuals who failed to report cryptocurrency (and presumably NFT assets).

Investing in cryptocurrency and NFTs is a hot trend in 2021. Although these digital assets may “exist” only as part of the virtual blockchain, the IRS considers them very real and very taxable. This is a constantly changing and developing area, so it is especially critical to consult a tax and legal professional before making any investment decisions. As I pointed out in my earlier post about SDIRAs, even if you are right, you may still end up litigating against the IRS in Tax Court.

More questions? Thinking about investing in cryptocurrency or NFTs? Funding your retirement through an SDIRA? Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

What is a Self-Directed IRA and Is It Legal in Michigan? 5 Essentials to Know Before Taking Control of Your Retirement Accounts.

You may have seen YouTube videos or advertisements touting the merits of the self-directed IRA (“SDIRA”) as a “magic” way to leverage your retirement accounts and outperform the stock market by investing in private companies, real estate, gold, and even cryptocurrency. SDIRAs are perfectly legal when done right and for the right reasons, but unfortunately there is nothing “magic” about them. Nor are they appropriate for everyone. They are a sophisticated investment tool for persons who want to diversify their retirement account holdings and invest in something other than the stock market or mutual funds. It also gives the beneficiary (or owner) direct control over the investments, rather than relying on a bank or investment firm like Merrill Lynch to choose what stocks to buy. An SDIRA can invest traditional securities like stocks and bonds, and also in rental properties, precious metals, and yes, even cryptocurrency.

As an IRA, the SDIRA enjoys certain tax benefits (similar to a traditional IRA or 401k). There is also a self-directed Roth option. Federal law has a complicated set of rules and restrictions for SDIRAs because of the potential for abuse by SDIRA owners, and the IRS field manual and policies contain detailed instructions regarding various schemes and situations to spot the prohibited transactions. Violating these rules has significant tax consequences – an illegal transaction effectively distributes all assets of your retirement account early, with retroactive capital gains liability and penalties.

It goes without saying that you should hire an experienced professional to advise you on the SDIRA structure. Not all attorneys and accountants are knowledgeable and experienced in this area, so make sure you are talking to the right person. While there is a lot to know about SDIRAs and books have been written on the subject, here are 5 essentials to know if you are thinking about taking control of your retirement investments.

1. An SDIRA is not a source of start-up capital for your small business. One common misconception is that an SDIRA can fund a transition from “corporate America” to “small business owner.” That is not the case – the IRS rules prohibit related-party transactions. For example, you cannot use the SDIRA to invest in a used-car dealership and then you work at the dealership and draw a salary, commissions, or some other compensation personally. Nor can you use the SDIRA to loan money to your business, even if the transaction is commercially reasonable, papered, and your business pays market interest on the loan.

2. An SDIRA cannot buy real property from you or your family, or for you or your family to live in or use. Another misconception is that since real estate is a common SDIRA investment, you can transfer your mortgage to the SDIRA and basically pay interest to your retirement account on your house. Or, that the SDIRA can invest in rental or vacation property that your kids can use during winter break. Self-dealing with the SDIRA is prohibited. You cannot sell property from your own self to the SDIRA. Nor can you personally benefit from the SDIRA’s ownership of property, such as for example staying at the property or letting your kids use it during vacation.

3. Using a corporate entity as a conduit for investing is a good idea, but it must be set up in the right way. A common structure for investing is to create an LLC or corporation for the SDIRA to own 100% – which then can then create its own bank account, own property as the LLC, and protect the SDIRA and its owner from liability. For example, if the investment is a rental property and a tenant is injured, the tenant would be limited to suing the LLC (and the property insurance would pay), instead of the entire IRA or the IRA owner personally. That is not to say that the IRA is somehow immune from bad investments, creditors, or losses. Rather, the IRA/LLC structure allows to compartmentalize and limit liability to certain assets. Another important thing about the LLC structure is that a normal operating agreement does not work for an LLC that will be owned by an SDIRA. Special provisions are necessary to comply with IRS rules, as well as certain restrictions that preclude prohibited transactions and self-dealing. The custodian for the SDIRA will likely require a review of such an operating agreement before creating an SDIRA.

4. A special SDIRA custodian needs to be involved to create and administer the SDIRA. Not all banks or investment companies handle SDIRAs. This is not because there is something illegal about them – rather, self-directed investments are more expensive to administer and require more direct oversight than a traditional mutual fund, index fund, stock, or bond investment. Special SDIRA custodians that meet certain federal criteria exist to serve as administrators for these accounts. Because of the higher involvement, they usually charge higher administrative fees. They also will require documents (like the operating agreement or corporate bylaws if you are using a corporate entity structure). Some may even require an opinion letter from an attorney or qualified financial advisor attesting to the legality of a structure before they open your account. And, to the frustration of some, the custodian cannot give financial or legal advice to their clients.

5. Even if you do everything right, you may still be audited or end up in tax court. The IRS has spent a lot of time and resources litigating SDIRA cases and structures. They have lost some cases and won others. The bottom line is that unless you want to invest tens of thousands of dollars into making precedent and trailblazing new law in the area, conservative investing is your best bet. Simple is better. The golden rule is this: passive investments are ok, active investments are prohibited. So long as you stick to a conservative investing approach, do not commingle personal and SDIRA business interests, and treat the SDIRA as an investment opportunity for your retirement account, you will be in good shape. However, there are no guarantees that you will not have to defend your structure in tax court, and the more entities, companies, and investors are involved, the higher the risk.

In sum, SDIRAs are out there and make it possible to leverage your retirement assets into self-directed investments. Real estate, privately-held businesses, precious metals, and even debt portfolios are all potential avenues to receive greater-than-market returns for your retirement account. Or, it is also a great way to lose your entire nest egg if you invest in the wrong venture. Even when making a prudent investment, it is critical to do it right and act only with the counsel of experienced attorneys, accountants, or financial advisors. This is not a simple area and is rife with potential pitfalls and hazards. Use caution.

More questions? Thinking about funding your retirement through an SDIRA? Contact Dan Artaev by email or call or text to set up your initial consultation.