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Are NFT Collectible Card Games Legal in the United States?

NFT collectible card games are generally legal within the United States, provided that developers and players comply with several key laws. Specifically, these games implicate securities regulations, anti-gambling laws, and tax issues. NFT collectible card games are a natural Web 3.0 extension of over-the-board card games like Magic: The Gathering and have drawn a lot of attention, including from Reddit co-founder Alex Ohanian. These games leverage Non-Fungible Tokens (NFTs) to create scarce and valuable digital cards that players can collect, trade, and use in gameplay. The idea is similar to play-to-earn games that attach real-world value to in-game digital assets. While lucrative from a business standpoint and fun to play, these games create potential legal issues for both players and developers alike.

Gameplay

Before analyzing where NFT collectible card games fit within a legal framework, one must first understand the games themselves. The basic concept is that players purchase or otherwise acquire packs of random cards (with preset rarity distributions) that can be used to play a board/table-top game and also have collector and secondary market value. NFT or “digital” collectible card games are based on the same concept – players purchase or “mint” a pack of cards that they can use to play a game, collect for their own enjoyment, or trade or sell on the secondary market. Of course, the NFT cards do not have a physical component and exist only on the particular blockchain. Integrating NFTs ensures immutable value to these assets, same as physical cards in the old-school table-top games.

Here is a brief overview of a few of the most popular NFT collectible card games:

  1. Gods Unchained

Theme: Gods Unchained is a strategic card game set in a mythological universe. Players become powerful gods battling for supremacy.

Rules: Players start by choosing a god, each with its unique powers and abilities. Next, they build a deck of 30 cards consisting of creatures, spells, and weapons. The game proceeds in turn-based rounds. Each player uses their cards to attack the opponent’s god, defend their own god, or manipulate the game board. The objective is to reduce the opponent’s god’s life points to zero. Gods Unchained utilizes the Ethereum blockchain to mint its cards as NFTs. Players can then trade or sell in various marketplaces.

  1. Splinterlands

Theme: Splinterlands is a fantasy-themed card game. Players summon creatures and cast spells to outwit their opponents in fast-paced battles.

Rules: First, players build a deck by choosing a Summoner and selecting a set of monsters from their card collection. Each card has unique abilities, attack and health points, and mana cost. During a match, players have a limited amount of mana, which they use to summon monsters and cast spells. Players compete in automated combat rounds, trying to defeat the opponent’s team of monsters. As with other NFT collectible card games, players can trade, rent, or sell the various NFT cards to other players.

  1. Skyweaver

Theme: Skyweaver is set in a rich, cosmic universe. Players engage in strategic battles using cards representing creatures, spells, and enchantments.

Rules: In Skyweaver, players initially assemble a deck of 20 cards from a diverse pool of over 500 unique cards. The game categorizes cards into various prisms, each with its unique playstyle and strategy. Players take turns playing cards from their hand. They use their hero’s mana to cast spells, summon creatures, and attach enchantments to other cards. The objective is to reduce the opponent’s hero’s life points to zero. Skyweaver mints cards as NFTs on the Ethereum blockchain, and players can buy, sell, or trade the NFTs on various platforms.

Other popular NFT Collectible card games include:

  • CryptoSpells
  • Dark Country
  • ChainGuardians
  • Sorare
  • Axie Infinity (Card-Battler)
  • Relentless (formerly known as Zombie Battleground)
  • War Riders
  • CryptoAssault
  • Ether Legends
  • Force of Will (FoW) NFT

Legality of NFT Collectible Card Games

Are these games are legal? NFTs, cryptocurrency, and blockchain technology in general have all attracted significant legal scrutiny. So, are NFT collectible card games legal within the United States? Short answer: it depends.

  1. Are the NFTs used in these collectible card games unregistered securities? I have previously written on the topic of whether play-to-earn games really just sell unregistered securities and it is certainly possible depending on how the particular game is structured. The Securities and Exchange Commission applies the 4-prong Howey investment contract test to any novel NFT/cryptocurrency offering, which is a balancing analysis that asks whether a particular scheme is (1) an investment of money, (2) in a common enterprise, (3) with an expectation of profit, and (4) with the profits derived from the efforts of others. Generally, NFTs that represent digital assets like art, collectible cards, or virtual real estate do not qualify as securities under U.S. law, but this very question is currently being decided in private litigation between the holders of NBA Top Shots digital trading cards and their creator, Dapper Labs. Recently, a federal court denied Dapper Labs’s motion to dismiss, setting the stage for an in-depth court battle to determine the status of the NFTs under federal securities laws.
  2. Is an NFT collectible card game gambling? The question of whether trading cards and collectible cards are “gambling for kids” has been litigated since at least the 1980s when baseball card manufacturers had to defend against allegations of their purported use of gambling mechanics to sell their products. Courts have consistently held that plaintiffs get what they paid for – baseball cards – and suffer no damages from their “disappointment” in failing to get an ultra-rare chase card. More recent cases involving video game loot boxes suggest that the answer may depend on whether the NFTs are considered “things of value” under state gambling laws. In general, gambling is defined as risking something of value on an uncertain outcome to win a prize. A game where players wager real money or valuable NFTs on game outcomes could be subject to state and federal gambling regulations. To avoid a gambling classification, game developers should ensure that their games focus on strategy and skill-based gaming, and that players earn value through skill, rather than chance.
  3. Additionally, what are the tax implications of purchasing and selling NFT collectible card game assets? The IRS has indicated that it will apply a “look-through analysis” in determining how an NFT will be treated for tax purposes. In essence, the IRS is looking beyond the non-fungible token itself and considering the nature of the digital asset it represents. Consequently, the IRS may classify NFT cards as collectibles, which are subject to a higher capital gains tax rate than other property types. Aside from these tax implications for the players themselves, investors and NFT creators must also consider other tax implications of minting and obtaining NFTs.

