Heed custodian’s asset allowances

The Tax Court has ruled that an individual had a taxable IRA distribution when he tried to get around his custodian’s policy of not allowing real estate as an individual retirement account investment. The court said the custodian didn’t have to offer real estate as an investment, even though the Tax Code allows it. As a result, the individual was not acting as an agent for the custodian when he bought a property with his IRA money and tried to title it in the IRA custodian’s name (Guy M. Dabney et ux. v. Commissioner; T.C. Memo. 2014-108; No. 14566-12, June 5, 2014).

Guy M. Dabney had an IRA with Charles Schwab & Co. Inc. and wanted to buy a piece of undeveloped land in Utah with his IRA funds. But Schwab, like many IRA custodians, did not allow alternative investments to be held in its IRAs. They do not have to allow it, even if the law does.

TAXABLE DISTRIBUTION

But Mr. Dabney did it anyway and the court ruled that the $114,000 IRA distribution used to buy the land was a taxable distribution, and added a 10% early withdrawal penalty since Mr. Dabney was under age 591/2. The Internal Revenue Service also sought the 20% accuracy-related penalty but the court declined to impose that, finding that Mr. Dabney acted with reasonable cause and believed the IRA land purchase was appropriate.

In March 2009, Mr. Dabney proceeded with the purchase of the property by having $114,000 wired from his Schwab IRA directly to the seller of the property and titling the property in the name of “Guy M. Dabney Charles Schwab & Co. Inc. Cust. IRA Contributory.” This did not make the property “IRA” property. In fact, due to a bookkeeping error, the property was titled in Mr. Dabney’s own name (that error was corrected in 2011).

Mr. Dabney’s plan was then to sell the property at a gain and contribute the sales proceeds back into his IRA, but he could not find a buyer. He eventually sold the property for $127,226 and had those funds wired into his Schwab IRA in January 2011. He marked the deposit as a rollover contribution and Schwab accepted the IRA deposit.

For his 2009 taxes, Mr. Dabney received a 1099-R from Schwab for the $114,000 IRA distribution, also showing an early distribution with no exceptions applying. He did not report the distribution on his 2009 tax return.

The end result: The $114,000 IRA distribution was taxable and subject to the 10% early withdrawal penalty, but no 20% accuracy-related penalty due to reasonable cause.

This was not a purchase of an asset by Mr. Dabney’s IRA, because his custodian did not allow land in its IRAs. This was a taxable distribution, and subject to the 10% penalty. Mr. Dabney was advised of this but went ahead with the transaction anyway (based on his own online research).

Mr. Dabney argued that the IRA purchased the property and that this was not an IRA distribution. But since the custodian would not allow this transaction, his IRA could not have purchased the property. Instead it was a distribution.

The court pointed out that Mr. Dabney could have done a rollover or transfer to another IRA custodian that would allow the IRA to purchase the property.

What about the $127,226 rollover into Mr. Dabney’s Schwab IRA in January 2011? The court noted that the contribution of funds back to the IRA in 2011 was not a valid rollover since it occurred nearly two years later, but the court did not address the excess IRA contribution problem. The $127,226 sales proceeds Mr. Dabney rolled into his Schwab IRA became an excess contribution subject to an additional 6% excess contribution penalty for each year the excess funds remained in the IRA. That’s roughly another $7,000 in penalties each year. To make matters worse, if the 6% penalty is not reported in a timely manner and paid on Form 5329, the three-year statute of limitations does not start running.

Real estate is a valid investment inside an IRA and there certainly are IRA custodians that allow it (self-directed IRA custodians). But many, if not most, don’t allow such investments in IRAs.

LESSONS LEARNED

Before investing IRA funds in an alternative investment, check to see that the IRA custodian is willing and able to accept it. If not, find a custodian who will.

Make sure all IRA assets are purchased by and held inside an IRA. Simply titling an asset in the name of an IRA does not mean the asset is actually held by the IRA. That’s what happened in this case and an intended IRA investment became a taxable distribution.

Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group. He can be reached at irahelp.com.