Real Estate Investments in an IRA – A Warning!
When most people think of investments appropriate to an individual retirement account (or IRA), they think of the typical standard investment vehicles such as stocks, bonds, mutual funds and the like. In recent years, more "sophisticated" investment products such as ETFs (exchange traded funds) and master limited partnerships have come into vogue.
But there are other, less common investments that an IRA can hold and that could be an important element of diversification for your portfolio.
One such investment is real estate. Yes, good old terra firma, buildings, etc. Real estate may sometimes be an appropriate part of your retirement investment plans and such an investment is allowed by law.
But when considering real estate investments in an IRA, it is important to note that you can't just go out and buy a piece of property, as a recent Tax Court case pointed out.
In this case, a Mr. Dabney did some research and determined that an IRA could indeed invest in real estate. The custodian for his self-directed IRA at the time was Charles Schwab.
Mr. Dabney made a phone call to Schwab, discussed his idea for buying a piece of property he had identified as a good investment, and asked for the custodian's help. The problem was, the representative informed Dabney that Charles Schwab as a custodian did not allow alternative investments such as real estate.
Dabney was not deterred. He knew (after all he had done his internet research) that his IRA COULD invest in real estate. I don't know what Dabney was thinking; maybe he just thought the Schwab representative didn't know what he was talking about; but for whatever reason, Dabney came up with a plan for his IRA to own that real estate with Schwab ostensibly as the custodian.
Dabney decided to wire funds from his Schwab account to purchase the property and to title it "Guy M. Dabney Charles Schwab & Co. Inc. Cust. IRA Contributory". Essentially he was trying to make it appear that Schwab was the custodian of the investment without Schwab having any idea!
He assumed he could make the investment, quickly resell it at a small gain and redeposit the funds into his account, and it wouldn't be an issue. This is exactly what he did, although it took a couple of years longer than expected for him to make the sale.
There was just one problem. Because the wire transfer was not made directly to another IRA custodian, it was considered a distribution, which Schwab rightly reported to Dabney on Form 1099-R as taxable.
And guess what, you got it - the IRS through its 1099 matching program picked up on the transaction and treated it as a taxable early withdrawal with related income tax and early withdrawal penalty. The Tax Court agreed with the IRS, no surprise there.
So what is to be taken away from this case?
Mainly this – just because the law allows an investment, in this case real estate, doesn't mean a custodian is obligated to ACCEPT such an investment. In fact, many traditional custodians will NOT allow alternative investments, be it real estate, precious metals, works of art, etc.
So, if you feel like an investment in real estate makes sense for your IRA, by all means consider that, but make sure you find a custodian that will act as trustee for such an investment. Not only that, but make sure they are a reputable custodian that has successfully done more than a few of these transactions.
The last thing you want is to end up like Dabney, with an unintended tax burden, because an otherwise legitimate IRA investment was not handled properly.