Securities laws, anti-gambling regulations, and tax issues are all implicated in the rapidly evolving market of NFT collectible card games and digital gaming in general. Legal compliance is critical to not only avoid regulatory actions or tax penalties, but to also secure credible investors, banking, payment, and other technological partnerships.

The qualified and specialized attorneys at Artaev at Law PLLC know gaming and blockchain law – email or call us to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, tax, or investment advice. Every situation is different and has 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.

© 2023 Artaev at Law PLLC. All rights reserved.

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Are Play-to-Earn Video Games Legal in the United States?

Are play-to-earn games legal? The answer depends on the specifics of the game. For many gaming developers, play-to-earn is a lucrative business model in 2023 and beyond. These games let players compete against other players (PvP) or against the the game itself (PvE) to earn rewards that have real-world value. For example, players may pay real money to buy in-game currency to purchase virtual gear or real estate, but players also have the option to redeem the in-game currency for real-world money. Players can trade resources or earn the in-game currency through gathering, completing tasks or quests, or other gameplay. However, any company looking at play-to-earn should retain an experienced gaming attorney to consult on their game. It may be an attractive business model, but any real-money gaming implicates multiple legal areas, including taxes, securities law, and both state and federal-level anti-gambling prohibitions.

Earning real-world cash for virtual goods or gameplay is not a new concept. In fact, the first generation of massively-multiplayer online roleplaying games (MMOs or MMORPGs) like Ultima Online, Runescape, and Everquest had robust real-money economies for in-game items. Resource “farming” – where one would gather virtual resources and then transfer them to another player for a real-world money payment – became even more popular with World of Warcraft and the next generation of the MMOs like EVE Online. However, the developers did not officially sanction these in-game economies. Anti-RMT (real-money trading) provisions are prevalent in most end-user license agreements. Real money components in video games may be too close to gambling, which is obviously problematic. Developers are generally reluctant to assume additional liability and risk associated with any real-money economic component.

Play-to-Earn is Hot, But Rife With Legal Pitfalls.

However, it is the end of 2022, and making money playing video games is a real and viable career choice. Esports and video game tournaments are mainstream events, with their own ESPN page, multi-million dollar teams, and celebrity-status professionals. Many colleges offer esports scholarships. Casual video game tournaments (Call of Duty, FIFA, Gran Tursimo) are also a thing. For the more casual gamer, there are also real-money skill-based games (timed solitaire, bingo, etc.) available on the web or from the App Store. Daily Fantasy Sports giants like DraftKings and FanDuel also offer skilled players an opportunity to win real money by drafting the best fantasy sports teams.

There are also a number of NFT-based collectible card games, horse racing simulators (like Zed.Run), and countless other permutations of games where players are able to own in-game assets that they can sell and trade like their real-world counterparts. This sector of the gaming economy continues to grow, as the relatively low cost of cryptocurrency makes entry a lot more accessible. Many players also see the current “bear” market as a prime opportunity to enter some of these projects at low cost and potentially see significant growth in their in-game assets as the economy rebounds.

Modern play-to-earn games are simply another variation of the real-money gaming business model. Developers in this space fully embrace the concept of a virtual economy and the ability to earn real-world compensation for game play. The most prominent example is Axie Infinity (a Pokemon-type trading, collecting, and battling game), which has integrated blockchain technology (crypto and NFTs). Investors around the world, including Mark Cuban, quickly embraced the play-to-earn gaming model. Even in the times of the “crypto winter,” Axie is still worth many millions of dollars.

Advertising and Onboarding May Require a Legal Opinion.

Any real-money gaming business (including play-to-earn) needs experienced gaming counsel to guide them through various compliance issues. Advertising a real-money game on social media and getting through Apple’s approval process on the App Store requires a legal opinion that the game is truly skill-based and not illegal gambling. Is your game structured so that they are providing a service to you in exchange for compensation? Depending on the nature of your game, you may have unintended labor law obligations and even tax filing (W-2 or 1099) obligations to the IRS and state tax authorities.

Make Sure Your Game is Not Selling Securities.

Another potential pitfall is with the Securities and Exchange Commission (“SEC”). When designing your game and reward system, you must make sure that you are not inadvertently marketing a security and violating federal law. Securities are not just traditional stocks and bonds. An “investment contract” is also a regulated security and broadly includes any scheme where individuals pay money with the expectation that their money will be invested and they will earn a return. In the cryptocurrency world, initial coin offerings (“ICOs”) face heavy SEC scrutiny, especially after several high-profile cryptocurrencies turned out to be pyramid schemes.

The “investment contract” analysis is highly specialized and requires a thorough legal opinion. Each game is different, the laws are quickly changing in this area, and regulatory agencies are especially sensitive to crypto-related businesses in light of the numerous 2022 failings, bankruptcies, and rug pulls – with FTX being only the most recent example.

Beware Tax and Other Regulations If Your Game Uses Cryptocurrency or Other Blockchain Tech.

