Most taxpayers likely believe that having a team of professionals on their side should prevent mistakes from occurring during an IRA rollover. However, a recent IRS ruling shows some of the significant failures that can happen despite having this kind of backup - and how advsiors can keep them from happening.
In one case, a taxpayer wanted to buy an investment property and place it in his self-directed IRA. To ensure everything was done correctly, he hired a CPA, a lawyer, a financial advisor and a realtor to help with the transaction. So far, so good.
But even with this team in place, the attempted rollover failed three different IRA rules:
- It violated the once-per-year IRA rollover rule.
- It violated the same-property rollover rule.
- It missed the 60-day rollover deadline.
How do these mistakes happen, and how can they be prevented?
This case dated from Feb. 1 and Feb. 6, 2013, when the taxpayer took two IRA distributions he used to buy the investment property. This was his first failure; because of the once-per-year rollover rule, only one of the IRAs was eligible for rollover.
He went on to make matters worse by using the money from his IRA distributions to buy the investment property outside of his IRA.
He intended to put the property in the IRA, completing what he thought would be a 60-day rollover. But his method violated the same-property rollover rule, which holds that taxpayers must roll over the same property that was distributed. You cannot distribute cash from the IRA, then roll over real estate back to an IRA.
The taxpayer also missed the 60-day rollover because neither he nor his alleged expert team realized that his investment property had not yet been placed into his IRA.
As it turned out, that didnt even matter, as the property was not actually eligible to be rolled over in the first place. But aiming to resolve the dilemma, the taxpayer submitted a private letter ruling request to the IRS, asking for an extension.
In making the request, he placed no blame on his financial advisor, CPA or lawyer. In fact, he represented that he, and not his professional advisors, had orchestrated the transaction.
He did say, however, that around the time he bought the real estate, he was undergoing treatment for an illness, which he claimed was a contributing factor to his inability to adequately manage his finances. He said his medical condition weakened his ability to handle his finances and he was confused regarding the structure of the transaction.
The IRS denied the request for more time making his IRA distributions taxable, and ensuring that any income or capital gains generated from the real estate investment property would not be tax-deferred, because the property was not held inside the IRA.
The IRS also said he didnt provide enough proof that outside factors caused his failure to complete a timely rollover. During this time, [the] taxpayer continued to maintain employment and handle his other affairs, the IRS noted suggesting that whatever his medical condition, it wasnt serious enough to diminish his ability to handle his IRA.
But again, timing wasnt the only issue. Even if this taxpayer had moved the investment property back into an IRA within the 60-day window, it still would not have been a valid rollover.
In fact, had he completed such a transaction, the tax consequences of doing so would have been even more severe than what he already faces.
The reason stems from that same- property rule. For IRA-to-IRA rollovers, including those going from Roth IRAs to Roth IRAs, the property distributed from the original account must be the same property contributed to the receiving account. These rules also apply to SIMPLE and SEP IRAs.
If cash is distributed from an IRA, as was it was in this case, then cash must be rolled over within 60 days. An individual cannot, as this taxpayer falsely believed, receive an IRA distribution of cash and then roll over property (such as shares of stock or real estate), even if it was purchased with that cash.
If this taxpayer had managed to make such a transaction, not only would the amount of the failed rollover be taxable, but the property contributed to the IRA would likely result in an excess contribution subject to a 6% penalty every year until it was removed.
The same-property rule extends beyond cash. If a client takes an IRA distribution of property other than cash, the same property must be put back into a retirement account in a timely manner if the client wants to complete a valid rollover.
For example, if 100 shares of ABC stock are distributed from an IRA, the same 100 shares of ABC stock must be rolled over to an IRA within 60 days to complete the transaction regardless of whether the price of ABC shares have gone up, down or remained the same since the initial distribution. (Remember, its the same-property rule, not the same-value rule.)
Clients also cannot receive an IRA distribution of 100 shares of ABC stock worth $20,000 and roll over $20,000 of XYZ stock because its not the same property that was distributed from the IRA.
There is an exception to the same-property rule for rollovers distributed from a company retirement plan, such as a 401(k). In this case, recipients have a choice: They can either roll over the same property to an IRA or they can sell the property distributed from the plan and roll over the cash proceeds from the sale.
This is true even if the sale proceeds are greater or less than the value of the property when it was initially distributed from the company plan. The clients would also not have to recognize any loss or gain on the sale.
BLAME THE PROS
What about all those advisors and professionals the taxpayer hired to help him? Shouldnt at least some of them have known about the same-property rule, the once-per-year IRA rollover rule and the 60-day rollover window? Arent they at least partially responsible for the faulty rollover?
In the real world, that may be true. But when the taxpayer submitted his extension request to the IRS, he didnt claim his mistake was in any way due to advisor error or negligence.
Although there are never any guarantees, the IRS has been fairly consistent in allowing late 60-day rollovers when taxpayers provide evidence that they relied on advice from a professional who accepts blame for the mistake.
To avoid costly blunders like this, advisors need to understand these specific IRA rules. They must advise clients not to take an IRA distribution of cash, then try to roll over property bought with that cash outside the IRA. They must also be sure to check that only the identical property is rolled over. And of course, when the 60-day clock is ticking, they need to keep a watchful eye on it.
If advisors are careful about ensuring all rules are followed, they can help clients avoid these damaging IRA rollover mistakes and keep taxpayers from suffering such detrimental consequences. FP
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 several books on IRAs. Follow him on Twitter at @theslottreport.