In this episode of Adam Talks, IRA Financial’s Adam Bergman Esq. discusses digital real estate, what it is and if you can invest in it with your Self-Directed IRA retirement funds.

Digital Real Estate and Your IRA

Hey everyone, Adam Bergman here, tax attorney, founder of IRA Financial. And on today’s Adam Talks, want to talk to you about the concept, or the actual product, intangible product of digital real estate. What it is, is it worth anything? How the heck do you actually buy it? And can you buy it in an IRA?

So, pretty cool podcast for you today. Kind of been looking at digital real estate for a bit. My kids have kind of talked to me about it. They’re big Fortnite gamers. So, I’ve kind of gotten some proximity to the concept of buying or using a digital platform to purchase a good or a service. So, it kind of leads to this next phase is, hey, you can game; now we know there’s decentralized potential for Metaverse, Web 3.0, which I’ll get to in this podcast, how can we take it a step further? Are people going to actually buy real estate on a platform or game? Does that make sense? Do we have any control over this? This is just code, right? It’s not hard dirt that you can see and touch. There’s an unlimited amount of space. I guess you can just create more parcels of land on this platform, whereas if you’re buying an apartment in New York City, there’s only so much space available to keep building.

Anyways, we’ll tackle all those subjects in today’s podcast. So buckle up and let’s get going. So, what is digital real estate? Okay, so basically, keep it simple – it’s everything you see online could potentially be real estate, whether you’re buying a website, a domain name; that is all deemed digital real estate or a digital asset. But I’m going to be talking about actual digital plots of real estate. So, not just a URL, you go on GoDaddy and buy a URL for $12 a year or buy a website. I’m talking about actual plots of space. I don’t want to call it land or real estate, but it is digital real estate that you can buy.

So, it’s basically any land or any parcel located on a Metaverse/digital platform. It’s like physical property. They’re situated in certain areas, and you could locate them, generally based off virtual reality or just going on the platform, which we’ll get to in a sec. You can own it; you can monetize it. We’ll get into NFTs; how that works. There are platforms like Decentraland and Crypto Voxel and Sandbox. Probably. Decentraland and Sandbox are the two most popular platforms to purchase digital real estate.

Okay, we’ll get into some examples in a second, but you’d be shocked what people are paying. Like, for example, land on the Decentraland a few weeks ago is selling as high as $900,000 for 16 virtual acres. Some virtual plots are being sold for close to a million bucks, but you can get things for as low as like $10.

Okay, so there’s a wide range of real estate you can buy digitally. Now, the Metaverse kind of opens this up to make it kind of interesting, right? We’ve all heard of the Metaverse and what, yanno Facebook changed their name to Meta. And you may have heard about Oculus, where my kids’ friend has it. And you can punch Mike Tyson out. It looks kind of real. There’s some cool stuff you can do on Oculus. And that’s the whole idea, right? We’re all going to kind of put these on in the future and you’ll be able to mow the lawn in your digital real estate and hang out at the pool and maybe walk up the stairs in your chateau.

All digital, all on the Metaverse, right? And Metaverse, essentially, a future advancement of the Internet we have today, right? We’ve seen Microsoft – they’ve talked about this mesh where they’re going to blend mixed reality and augmented virtual reality like on Microsoft teams. We’ve seen the digital avatars, but it’s taking the Internet and taking it a step further with virtual reality.

What’s an NFT? Non fungible token. Basically, it’s unique. You can’t replace it. You can use it for digital assets like art, collectibles, games, items. Also, it has utility like tokens. Okay. Ethereum Blockchain allows developers to create smart contracts, which is part of the NFT foundation. And it’s all driven by Blockchain. That’s the whole idea – that you own this, you’re the only one that owns it. You can follow the chain of ownership on Blockchain.

So, if you look at Web 1.0, which is back in like the 90s, email, web domains, blogs. Web 2.0 – 2000’s, we moved to social media, mobile apps. Now, Web 3.0, which will be virtual parcels, digital currency, NFTs.

That’s the hope, right? Facebook changed their name to Meta. That’s kind of where they’re positioning themselves. So Web 3.0 and Metaverse can work closely together. For example, you can see a situation where you may be doing zooms with VR headsets. Right? So you’re kind of using your computer, using the Internet, but you’re using virtual reality. A digital creator may create some type of outfit for an avatar or ability to decorate your house in the Metaverse. Right? So you’re using an NFT, using some way to digitally enhance the Metaverse experience. So, that’s how the Web 3.0 and Metaverse can essentially collide.

So, going back to digital real estate, I’m going to just spend a few more minutes on this and then go into potential taxation – can you buy it with an IRA, pros and cons; all that good stuff. But, I mentioned earlier that people are paying crazy amounts for this stuff. I saw Snoop Dogg is replicating his California mansion on Sandbox and someone paid $450,000 to be his neighbor. That’s serious. That’s true. Price Waterhouse Cooper in Hong Kong purchased land on Sandbox, like an office. A physical real estate company, the Metaverse Group; they paid $2.4 million to purchase a plot of land on Decentraland.