Speaking of crypto, if you are utilizing cryptocurrencies, tokens, NFTs, or other blockchain technologies as part of your game, there are more legal issues in play. Tax reporting and tracking are essential because the IRS considers cryptocurrencies to be property subject to capital gains tax. Does the game involve any crypto staking? If so, is your company now considered a bank subject to the FDIC’s jurisdiction? Are you involved in the business of money transmission and required to be licensed in each state where you do business?

Despite the slow regulatory change in this area and continued lack of centralized regulation, this area remains in the public eye and something of continued interest to regulators.

The bottom line is whatever your game and whether you are a veteran or just starting out, an experienced gaming attorney is a necessary asset to your business team.

Contact Artaev at Law PLLC to set up your initial consultation. We are Michigan’s gaming law firm and we specialize in the unique concerns that you may encounter as a game developer.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, tax, or investment advice. Every situation is different and has 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.

© 2021 Artaev at Law PLLC. All rights reserved.

Stablecoins 101: What Are They, How Are They Taxed, and Can I Use Them In My Business?

Cryptocurrency has significant business utility, especially in international transactions. Companies can exchange funds directly, without wiring fees or banking delays, and easily convert their native currencies into crypto and vice-versa using a mobile phone. However, traditional cryptocurrencies like Bitcoin and Ethereum are extremely volatile and their exchange values can easily fluctuate 10-20% or more in a matter of days or even hours. Market supply and demand forces determine the prices of these most popular cryptocurrencies and their value is particularly sensitive to various external factors. Events like China’s crypto clampdown, significant buys or sells by capital investors, or even Elon Musk’s tweets can crash the market or send the price of crypto soaring. Obviously, price volatility makes businesses and consumers reluctant to adopt these cryptocurrencies for day-to-day transactions. Price volatility translates into purchasing power uncertainty, which in turn devalues the currency.

Stablecoins are cryptocurrencies that try to solve the volatility problem. They do so by pegging their price to the price of another asset (such as the U.S. Dollar or an ounce of gold). For example, the USD Coin (USDC) can be acquired and sold for U.S. Dollars on a 1 to 1 ratio. USDC is actually backed by existing dollar reserves, meaning that each USDC has a real-world dollar counterpart held by regulated financial institutions. USDC reserves are also periodically verified by a third party (but not audited).

There are other stablecoins as well, for example Tether, Binance USD, TrueUSD, DAI, and more. Like USDC, some are tied 1 to 1 to U.S. Dollar reserves. Others are backed by commodities like gold, silver, or oil. The price of a commodity-backed stablecoin is tied to the market price of a commodity unit, like an ounce of gold. There are also stablecoins that attempt stability through overcollateralization using other cryptocurrencies. Finally, there are algorithmic stablecoins that automatically adjust the cryptcurrency’s supply to keep its market price within certain parameters.

Stablecoins are however still cryptocurrency. Even if the stablecoin has a pegged 1 to 1 exchange ratio with the U.S. Dollar, it is not the same as cash. For tax and regulatory purposes, the IRS treats all cryptocurrency as intangible property subject to capital gains tax. They may be subject to separate state-level regulation as well.

Paying for goods and services in stablecoin is a taxable event because the IRS treats it like a sale or exchange of an asset, which is subject to capital gains tax. Technically, if the stablecoin is pegged to the dollar at a 1 to 1 ratio, the capital gain is 0 and there is no tax owed. But the transaction must still be recorded and reported, just like if you were buying and selling a stock at zero net gain/loss. Otherwise, you risk attracting an IRS audit to determine whether you underreprted taxable income. Buying stablecoin for cash and holding it is a non-taxable event.

Receiving stablecoin in exchange for goods and services is a taxable event. It is not much different than receiving payment in fiat currency, which is income subject to tax. The fair market value of the cryptocurrency as of the date of receipt determines its value for income reporting purposes. With stablecoin, it is easy to calculate because of the 1 to 1 ratio. Receiving 500 USDC is the equivalent of receiving $500 cash. However, spending the 500 USDC is not the same as spending $500 cash – rather, the transaction is considered a liquidation of property (subject to capital gains). Again, if the value of the stablecoin is pegged to the dollar, you are not going to have capital gains. But you must still keep records and record the transaction. If you are using a stablecoin that is pegged to an asset like gold, its price will fluctuate and you may record a capital gain or loss.

Converting other cryptocurrencies into stablecoin and vice-versa is also a taxable event. The sale of the crypto is an asset disposition that is subject to capital gains tax even if the transaction is an exchange of one currency to another. Similarly, using stablecoin to purchase other cryptocurrencies is a sale of the stablecoin that must be reported as income, even if the the capital gain is $0.

Stablecoins are still risky and unregulated. Not all stablecoins are created equal and it is a mistake to think that “stablecoin” means there is no risk involved. The LUNA/TERRA debacle is a good example because TERRA was supposedly a “stablecoin” pegged 1 to 1 to the U.S. dollar, yet it was pegged algorithmically (meaning artificially without any actual assets or fiat currencies backing it). An algorithm that no one really understands is not the same backing as fiat in a vault or money market securities or corporate bonds or commodities portfolios. The bottom line is that without a uniform definition of “stablecoin,” users should at a minimum know what “stabilizes” the value of the purported “stablecoin.”

