IRAs are allowed to hold real estate as an investment, but IRA custodians aren’t required to let an investor include real estate in his account. Taxpayer Guy Dabney learned this lesson the hard way, and his experience may be of value when dealing with clients who wish to hold alternative investments inside a retirement account.
The lesson came down in a Tax Court ruling earlier this year. Dabney had rolled IRA funds into an existing self-directed IRA he had with Charles Schwab, and he decided he wanted to invest in undeveloped land in Utah.
Dabney did some online research and determined that IRAs could invest in real estate. 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.
Dabney also called his CPA, who said he didn’t have any training in retirement accounts and didn’t know whether an IRA could invest in real estate. Yet after Dabney showed him his online research, his CPA said it might be OK. Apparently, Dabney wore down his CPA until he told him what he wanted to hear.
BUYING & SELLING
Dabney arranged what he believed to be a legal way for his Schwab IRA to buy the land. Instead of finding a custodian who would allow real estate as an IRA investment, he had the money wired from his Schwab IRA to the seller and had the property titled in the name of his Schwab IRA.
In March 2009, Dabney proceeded with the purchase. He had $114,000 wired from his Schwab IRA directly to the seller and titled the property in the name Guy M. Dabney Charles Schwab & Co. Inc. Custodian IRA Contributory.
This did not make the land IRA property, however. In fact, because of a bookkeeping error, the property was titled in Dabney’s own name. He didn’t discover the error until he sold the land two years later, for a bit over $127,000. (He then promptly got an affidavit from the title company in which the firm admitted it had made the mistake.)
He wired the sale proceeds directly into his Schwab IRA in January 2011, and marked the deposit as a rollover.
But Schwab had issued a Form 1099-R for 2009, reporting a taxable early IRA distribution of $114,000, although Dabney has said he doesn’t remember receiving it. When his accounting firm prepared his taxes for 2009, the IRA distribution wasn’t reported on his Form 1040 — so he didn’t pay taxes on the withdrawal.
IRS CATCHES UP
When the IRS caught up to him for not paying taxes on the 2009 IRA distribution, Dabney claimed that it 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; Dabney represented himself and lost.
At trial, Dabney argued that he was acting as an agent through which his Schwab IRA bought the land, so the $114,000 withdrawal was not a distribution, but an investment.
He likened his situation to a 2002 Tax Court case. In that case, the court ruled there was no IRA distribution when the taxpayer used IRA money to make an investment in stock that was not publicly traded and the check from the IRA custodian was made payable to the issuing company to buy the stock.
But in that case, the IRA custodian could not buy the stock for the taxpayer’s IRA because it was not publicly traded. The Tax Court ruled in 2002 that there was no distribution when the custodian delivered the check to the taxpayer, because there was no constructive receipt of the check, and ownership of the stock was assumed by the IRA. The taxpayer acted as an agent for the IRA custodian. At all times, the IRA was the owner of the shares, even though it may not have been in physical possession of the stock certificate.
But Dabney’s case was different, the Tax Court found, because Schwab’s policy did not allow IRA owners to invest in real estate — and therefore the IRA did not agree to accept the asset.
The fact that the land was mistakenly titled in Dabney’s name personally didn’t really matter because his Schwab IRA couldn’t have owned the land even if it had been titled correctly.
Dabney’s second argument — that the funds wired directly to the title company were a transfer between two IRA custodians — also failed. The court again backed the IRS, finding no evidence that the title company was an IRA custodian (nor that Dabney had an IRA there). 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. But the accuracy-related penalty is waived when the taxpayer acts with reasonable cause and in good faith.
The court noted that Dabney wasn’t a sophisticated taxpayer; he had no background in accounting or tax, and had gone to great lengths in trying to ensure that the land purchase would qualify as a tax-free event.
Because the court said Dabney honestly believed the land purchase was appropriate, and had acted reasonably and in good faith, it ruled the 20% accuracy-related penalty didn’t apply.
There was yet another complication the court did not address: an excess IRA contribution. The deposit Dabney made in 2011 after selling the land happened two years after the 2009 IRA distribution.
The deposit was not eligible for rollover, so it would likely be treated as a tax-year IRA contribution. Because that amount would have greatly exceeded the IRA contribution limit for the year, he would now have an excess IRA contribution, subject to a 6% penalty for 2011 and each year afterward until it’s corrected.
That would be roughly another $7,000 in penalties each year. Making matters worse, if the 6% penalty was not reported in a timely manner and paid on Form 5329, the three-year statute of limitations would not begin.
From a legal standpoint, real estate is a valid investment inside an IRA. And there certainly are custodians that allow it — generally, self-directed IRA custodians. But many, if not most, custodians, disallow it (as Schwab does). There are numerous administrative and legal issues involved that dissuade most custodians from offering it.
The lessons learned from this case are straightforward: Before investing IRA funds in an alternative investment, check to ensure the IRA custodian is willing and able to accept it. If not, find a custodian that will.
Beyond that, 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 retirement account.
That’s what happened in this case and an intended IRA investment became a taxable distribution.
Ed Slott, a CPA in Rockville Centre, N.Y., is a Financial Planning contributing writer and an IRA distribution expert, professional speaker and author of many books on IRAs. Follow him on Twitter at @theslottreport.
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