So, people are taking this serious. People want to get in early. Is this valuable? Is this worth doing? I don’t know. I guess like physical real estate: supply and demand. You can hold the asset, you can monetize it through NFTs, blockchain. It’s easy to monetize it. It easier to sell a digital asset than sell a physical house, right? You don’t need a real estate agent and no closing. You can literally just sell it on a website and it gets transferred by crypto. And then you can just move the crypto to Fiat or US dollar. So that’s a pro. Obviously, the con is, hey, who’s to say they can’t just create more space on this platform, right? And who’s to say that people you stay on this platform, maybe they’re going to buy and start using a different platform. Or maybe it’s going to be the new hot area on the Metaverse. And now you own a plot of digital real estate on a MySpace-type website or platform that no one goes to anymore. So, we’ll see how this all connects. This is kind of first pitch, first inning of the Metaverse.

So, kind of risky to get in. If you pick the right piece of land on the right platform, you could hit it big, or you just may have wasted your money. No one really knows. What are some of the pros? Obviously, you diversify, you get it into an emerging asset. You’ll use blockchain technology, so it will be unique. It will be clear that you’re the sole owner and you could capitalize on it quick by selling it like on open sea and selling the actual ownership to that digital piece of real estate. The cons, that’s obvious, right? The risk, volatility, security – you actually have to hold the cryptos, right? So there’s risk on that. And then the risk of the underlying Ethereum currency that you’re going to get when you sell it.

So, how do you buy it? Well, the first thing you got to pick a platform, right? Whether it’s Decentraland or someone else. Decentraland uses Mana, which is a pretty interesting crypto. It’s Ethereum-powered blockchain or sandbox; whatever you want to use. You got to choose the storage method, right? So you purchased the digital real estate, you need to store the digital NFT, and the most common platform, again, is Decentraland, sandbox. And it requires a MetaMask extension to store the assets. You’ll need to use MetaMask-type wallet, and then you purchase your parcel. Right? Just like basic real estate, choose the right property. You make money when you buy it, not when you sell it. And then obviously you can put it on open sea to sell.

But, it’s not super hard to buy or sell. It’s just super risky. Okay, so is there any tax on, like, digital real estate? Well, there’s no digital property tax yet. That could change, I guess, down the road. So, there’s no stamp tax or property tax when you buy or sell real estate. However, there is a federal income tax, depending on how the digital real estate is treated. Is it a capital asset? Yeah, probably. Could it be deemed inventory? Maybe, if you’re a business; in the business of buying or selling digital real estate. Or is it a collectible, which is a higher long-term capital gains tax rate at 28% versus 15% or 20% for a regular long-term capital asset. All depends, right? We don’t know. There’s very, very little guidance on the taxation of NFTs in general.

Now, digital real estate, is it a collectible, right.? And why is that important? Well, we know IRAs cannot invest in collectibles – Section 408(m). If you’ve watched my videos, listen to my podcast, read my blogs, you know straight off that there’s three things you can’t do in an IRA: can’t buy life insurance, can’t buy collectibles (art, cards, baseball cards, stamps). There’s a carve-out under 408(m) for metals, bullion-type, gold, silver, palladium, American Eagle coins, state-minted or bullion coins. But they all need to be held in physical possession of a depository. And then thirdly, you can’t do a prohibited transaction outlined in Internal Revenue Code Section 4975, which basically means you can’t self deal or benefit in any way, directly or indirectly from the IRA asset, i.e. live in an IRA-owned home. Okay. Or take your IRA and buy yourself a Rolex watch. Whatever your IRA does, it needs to exclusively benefit the IRA.

So, the first question is, is digital real estate a collectible? We don’t know. Okay? This is the definition of collectible (I’m taking this from the Code). Any work of art, any rug, antique, any metal, gem, stamp or coin, with limited exceptions, and alcoholic beverages, which is always a strange one. But, this is the interesting part: or any other tangible, doesn’t say property, it says any other tangible, personal property that the IRS determines is collectible under this Section.

Is digital assets as digital real estate tangible? No. What’s the definition of tangible? It literally means anything that can be touched, includes both real property and personal property. You can’t touch digital real estate on the Metaverse – Sandbox, Decentraland. You can’t touch it okay? So, what does that mean? Does that mean that a digital asset potentially not be deemed collectible? Maybe. It’s also very possible for the IRS to change the language in Section 408 to clearly outline NFTs right? They can add; just like they added a specific line item like art or antiques, they can just say NFTs or digital assets.

Today they haven’t right? The way Washington works, probably not going to happen for a while. The IRS has been very slow to react on any type of guidance for cryptos and taxation. The only real guidance we have goes all the way back to 2014: 2014-21. It’s an IRS notice that really is the only public written offered statement on the taxation of cryptos. That’s eight years ago. A lot has happened in the last eight years right?