There are other hurdles to using stablecoins in day-to-day business operations. As cryptocurrency, they are still subject to government regulation. For instance, it is illegal under federal labor law to pay workers in anything other than U.S. Dollars. On the international scene, China recently tightened anti-crypto regulations, prohibiting financial institutions from providing crypto exchange services, which presumably includes stablecoins. At the same time, China is rolling out its “digital yuan,” which is a sovereign-backed virtual currency. United States regulators have also expressed interest in the “digital dollar,” in part to improve financial services access to unbanked or underbanked communities. Additionally, all cryptocurrency transactions are still subject to exchange fees imposed by the intermediaries, and there may be delays or additional processing costs associated with converting stablecoin into fiat currency. Widespread adoption by merchants and the public is a must for stablecoins to develop practical utility – but right now, holding a wallet full of stablecoin is not the most practical or liquid solution for most businesses. Nor does a 1 to 1 dollar stablecoin provide any investment upside and in fact periodically loses value due to inflation.

Finally, there are at least 36 different stablecoins available for purchase via most popular exchanges. It is unknown which stablecoin (if any) will enjoy widespread adoption and popularity sufficient to result in real utility for businesses. Further, stablecoins are not truly decentralized because a central entity is holding the collateral, which in turn must be audited or otherwise verified. If a holding entity starts issuing stablecoins that are not actually collateralized, this would cause hyperinflation and essentially render the stablecoin worthless.

Stablecoin certainly holds a lot of promise for business use, but only solves the problem of volatility. Reduced volatility comes at a cost of a centralized authority and reintroduces trust into the cryptocurrency equation. At the same time, sovereign-issued digital currencies are on the horizon and may very well dispel the need for and demand for stablecoin.

Want to know more? 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.

© 2021 Artaev at Law PLLC. All rights reserved.

Ask the Crypto Tax Lawyer: Are Play-to-Earn Games Taxable?

Disclaimer: This article is not investment advice, tax advice, or legal advice. It is for informational and promotional purposes only. Do not take any action (including investments) until you have consulted with a professional about your specific situation.

At the end of 2021, Ubisoft announced its plans to add NFTs (Non-fungible Tokens) into Ghost Recon: Breakpoint. Players’ in-game weapons, vehicles, and other rewards will be tradable and sellable on a secondary market, adding a real-world value component to the game. Ubisoft will become the first mainstream videogame developer to incorporate NFTs into its video games, although other A-list developers like SquareEnix are also planning to transcend the virtual and real worlds through blockchain technology.

Ubisoft follows in the wake of some popular Play-to-Earn (P2E) games like the global sensation Axie Infinity. According to a January Business Insider article describing the P2E crypto gaming model, Axie Infinity increased the value of its native AXS cryptocurrency (an Ethereum token) by a staggering 18,000% in 2021. Metaverse platforms that promise fully functional virtual worlds in the near future like Decentraland and Sandbox also saw explosive growth. For example, Decentraland’s native MANA token increased in value by 4000%. The main draw of these virtual worlds is that they allow users all over the world to earn cryptocurrency and NFTs that tradable for mainstream crypto or fiat money. Obviously, the returns and growth potential have captured the attention of many.

However, real world earnings mean real world taxes. As crypto and NFT earnings become more and more mainstream, more tax payers will have to consider the tax implications of cryptocurrency. The IRS considers cryptocurrency to be property, which is subject to capital gains tax similar to stocks or bonds. While the IRS has had guidance on cryptocurrency transactions since 2014, NFTs are a much more recent phenomenon without official guidance. Which then creates a number of questions for P2E players about how their winnings are reported and taxed.

Do I owe taxes on my play-to-earn winnings?

Absolutely. Because play-to-earn games allow users to earn cryptocurrency or NFTs, which then can be exchanged for fiat currency (e.g. U.S. Dollars), these earnings are considered income. In general, real world earnings mean real world taxes; however, the way your earnings are taxed will depend on several different variables.

To understand how the IRS will tax play-to-earn gains, you must first apply a few basics:

Are all P2E earnings the same?

No. Although both cryptocurrency and NFTs exist on the blockchain, they are two very different things and have different tax implications. Non-fungible tokens or NFTs are unique digital-only objects or unique digital versions of real-world objects. This is basically computer code. Mostly associated with collectibles and art, NFTs use blockchain technology like cryptocurrency but can represent almost anything, including virtual real estate, in-game vehicles or weapons, and personalized avatars. In the case of Ubisoft’s Ghost Recon, the “in-game earnings” will be in the form of NFTs. Similarly, the Pokémon-like Axie creatures that players acquire in Axie Infinity are also NFTs. These in-game items are pieces of unique computer code stored on the blockchain. These NFTs can later be exchanged for other NFTs or cryptocurrency.

Cryptocurrency, however, is not a unique collectible, but rather, a virtual currency. The IRS, in its Frequently Asked Questions on Virtual Currency Transactions, defines crypto as a type of virtual currency or “a digital representation of value, other than a representation of the U.S. dollar or a foreign currency (“real currency”), that functions as a unit of account, a store of value, and a medium of exchange.” Play to Earn games like Axie Infinity will commonly use crypto. In fact, Axie Infinity, much like Decentraland (which is more of a general attempt at a metaverse, rather than a stand-alone game), developed its own crypto token (AXS). AXS is tradable and exhcnagable into more mainstream currencies like Bitcoin or Ethereum (which are easily convertible into fiat), giving them value – not only within the game sphere itself – but also within the real world.

How do P2E gamers make money?

