Before purchasing the property, Mr. Dabney spoke with a customer service representative who told him that Charles Schwab did not permit “alternative investments” in self-directed IRAs. Despite this conversation, Mr. Dabney concluded that real estate was not an “alternative investment” and initiated a withdrawal of $114,000 from his IRA to purchase the Brian Head property. His plan was to title the property in the name of his IRA, sell it for a profit, and treat the entire transaction as a tax deferred investment within his self-directed IRA.
While he hoped to sell the property quickly, Mr. Dabney was unable to find a buyer until 2011. However, he did make money on the investment, receiving $127,266 after taxes and fees. The proceeds were wired directly to his self-directed IRA and he Marced the deposit as a rollover contribution. The IRA custodian accepted the deposit and contributed it to his account.
While Mr. Dabney did receive a Form 1099-R for the $114,000 withdrawal, he did not report that on his 2009 tax return due to his mistaken belief that the entire transaction was tax deferred. The IRS quickly noticed the discrepancy and issued Mr. Dabney a tax deficiency notice of $42,431 plus an accuracy-related penalty of $8,486.
Mr. Dabney decided to take the issue to Tax Court and argued that the IRA purchased the property and therefore the $114,000 withdrawal was not a taxable distribution. He also pointed out that the tax code allows IRA assets to be invested in real estate. While the Court agreed with him that real estate is a permissible investment for IRA assets, it noted that the custodial agreement explicitly prohibited its self-directed IRAs from holding real estate. As a result, because the IRA wasn’t permitted to hold that asset class, his investment was deemed a taxable distribution.
In its holding, the Court stated what Mr. Dabney should have done; roll the assets over to a self-directed IRA that would have allowed real estate investments. Of course, this was wonderful advice but given much too late. In the end, the Court did have a little mercy on Mr. Dabney. They waived the $8,000 plus accuracy-related penalty after noting his efforts to comply with the tax code. Nevertheless, he wound up owing over $40,000 in unnecessary taxes.
The takeaway from Mr. Dabney’s folly is clear. While the tax code is obviously very important, the underlying custodial agreement should never be overlooked. All too often, taxpayers open self-directed IRAs, sign the necessary documents, and tuck them away in some filing cabinet. But before you make an investment in non-traditional assets, it is absolutely essential that you carefully examine what is permitted with the IRA custodian. Don’t be like Mr. Dabney.