So, we’ll see where this goes. There’s zero guidance, but if you look at 408, you have some support because digital real estate is not a tangible property. So, 408 seems to suggest that the IRS doesn’t have the ability to even prescribe any intangible assets as a collectible. I don’t know. This, 408 was written a long time ago, before anyone ever thought about intangible types of collectibles. Back in the 70s and 80s, people collected baseball cards and stamps and antique cars and things like that. They didn’t think about digital manifestation of real estate; that just didn’t exist.

So, we shall see. What does taxation mean? Well, if you own this outside an IRA, it’s important if it’s treated as a collectible, why? Because the capital gains tax rate for long-term capital gains – assets over twelve months is 28%. Again, there could be a 3.8% surtax, depending on your income. Whereas, if you have a regular capital asset, not a collectible, and you make less than $488,000, you pay 15% tax on the capital gains, held longer than twelve months, more than $488k, you pay 20%; so, that 15% to 20% is less than the 28%. The 20% could also be subject to a 3.8% surtax, depending on your income, but 23% is still less than 31&.

So, the determination of whether a digital piece of real estate or an asset as a collectible is quite significant and adds potential tax liability to the investment. So, it’s super important. Unfortunately, there’s not much guidance now that we are aware of or have been given by the IRS. So, what can you do? Well, again, even if guidance is provided down the road, I’m assuming they’ll either grandfather it in or there’ll be some period where you can exit out of that investment if you own it in an IRA, because there hasn’t been any guidance in the past. I’m not sure; it can take years for any IRS guidance on the tax treatment of NFTs and whether it’s collectible under 408.

Retirement account legislation is not the hottest thing on the agenda for Ways and Means. It’s not something that they’re extremely focused on. Yes, they are focused on helping people retire. We saw SECURE Act 1.0 passed in December 2019, SECURE Act 2.0, which should pass, it’s in the Senate now for review, and then we’ll go back to the House, and then some version of the House incentive bills will go to the President to sign probably later this year. There is movement in the retirement world, but to actually have specific legislation tackling cryptos, collectibles, NFTs; don’t think we’re going to see it for many years.

So, I guess buyer beware. Number one, obviously, there’s risk. There’s volatility. There’s also uncertainty in the tax treatment. Is it a collectible? Is it just a capital asset? Of course, if you hold any capital asset less than twelve months, subject to ordinary income tax, but from an IRA standpoint, you want it to be treated as a capital asset. You do not want it to be treated as a collectible. And you also don’t want to be deemed to be in a business of buying and selling digital real estate. Why? Because business income is subject to a tax known as unrelated business income tax, which would travel as high as 37%.

So, I assume the best way to get exposure to these types of digital real estate assets; you can do one-off investments. But again, there’s no guarantee that the IRS won’t come down and argue is collectible. And if it’s collectible, it can’t be owned in an IRA. So then it’s not just a tax issue, it’s the issue of is the IRA investment disqualified and subject to tax? I’m not sure.

I do think that they will have some leeway in terms of getting people who have used an IRA in the past to purchase this asset some way to exit it before being subject to disqualification because it has not to this day being deemed the collectible. And section 408 really just talks about tangible collectibles. Right? And then, it has a clear statement that says the IRS could prescribe as a collectible, any other tangible personal property; doesn’t say just property or real or personal, just a tangible, personal. So, here we are talking about intangible real property.

So, I think there’s a good case to be made that 408 maybe would not apply to digital real estate. But again, there’s no clear cut evidence or support from the service at this point.

So, there you go. It’s a pretty interesting area. Obviously, this will coincide with the value of cryptos. The more popular cryptos get, the more popular people want to use cryptos and decentralized investment models and blockchain technology to invest. The next question is, can you do it in an IRA? And then obviously that answer turns on whether the digital real estate is deemed a collectible. As of today, as I mentioned, no support, no direct guidance. But, there are some good arguments to be made that potentially it could be allowed because it’s not a personal property and it’s not a tangible personal property that the IRS would seemingly to have the authority to add to the list. So, they’d have to amend 408 to give them the ability to add an intangible asset like a digital NFT to the list of collectibles.

So, there you go. But, if you do buy personally as well, it’s up to you and your accountant, I guess, to decide if you’re going to treat this as a collectible, pay up to 28% capital gains tax, or argue it’s not a collectible, and then pay either 15% or 20%. So, that’s also an issue, whether you buy it in an IRA or not.

So, hope you guys enjoyed today’s podcast. I know I did. Pretty cool topic. Always piqued my interest in where the Internet is going from 1.0 to 2.0 to 3.0, and what the economics will be of the Internet 3.0. And hey, whether Zuckerberg and Facebook made the right move by pivoting to Meta. What does that mean for all of us and for investments like real estate in a retirement account?

So, thank you again for spending some time with me today. I hope you have a great rest of your day. Don’t forget to check me out again next week.Take care and be well.