To fully understand taxes, it is first important to understand the basics of the P2E economy. Play-to-earn games give players an opportunity to win both cryptocurrency and NFTs by playing a game. Most often, the game will use its own native token as an in-game currency. The in-game currency and NFTs have value on the secondary trading market. To use Axie Infinity as an example, a player can earn value in several different ways:

  • First, a player acquires NFTs known as SLPs (Smooth Love Potions) through monster battles, player versus player fights, or by completing daily missions and quests. The player can then exchange those potions for cryptocurrency or even cash by selling them on an NFT exchange or DEX.
  • Second, a player can use SLPs to breed rare magical creatures (NFTs) known as Axie. Depending on the Axie’s traits and characteristics, an Axie NFT can fetch $200 or more on the secondary market.
  • Third, a player can stake AXS tokens in exchange for a particular return rate. Staking with crypto tokens is akin to holding money in a certificate of deposit (albeit, much riskier).
  • Finally, the game may award tokens or NFTs via airdrops. Airdrops are giveaways that the game may send its players as part of random promotions or in return for doing specific tasks.

What (and how) the game pays the player determines the type of taxes that particular player will owe. Is the income in the form on an NFT? Tokens? Staking income? An airdrop?

Are there taxes on tokens?

Whether it is called a token, cryptocurrency, or virtual currency, a native game token is taxed like intangible property and is subject to capital gains tax. The IRS has had a consistent position on this since at least 2014. When you purchase cryptocurrency or tokens with fiat currency (e.g. U.S. Dollars) you do not pay tax on the transaction. So if you buy AXS directly for USD, this is not a taxable transaction. However, if you buy AXS for ETH or BTC or another cryptocurrency, stablecoin, or token, you have incurred capital gains because the IRS considers you to have sold cryptocurrency you have traded – even if the transaction is a direct exchange.

If you earn crypto tokens as a part of a Play-to-Earn game, the value of such crypto is taxable as ordinary income. Likewise, when you sell crypto tokens on an exchange, you are taxed on the gain (if any) just like you would be if you sold a stock or investment real estate. Again, when you exchange one cryptocurrency for another (for example, you buy AXS with stablecoin) the exchange is taxable. Accordingly, it is critical to keep accurate and clear records of every transaction involving cryptocurrency, regardless of gain or loss.

How are NFTs taxed?

The IRS has not issued definitive guidance on how NFTs will be taxed, but most experts agree that NFTs will probably be considered property like cryptocurrency and be subject to capital gains tax. When applying this framework, NFT investing generally involves three different taxable events:

  • The Purchase of a NFT with Crytpocurrency. Play-to-Earn games often require a buy-in. Axie Infinity, for example, requires players to buy three Axies to start, which currently costs around $1,500. If you “buy-in” with cryptocurrency like ETH, the IRS will consider you having sold the ETH and have earned income equal to the difference between your purchase value and sale value. The acquisition of the NFT itself is not taxable for the buyer – but, is taxable for the seller as income.
  • The Sale of the NFT in exchange for Crypto. Selling an NFT creates a taxable capital gain or loss equal to the difference between purchase and sale price. Simply put, if you bought an NFT for $1,500 and sold it for $2,000, you incurred a $500 gain. If you bought the NFT for $1,500, but sold it for a $1,000, you have a $500 loss that you can use to reduce your other capital gains or even your ordinary income up to a certain amount.
  • The Exchange of the Crypto proceeds for U.S. Dollars or other fiat currency. Like the sale and purchase of NFTs, the exchange of a cryptocurrency into USD or other fiat currency will also trigger a taxable capital gain or loss depending on the difference between the original purchase price of the cryptocurrency (or token) and the price at the time of its sale.

Currently, there are no tax exemptions or safe-harbor periods that allow traders avoid capital gains tax on exchange type transactions.

Are NFT investors taxed differently than NFT creators?

Yes. Let’s say you’ve found a way to farm massive amounts of SLP (Smooth Love Potions) in Axie; these are NFTs. The initial creation or the minting of the NFT is not a taxable event. However, the sale of the NFT is taxable. However, in this case, since you are the creator and also the seller, and you technically “did the work” to earn the NFT, the IRS will likely consider the proceeds from your NFT sale ordinary income for tax purposes.

Is staking taxable?

Yes. Sure, my staked sheep in Wolf Game owe a 20% tax to wolves on all sheered WOOL; everyone knows that. But do I also have to pay WOOL taxes to the US government? Yes. Many taxpayers currently consider staking the same as crypto mining income, which means they will owe taxes on the fair market value of the WOOL the moment they receive the WOOL in their wallet – not just when they sell it.

The IRS is currently in litigation regarding this issue. The question being considered is whether the cryptocurrency or token has taxable value at the time of minting ( in my case “shearing”) or whether it should be taxed only upon sale of the WOOL – similar to the way traditional manufacturing companies operate. (For example, factory owners don’t pay income tax on a manufactured table, even though that manufactured table holds value, until the table sells.) This is one of the many unanswered questions in the blockchain sphere that regulators are catching up to answer.

Are Airdrops Taxable?

Yes, generally airdrops are considered ordinary income based on the fair market value of the drop at the time you get it. As with everything else, crypto-related, be sure to keep detailed records of all your crypto transactions to make sure that you account for them properly.

So, Do I Owe US Taxes on My Earnings from Play to Earn Games?

Yes. Real world earnings mean real world taxes. Whether you earn NFTs, native tokens, or Bitcoin, those assets have value and therefore subject to income tax. You, as the taxpayer, are still obligated to report income just like you would be if the game paid you in stock. As always, it is important to consult a crypto tax expert to see how the specifics of your situation apply to current IRS guidelines.

