In recent weeks, many of our posts have addressed the need for taxpayers to consult with an experienced tax professional for tax preparation and tax planning strategies before making a financial decision. Here is yet another real-life example of why that advice is so important.
The taxpayer, Guy Dabney, decided to invest in undeveloped land in Utah using his IRA (individual retirement account). Dabney did some online research and concluded that real estate can legally be held in a self-directed IRA. But when he called Schwab’s customer service line, a representative told him Schwab did not allow alternative investments (such as real estate) in an IRA.
Despite Schwab telling Dabney that it would not accept real estate in its IRA accounts, he proceeded with the purchase and had the money wired from his Schwab IRA to the seller and requested that the property be titled in the name of his Schwab IRA. Dabney sold the property a couple of years later and he wired the sale proceeds directly into his Schwab IRA and marked the deposit as a rollover.
The IRS’s document matching program eventually caught-up with Dabney and saw that Schwab reported a taxable distribution on Form 1099-R when the monies were withdrawn from Dabney’s IRA to purchase the Utah land but that Dabney had failed to report this distribution on his personal income tax return. This resulted in Dabney underreporting his taxable income and underpaying his taxes which resulted in the IRS assessment notice. Dabney argued that the distribution wasn’t taxable, saying it was either an investment purchased by his Schwab IRA or a transfer between two IRA custodians. The IRS argued his IRA didn’t buy the land because Schwab’s policies don’t allow it, and that no IRA trustee-to-trustee transfer happened. The issue went to Tax Court and Dabney made yet another major mistake by deciding to represent himself.
The Tax Court ruled in favor of the IRS finding that titling an asset in the name of an IRA does not mean the asset is actually held by the retirement account. Since the court ruled that his IRA never bought the property and a trustee-to-trustee transfer never happened, the IRA distribution was taxable and subject to the 10% early-distribution penalty. The IRS had also assessed a 20% accuracy-related penalty for substantial underpayment of income taxes. The “good news” for Dabney was that the Tax Court found that the substantial underpayment penalty did not apply to the facts of this case. The “bad news” that the IRS assessment of taxes, interest, late payment penalties, and the 10% early withdrawal penalty were all sustained by the Tax Court.
The Tax Court did not address another potential assessment that Dabney needs to address. When he transferred the proceeds from the sale of the land to his IRA, those monies were not eligible for a rollover and therefore would be considered an excess IRA contribution in that year. Excess IRA contributions are subject to a 6% excise tax in the year of the contribution and each year thereafter until the excess contributions are withdrawn from the IRA.
While real estate can be held in a self-directed IRA if the custodian allows such an investment to be held, taxpayers need to understand the reasons why some custodians do not allow such investments. There are numerous tax and legal complications associated with these IRAs. First, the taxpayer (or his family members) cannot receive any rent or compensation from the IRA and there cannot be any personal use of the real estate. Second, the taxpayer receives no current tax benefit for the normal operating expenses, interest and depreciation. Third, when the property is sold, it will be taxed at ordinary income tax rates rather than the preferred capital gain rates had the property been purchased outside of the IRA. If the property were sold at a loss, the taxpayer would not receive a benefit of deducting that loss on his Form 1040.
Dabney could have avoided all of this had he met with an experienced tax professional before unilaterally deciding to use his IRA fund to purchase the Utah land.
If you want to learn more about your personal tax and financial planning strategies, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.
