IRAs must be valued, for tax purposes, and imprecise valuations can be costly.
"Overvaluation is more common than undervaluation," said Joe Luby, a CFP who is the founder of Jagen, a financial education and consulting company in Henderson, Nevada. "In a lot of cases, amending tax returns can provide substantial refunds to clients."
Luby, who has written a book on this subject, KEEP IT! Advanced Tax Strategies for IRAs, said the problem comes from illiquid, hard-to-value assets held in IRAs. "Often, a net asset value is reported. However, the proper value for tax purposes is fair market value, which is what a well-informed willing buyer would pay a well-informed willing seller."
Many clients hold IRA assets that can be mis-reported, Luby asserted. Non-traded REITs are widely held in IRAs; some clients hold interests in hedge funds, private equity partnerships, Delaware statutory trusts, etc., in their IRAs. The sponsors might provide a net asset value to investors but that's not necessarily the fair market value.
If a client has illiquid assets in his portfolio, how can a planner help to obtain a valid valuation? "The client can hire a qualified appraiser, as defined by the IRS," Luby said. "That appraiser might look at the entity itself, at the assets it holds, at the latest reports, and so on. If possible, the appraiser also will look at transactions where similar interests have changed hands recently, in a secondary market."
That is, a fund sponsor might make arrangements for an investor to cash out before the deal goes through its entire life cycle. If an interest is officially valued at $10 but a buyer recently paid $6 to a investor wanting to exit, then $6 might be closer to fair market value, in the appraiser's judgment. Obviously, a Roth IRA conversion will be less taxing if $6 interests are involved, rather than $10 interests. According to Luby, secondary market trading prices are often 25% or more lower than the reported value of illiquid assets.
Luby suggests having illiquid IRA assets appraised professionally before relevant events such as Roth IRA conversions, required minimum distributions, and in-kind distributions. "It's also possible review past events," he said, "to see if IRA overvaluations resulted in tax overpayments. Then clients can claim refunds.
Such appraisals can cost anywhere from a few thousand dollars up to tens of thousands. "If planners have multiple clients holding the same type of illiquid IRA asset, such as shares in a non-traded REIT, a group appraisal can lower the cost for individual clients," Luby said. "Fair market values might not make a huge difference, if small amounts are involved, but clients with large investments may find paying for appraisals worthwhile." Even without an overpayment and refund, an accurate appraisal can help clients avoid tax underpayments that result in IRS interest and penalties.