Further reading:

https://artaevatlaw.com/2021/10/05/play-to-earn-games-legal/
Is Playing Video Games for Real Money Legal? It May Depend on the Game.
Ask the Crypto Tax Lawyer: What Are the Tax Implications of Cryptocurrency and NFT Investing?

Ask the Crypto Tax Lawyer: Offsetting Capital Gains Through Loss Harvesting.

Update: As of November 10, 2021, Congress is in the process of considering legislation to preclude loss-harvesting through cryptocurrency sales. Congress is also considering other amendments to the Tax Code and other laws to address cryptocurrency specifically. As this is a rapidly developing issue, it is critical that you consult with a tax attorney or other professional about your specific situation and the current state of the law before making any transactions or business decisions.

More than half-way through 2021, cryptocurrency remains an extremely popular investment. Although volatile and subject to unpredictable regulation (yes, that means China), the market has experienced substantial growth. Exchanges like Coinbase and integration with PayPal make owning, trading, and speculating in cryptocurrency easy. Sophisticated investors have even added cryptocurrency into their self-directed retirement portfolios, banking on the continued growth and popularity of the decentralized exchange medium.

As I have previously written, the IRS is keeping a close eye on cryptocurrency investors, transactions, and markets, looking to capture taxes on hundreds of millions in underreported or unreported income. In other words, crypto taxes are going to be an issue for many in the coming tax years, especially after the Biden administration’s mandatory $10,000 or more transaction reporting rule goes into effect in 2023. However, with proper planning and strategy, there are ways to reduce your tax liability even if you are planning to liquidate your crypto positions in the near term.

As a basic matter, know that the IRS classifies cryptocurrency as “property,” which means that it is subject to capital gains tax. General capital gains reduction strategies work for cryptocurrency as well as they do for more traditional property like investment real estate, stocks, and bonds. For instance, waiting at least 365 days to sell lets you take advantage of the lower long-term capital gains tax rate. Selling in a lower income year where your overall income puts you in a lower tax bracket is another strategy.

One advanced tax strategy involves taking advantage of the so-called wash sale rule. Or rather, it is taking advantage of the fact that the wash sale rules does not apply to cryptocurrencies (yet). Under Treasury Regulation 26 CFR 1.1091-1, an investor cannot sell “stock or securities” at a loss, use the loss to reduce taxable income, and then immediately repurchase the stock or security. Under the wash sale rule, there is a 30-day waiting period before purchasing the same or substantially the same stock or security – if an investor repurchases the security within the 30-day restricted period, the loss will be added to the cost basis of the repurchased security and reduce capital gains on the sale of the repurchased security, but it will not be treated as an investment loss to reduce general tax basis. In other words, you cannot manufacture losses in a bear market to reduce your taxable income that you receive from other investments, rentals, or wages.

The IRS has been clear that cryptocurrency is treated as “property” for tax purposes. However, whether it is a “stock or security” remains unanswered and both IRS Notice 2014-21 and the recently amended FAQ are silent on the issue. There is no express definition of “stock or securities” for the purposes of the wash sale rule. Looking elsewhere in the Internal Revenue Code, the definitions of stock and securities in various other sections include traditional shares, notes, bonds, and the like. Indeed, in 1988 the United States Tax Court adopted a narrow interpretation of the Code, holding that stock options were not considered “stock or securities.” Gantner v. Commissioner (91 T.C. 713 (1988). Congress responded by amending the wash sale rule to expressly include stock options, but still did not enact a definition of “securities” for the purpose of the rule.

Based on the current Code and Regulations and the lack of IRS guidance on the issue, there is a strong argument that cryptocurrencies are not “stock or securities” for the purposes of the wash sale rule. What this means is that crypto investors can take advantage of loss harvesting to accrue losses and use those losses to offset income. For example, if you buy one Bitcoin for $30,000 and the next day the price drops to $20,000, you can sell the Bitcoin at a loss of $10,000, “harvest” the loss, and repurchase the Bitcoin for $20,000 shortly thereafter. You still own 1 Bitcoin, but now you have accumulated a loss that you can use to offset capital gains income.

If your losses exceed capital gains, you can use up to $3,000 of loss to reduce regular income. Any excess loss can be carried over to future years to offset future gains.

At the same time, the Securities and Exchange Commission (“SEC”), the Commodities Futures Trading Commission (“CFTC”), and certain United States courts have ruled that cryptocurrencies are indeed “securities” within those Commissions’ regulatory scope. This regulatory effort was generally to stem the fraud and abuse through “initial coin offerings” or ICOs that sought to evade strict regulations designed to protect investors. While there is currently no indication that the IRS would consider cryptocurrency as “stocks or securities,” there is precedent for that conclusion from these other agencies and remains possible that the IRS could issue supplemental guidance and interpretations to that effect.

At the time of this writing, the IRS has not issued any such interpretation and savvy investors can consider the loss harvesting strategy if appropriate for their particular situation. As with all cryptocurrency transactions, good record keeping is paramount. It is especially critical to have accurate records to substantiate your losses if you are repurchasing the same crypto. Good and accurate records are the best tool in defending your position to the IRS, should the IRS take a position and disallow your claimed losses.

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.

© 2021 Artaev at Law PLLC. All rights reserved.

Ask the Crypto Tax Lawyer: How Can I Reduce My Crypto Taxes?

Important: The information in this article applies to individual investors and LLCs that are taxed as pass-through entities. The rules are different for corporations and LLCs electing to be taxed as a corporation and are not addressed here. This article is for informational and promotional purposes only and, as always, you should consult with a professional about your specific tax situation before taking any action.

