Self-Directed IRAs: Knowing the Law is Only Half the Battle
By Jeremy T. Rodriguez, JD
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Many individuals who open IRAs choose to invest in traditional asset classes, such as stocks, bonds, or mutual funds. But for a growing number of people, these options are not enough. Instead, they look to invest in other non-traditional assets. The tax code actually allows taxpayers to use IRA assets to invest in a much wider range of asset classes. In fact, the law doesn’t provide a list of allowable investments. Instead, the regulations only prohibit IRAs from investing in life insurance, collectibles (with exceptions), S corporation stock, and anything that constitutes a prohibited transaction. That leaves a wide range of other permissible unconventional investments, such as real estate, futures and options, partnerships, and even race horses!
To open the door to this wide world of unconventional investments, you will have to open up a self-directed IRA. All IRAs (e.g., Traditional, SIMPLE, and Roth) can be offered as self-directed IRAs. The only difference between a self-directed IRA and a standard, run-of-the-mill IRA is the expanded investment landscape. However, custodians of self-directed IRAs are not required to offer every type of investment option available. In fact, many custodians place limits on available assets due to valuation problems or high risk concerns. Therefore, while every IRA owner should be familiar with the custodial document that governs the account, it is especially important in the case of a self-directed IRA. If you invest in a non-traditional asset that is permitted under the tax code, but not allowed under the IRA custodial agreement, you could find yourself with a deemed distribution and all the taxes and penalties that come along with that.
Such was the case for Guy Dabney. In 2009, Mr. Dabney had a Traditional IRA at Northwest Mutual. During that year, he heard about a piece of undeveloped land in Brian Head, Utah that he thought was undervalued. Brian Head is a small town in southern Utah about 3 hours from Las Vegas. The town is known for its mountains and ski resorts. Seeing this as an excellent investment opportunity, Mr. Dabney did some internet research and figured out that real estate is a permissible IRA investment. As a result, he rolled his IRA assets into a self-directed Traditional IRA with Charles Schwab.
Before purchasing the property, Mr. Dabney spoke with a customer service representative who told him that Charles Schwab did not permit “alternative investments” in self-directed IRAs. Despite this conversation, Mr. Dabney concluded that real estate was not an “alternative investment” and initiated a withdrawal of $114,000 from his IRA to purchase the Brian Head property. His plan was to title the property in the name of his IRA, sell it for a profit, and treat the entire transaction as a tax deferred investment within his self-directed IRA.
While he hoped to sell the property quickly, Mr. Dabney was unable to find a buyer until 2011. However, he did make money on the investment, receiving $127,266 after taxes and fees. The proceeds were wired directly to his self-directed IRA and he marked the deposit as a rollover contribution. The IRA custodian accepted the deposit and contributed it to his account.
While Mr. Dabney did receive a Form 1099-R for the $114,000 withdrawal, he did not report that on his 2009 tax return due to his mistaken belief that the entire transaction was tax deferred. The IRS quickly noticed the discrepancy and issued Mr. Dabney a tax deficiency notice of $42,431 plus an accuracy-related penalty of $8,486.
Mr. Dabney decided to take the issue to Tax Court and argued that the IRA purchased the property and therefore the $114,000 withdrawal was not a taxable distribution. He also pointed out that the tax code allows IRA assets to be invested in real estate. While the Court agreed with him that real estate is a permissible investment for IRA assets, it noted that the custodial agreement explicitly prohibited its self-directed IRAs from holding real estate. As a result, because the IRA wasn’t permitted to hold that asset class, his investment was deemed a taxable distribution.
In its holding, the Court stated what Mr. Dabney should have done; roll the assets over to a self-directed IRA that would have allowed real estate investments. Of course, this was wonderful advice but given much too late. In the end, the Court did have a little mercy on Mr. Dabney. They waived the $8,000 plus accuracy-related penalty after noting his efforts to comply with the tax code. Nevertheless, he wound up owing over $40,000 in unnecessary taxes.
The takeaway from Mr. Dabney’s folly is clear. While the tax code is obviously very important, the underlying custodial agreement should never be overlooked. All too often, taxpayers open self-directed IRAs, sign the necessary documents, and tuck them away in some filing cabinet. But before you make an investment in non-traditional assets, it is absolutely essential that you carefully examine what is permitted with the IRA custodian. Don’t be like Mr. Dabney.