The IRS attack on illiquid IRAs

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Just as IRAs attract more alternative assets, they’re also attracting more IRS attention.

“The IRS has long believed that there is substantial noncompliance with minimum distribution requirements,” says Natalie Choate, an attorney with the Boston law firm Nutter McClennen & Fish. Recent changes give the tax agency a window into the IRAs that may be coming up short: large accounts containing hard-to-value assets, with owners over age 70 ½, according to Choate, author of Life and Death Planning for Retirement Benefits.

That age, of course, is when required minimum distributions from traditional IRAs must start. Choate points to two windows: Form 5498, filed annually with information on how much an IRA account is valued and whether a distribution is required, and Form 1099-R, which reports the amount of any distribution. Starting with the 2015 versions of these forms, due in the first half of 2016, IRA custodians must reveal the presence of hard-to-value assets, and the asset type.

This development “indicates that the IRS is making an effort to step up enforcement of the RMD rules,” says Scott McCartan, CEO of Millennium Trust, an Oak Brook, Ill., firm that offers alternative custody solutions.

“However,” he says, “I don’t believe the IRS is actively working to discourage investors from diversifying their retirement holdings with alternatives, or that the new rules will discourage the use of self-directed IRAs to hold them.”


The percentage of alternative assets being held in IRAs is growing, but they still account for a small portion of overall IRA balances, according to McCartan. Poor preparation and misunderstanding of the RMD rules are typically the chief reasons for inappropriate RMDs, in his view.

“This is particularly true,” he says, “when IRAs hold illiquid alternatives, such as real estate or hedge funds or private equity that are, by their very nature, hard to value.”

“Violation of the RMD rules has been an issue the IRS would love to tackle, but its resources are limited,” says Mary McGrath, a CFP and CPA who is executive vice president and portfolio manager at Cozad Asset Management in Champaign, Ill. “The IRS realizes that it doesn’t have the manpower to investigate all the IRAs with hard-to-value assets. With more-substantial reporting requirements, the IRS is hoping it can focus on those accounts where the abuse is worth the investigation.”

The new information from the forms can show the agency which large IRAs with illiquid assets are in the RMD stage. “By putting this requirement on IRA custodians,” McGrath says, “it will bring to light those accounts that might be abusing the valuation rules. I’m guessing the IRS is hoping that fewer custodians will be willing to hold hard-to-value assets, so it will be more difficult for IRA owners to hold them. It’s a backdoor approach to lessen or limit this abuse.”

Rick Kahler, a CFP who is president of Kahler Financial Group, a wealth management firm in Rapid City, S.D., believes the pressure on alternatives in IRAs may have a long-term impact. “I don’t think the new requirements will do much more than give the IRS a focused list of IRAs it may want to audit,” he says.
Nevertheless, this initiative ultimately might help the agency achieve some of its goals. “The valuation of assets without an obvious market value is difficult and subjective,” Kahler says. “My hunch is that, after the IRS litigates a few of these cases and people see the high cost of defending their self-directed retirement plan, taxpayers will think twice before using them.”

On the other hand, Barry Picker, a CFP and CPA/PFS who is co-founder of Picker & Auerbach, an accounting firm in Brooklyn, N.Y., questions the real-world impact of the new reports from IRA custodians. “Past experience,” he says, “has been that the IRS requests information designed to get taxpayers to improve compliance, but there is no follow-up.”

As an example, Picker mentions the IRS getting notification that an IRA has a required distribution, followed by no IRS contact if a withdrawal isn’t made.

“Maybe the same thing will go on here,” he says. “I doubt that the new rules will discourage people from investing in nontraditional assets with their IRAs.”


For advisors with clients who want to hold nontraditional assets in IRAs, other issues may precede valuations for RMDs. McGrath says she has a few clients with assets not readily valued.

“The custodian we use, Pershing, won’t hold this type of asset,” she says, “so I have located a local bank willing to. If someone approaches me with this type of asset in an IRA, I suggest establishing an IRA at the bank to hold the hard-to-value asset and transferring the balance of the IRA to Pershing.”

Kahler reports having one client with an IRA that holds land. “Several others have IRAs that have made direct loans secured against real estate or purchased discounted mortgages,” he says. “It’s up to the IRA owner to value these.”

Picker says his clients with hard-to-value IRA assets are in “pay status,” meaning they’re subject to RMDs, which the custodians compute. “I’m not involved in that aspect,” he notes. Custodians’ RMD calculations are based on the value of IRA assets and the IRA owner’s age; this information is then run through an IRS table.

“As a custodian for self-directed IRAs, it is not our role to value the assets,” McCartan says. “However, we require that a valuation be provided to us at least once per year, from an independent source.”


The type of asset may dictate the source of valuation, McCartan explains. “Some valuations come to us directly from the sponsor of the investment, from a general partner, or [in cases where the asset is private stock] from an executive of a private company,” he says. “If the sponsor is unable to provide a valuation, the IRA owner can get a third party to provide one. For real estate, we require an annual comparative market analysis.”

McCartan says his firm won’t accept a valuation directly from IRA owners, but “it is their responsibility to make sure that one is provided to us.”

As for advisors, McCartan says they may not be directly involved in IRA valuations but they should be certain that clients have enough cash to pay the tax on an RMD if it’s desirable to keep an illiquid IRA asset intact.

Advisors also should inform clients of the importance of making adequate RMDs, even if they hold nontraditional IRA assets, and the potential costs of not doing so.

“Regardless of what past practices may have been,” Choate says, “all IRA owners and sponsors should be prepared to support their valuations of non-publicly traded assets with professional appraisals.”
Advisors also might suggest that clients liquidate nontraditional IRA assets before they turn 70 ½, rendering moot the question of undervalued RMDs.

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IRAs Retirement planning