Despite its name, cryptocurrency or “crypto” is not really currency. For tax purposes, it is treated as “property,” which means it is taxed similar to stocks and bonds. As I previously wrote, buying and selling crypto is subject to capital gains tax. Paying for goods and services with crypto is likewise subject to capital gains tax. Exchanging one crypto asset for another is a taxable event as well.

“Crypto tax” has a nice ring to it, but it is nothing more than the application of ordinary capital gains tax to cryptocurrency transactions. The most important aspect of crypto investing – whether individually or as part of a business – is good record keeping. Exchange platforms like Coinbase can generate basic reports to use at tax time. But remember that you must also keep records when you pay for goods and services with crypto or receive payments in crypto. For tax purposes, when you pay someone in Bitcoin or Ethereum, the IRS considers that you have sold the cryptocurrency for cash (and realized a capital gain or loss). When you receive crypto as payment for goods and services, you acquired ordinary income in the amount equal to the market value of the crypto at the time of the transaction. In short, keep good records, you will need them.

What are some top strategies to minimize capital gains tax from cryptocurrency investing? As with any other investment, a little bit of planning can help you minimize your tax bill at the end of the year.

  1. HODL. The capital gains tax rate is different for short-term and long-term gains. Purchasing and selling crypto within a 365 day period is considered the short term, and any gains during that period are taxed like ordinary income (i.e. wages). Short-term crypto income will be taxed between 10% and 37%, depending on your tax bracket. On the other hand, selling crypto more than a year after buying it lets you take advantage of the lower long-term capital gains rate. Depending on your income level, long-term capital gains are taxed at either 0%, 15%, or 20%, with most people falling into the middle 15% bracket. For example, if you are paying a 22% rate on ordinary income, but are in the 15% bracket for long-term gains, you will end up with significant savings on your tax bill.
  2. Offset. Of course, not everyone buys crypto for long term investing. If you are trying to time the market and profit from crypto’s volatility, holding to gain favorable capital gains treatment may not be a feasible strategy. Tax law generally allows offsetting capital gains with losses, but the strategy does have limitations. Losses must first be used to offset gains of the same kind – for instance, short-term losses must be used to offset short-term gains, and only if you have excess short-term losses can you shift them over to reduce your long-term capital gains. If you still have remaining losses, you can take an ordinary income deduction of up to $3,000 for the tax year and retain the balance to offset next year’s gains and income.
  3. Decrease Taxable Income. Like with other “property,” you can time your sales to your specific income situation. You may want to sell appreciated crypto when you have less income than you anticipate in the future. Or, you may accelerate 401k/IRA contributions to take advantage of the up-front tax break. Health Savings Account contributions are another taxable income reduction alternative, especially if you are anticipating significant health care expenditures in the near future. For businesses, business expenses can be used to reduce taxable income, but be sure that the expense is both “ordinary” and “necessary.” For example, renting a building and paying electricity costs for your Bitcoin farm are probably ordinary and necessary expenses. Also, be careful to properly categorize any business start-up costs, assets, and improvements, which are treated as capital expenses (and therefore are different than your ordinary business expenses).
  4. Set up a self-directed IRA. Self-directed IRAs or SDIRAs are little-known but powerful investment tools for the sophisticated investor. They allow you to take full control of your retirement investments and direct the funds into non-traditional assets. Commonly used for holding real estate, private company stock, and precious metals, SDIRAs can certainly be used to buy and hold crypto. Most bank-managed retirement plans can be converted to the self-directed kind, but there are additional fees and special rules about what your SDIRA can and cannot do to retain the tax-favored treatment by the IRS. In essence, the SDIRA can be used to convert all or part of your retirement portfolio into an investment “checkbook” that you can then use to purchase and hold assets like crypto for the benefit of your retirement.
  5. Move, gift, donate, or leave it to your heirs. Depending on your situation, there are other options that may be used to optimize your tax situation. If you are in a state that imposes its own income tax, you may want to consider moving to a no income tax jurisdiction. Or potentially incorporating and locating your Bitcoin mining company there. Likewise, depending on your future goals, retirement situation, and estate planning, it may be advantageous to shift some of your crypto holdings (especially those where you are looking at a significant gain) towards those objectives. For example, if you leave your crypto portfolio as part of your estate, heirs would receive a “step up” in basis and receive the crypto at the fair market value at the time of death. This significantly reduces their tax bill and something to consider if a crypto portfolio is part of your estate planning.

There are other strategies that may be available based on your particular situation. Remember to keep good records, plan ahead, and get a professional to answer all your crypto tax questions.

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.

© 2021 Artaev at Law PLLC. All rights reserved.

Ask the Crypto Tax Lawyer: What Are the Tax Implications of Cryptocurrency and NFT Investing?

Important: The information in this article applies to individual investors and LLCs that are taxed as pass-through entities. The rules are different for corporations and LLCs electing to be taxed as a corporation and are not addressed here. This article is for informational and promotional purposes only and, as always, you should consult with a professional about your specific tax situation before taking any action.

2021 is the year of cryptocurrency. Bitcoin and its kin have attracted many institutional investors, smaller individual portfolios, and even some sophisticated self-directed retirement accounts. The accessibility, decentralization, and unlimited upside certainly make cryptocurrency (or crypto) an attractive investment. Or simply a fun way to try to make some extra fun money. Or lose it – the crypto market is extremely volatile and quickly reacts to government action (i.e. China’s ban) and Elon Musk’s tweets or SNL appearances.

Government regulators are watching the crypto markets. The Securities and Exchange Commission (“SEC”) has already applied securities laws to police initial coin offerings and to prosecute Ponzi schemes posing as crypto investments. As early as 2014, the IRS issued guidance (supplemented by a more recent FAQ) classifying cryptocurrency as property for tax purposes. More recently, the Department of Treasury and the IRS have zeroed in on cryptocurrency as a tax revenue source ripe for enforcement. As part of its tax reform plan, the Biden administration announced mandatory reporting of any crypto transaction of $10,000 or more starting in 2023. On May 20, 2021, the Treasury also released a report detailing the plan to close the so-called tax gap, which is the difference between taxed owed and taxes actually paid. In 2019, the gap was $600 million or 15% of all taxes, and is projected to grow to $7 billion in 10 years if left unaddressed. The biggest contributor is unreported income and Treasury and the IRS will be looking very closely at anyone who is trading cryptocurrency in the next few years for any signs of unreported or underreported taxable income.

Why are there taxes on trading crypto and how is crypto even taxed? Despite its name, cryptocurrency is not really currency for tax purposes. It is taxed like property and is subject to capital gains tax. When you purchase crypto with fiat currency (i.e. U.S. Dollars) you do not pay tax on the transaction. Note: States do not consider crypto purchases subject to sales tax – yet. But when you sell crypto, you are taxed on the gain (if any) just like you would be if you sold a stock or investment real estate. The tax rate depends on the length of time you held the asset and other factors related to your income status. Importantly, when you exchange one cryptocurrency for another (for example, you trade Bitcoin for Ethereum) the exchange is taxable. The IRS considers an exchange to be a sale of one asset for cash – income – regardless of what you do with the proceeds. Accordingly, it is critical to keep accurate and clear records of every transaction involving cryptocurrency, regardless of gain or loss. Interestingly, while the IRS considers cryptocurrency “property,” it does not consider it “securities” and therefore investors can take advantage of certain tax benefits. Specifically, crypto investors can do something called “loss harvesting” to offset taxable income from other sources.

How does the IRS verify income from crypto trading? In 2020, the IRS asked taxpayers about their participation in any cryptocurrency transactions as part of their 1040 filing. In large part, the tax system is based on self-reporting, but with third party verification checks. Bigger exchanges like Coinbase report your transaction history to the IRS and you should have received a copy of the 1099-MISC for tax year 2020. The IRS will then flag any returns that do not match the information received from the exchange and what the taxpayer puts on their return. Off-brand or off-shore exchanges may not report to the IRS, but you still have to report those transactions yourself and pay tax on any gains. As mentioned above, the Biden administration is cracking down on underreporting of taxable crypto income. This means expect to see significant and highly-publicized enforcement actions, including penalties, interest, and even jail time for tax evaders. If you do use an off-shore crypto exchange, you should also be aware of your tax obligations in the host country. The United States has tax treaties with many (but not all) countries – for example, while there is a treaty with mainland China, the treaty does not apply to Hong Kong and there is no separate treaty with Hong Kong. International tax law will also come into play if buy and sell crypto abroad or exchange it for goods or services in other countries.

What about NFTs? Non-fungible tokens or NFTs are unique digital-only objects or unique digital versions of real-world objects. This is basically computer code. Mostly associated with collectibles and art, NFTs use blockchain technology like cryptocurrency but can represent almost anything, including virtual real estate and personalized avatars. The IRS has not issued definitive guidance on how NFTs will be taxed, but most commentators agree that they will probably be considered property like cryptocurrency and be subject to capital gains tax. If you buy an NFT for U.S. Dollars, you do not pay tax on that transaction. If you sell an NFT for a profit, you just incurred capital gains tax liability, even if you are exchanging an NFT for another NFT or trading it for cryptocurrency. If you are buying an NFT with cryptocurrency, the purchase will also be subject to capital gains tax, as the IRS treats the transaction as a sale of an asset (cryptocurrency), income, and then use of that income to purchase the NFT. Currently, there are no tax exemptions or safe-harbor periods that allow traders avoid capital gains tax on exchange type transactions.

An additional question with NFTs is whether the tax rate will change based on what the NFTs represents. Is it a collectible piece of art? Then there is a special collectibles tax rate. Is it real estate? Something else? There are a lot of unanswered questions about NFT taxes at this time. But like with cryptocurrency trading, make sure to keep meticulous records of all transactions, including any gains or losses on sales.

A final item of note – estimated quarterly tax payments. The IRS (and state tax authorities) require the payment of estimated quarterly taxes from self-employed individuals or independent contractors. If you buy and sell crypto (and NFTs) make sure you are reporting and paying expected capital gains tax before the due date for payments that apply to the quarter of the sale. If you wait until the end of the year to pay taxes, you may be subject to penalties and interest for failing to pay quarterly. Additionally, you may have to liquidate other investments to pay taxes, instead of simply setting aside the capital gains estimate at the time of the original sale.

In short, if you are investing and trading crypto or NFTs, keep good records. Pay attention to any new guidance issued by the IRS. Beware false or misleading information on the internet. And above all, retain a trusted advisor to answer your questions and guide you through your tax obligations in this evolving field.

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.

© 2021 Artaev at Law PLLC. All rights reserved.

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

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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.

© 2021 Artaev at Law PLLC. All rights reserved.

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

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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.

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.


© 2021 Artaev at Law PLLC. All rights reserved.

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