Who Cares what it’s worth? A case for due diligence in providing fair market values to your IRA custodian.

For most assets IRAs invest in, providing the annual valuation doesn’t matter because most of the $4 to $5 trillion of those accounts is invested in publically traded investments.  For the 3% of that amount invested in self-directed IRAs however, it matters a great deal.  You receive a request from your IRA provider every year and you probably don’t realize that for the self-directed account this has become a hot button for the IRS.  They are sitting up and paying attention to the fact that with hard-to-value assets there is a wealth of taxes to either be reaped or avoided.  

Case in point, “Berks vs Commissioner of Internal Revenue”.  This is about a situation that is played out every year when the IRA holder is asked to provide a value for their IRA asset.  This particular instance involved an investment in notes where the borrower either defaulted or the collateral did not adequately secure the debt resulting in the notes being worth zero.  The IRA provider, over a period of several years, requested that the IRA holders, the Berks, provide an annual valuation.  The Berks referred these queries to the investment provider who allegedly in turn called the provider and only told them that “the notes are worth zero”.  No documentation supporting this assertion was provided.  The Berks requested that the assets be valued at zero and that the Provider terminate their accounts.  In accordance with the Provider’s policy, the assets were distributed from the IRA holder’s account to the IRA holder at the currently recorded book value of the asset.  In other words the IRA holder received a 1099-R (form for reporting distributions from pension plans) for the full amount of the account using the original face value of the notes.

The Berks had the means to fight this, however, and took the case to tax court challenging the valuation of the IRA at the time of distribution.  This is where this case becomes interesting.  The IRS did not see this situation the same way as the Berks did.  Not only would the IRS not accept the opinion of the Berks that the IRA was worth zero, they penalized them 20% of the account value for their “negligence” in failing to make a reasonable attempt to comply with tax laws, maintain adequate books and records or to substantiate items properly.  They were also cited with the intentional “disregard” for rules and regulations.   They surely did not see this coming.

As is usual in tax cases, the burden of proof falls on the taxpayer.  The Berks’ tax return claimed the IRA distributions were not taxable and therefore they paid no taxes on the reported distribution.  They blamed the preparer for this “oversight”.  They blamed the IRA Provider for distributing the account at full value.  They took no responsibility for their account or their tax preparation.  The court was not sympathetic.  Quite the opposite, the court found that these arguments actually weighed against them.

The moral of this story is this: when you have a self-directed IRA provide an annual valuation, with documentation, when the IRA provider requests it.  If the asset is worth zero, provide proof.  Much of what is done for those in the publically traded IRA investments is done for them by the IRA investment provider, usually at a fee that is three times what self-directed IRA providers charge, a fee that drastically reduces the rate of return.  Self-directed IRAs give you entrance to every investment allowed by law.  You find and manage the investment and provide the value annually.  Those are the rules.  With self-directed IRAs you get unlimited possibilities but you are also expected to know and understand the rules.

Retirement Home in a Self Directed IRA?

It never fails.  Cold winters up North bring cause lots of clients to think about retirement in the sun.  They come to our doors in search of ways to use their retirement accounts to purchase resort property in the warm areas of the globe.  Maui, Florida, Phoenix, even British Honduras are all the stuff of dreams when thinking about retiring somewhere winter never visits. 

There are many clients that want to use their IRA/401(k) accounts for purchasing the “dream retirement home”.  Is this possible?  It certainly is, within certain boundaries.   What does the IRS code say about buying retirement property in your IRA?  The answer is nothing.  The IRS does not endorse nor recommend any investment to be purchased by your IRA.  The rules prohibit only two classes of investment:  Life insurance and collectibles.  The code also requires that the money be used for investment.  The other rules governing investments deal with who you deal with and how the investment is used.   For a client purchasing a property for potential future retirement, we always point out the following:

• When you take the property out of your plan or “distribute” it for your personal use, you will be taxed on the fair market value of the property
• You must be over 59 ½ years of age or you will pay a 10% penalty as well as the taxes due.
• No personal use is allowed by you or by any disqualified person* while it is in your IRA
• All expenses of the purchase and maintenance must be paid entirely by your IRA while it is in the IRA
• You may rent it out but all monies must go back to the IRA
• You must have a plan for the ultimate distribution of the property from your IRA should you wish to use it upon retirement

Are you still  interested at this point?  The questions are “how to buy it in the IRA” and “what to do when you retire and want to use it” should be answered before plunging into the “retirement home purchase” scenario.  The services of a qualified tax professional may be necessary in order to determine what the tax burden will be upon retirement as there needs to be some strategy for paying taxes on the property distributed from your IRA.  The other important part of this scenario is that you need a self directed IRA with an administrator that is comfortable with real estate purchases.

There are two major ways to approach this problem, although there may be some variations.  Consider the first case: 

Bob and Frannie by a condo in Maui.

On vacation in West Maui, Bob and Frannie decide to purchase a home on the hill above Kahana.  Formerly pineapple fields, the developer took advantage of the great ocean views and created a subdivision close to the West Maui airport and Lahina that retired people just love.  Although Bob and Frannie are only in their early 40’s, they did not want to miss out on the opportunity to get in on the ground floor of something now, thinking they may not be able to afford it in the future. 

The cost of the property was $350,000.  Bob had an IRA that was approximately $250,000 resulting from his severance from a company layoff.  Frannie had about $100,000 in her IRA from the same company and the money was invested in a mutual fund after distribution from the company 401(k) plan.   Neither Bob nor Frannie had any great plans to make this money work harder but the idea of property in Maui was just too good to walk away from.  With the help of a self directed IRA administrator and a semi-knowledgeable real estate broker they managed to close on the property, title held in the name of the two self directed IRAs:  Bob’s IRA with a 71% undivided interest and Frannies’ IRA owning the remaining 29%.  The property was placed on a short term rental program in order that the IRA would have cash to pay for the real estate taxes, maintenance and HOA dues.  The property may not be used by Bob and Frannie while it is still in their plan.  

In the future the property may either be taken completely out of the IRAs as one large in-kind distribution or could be taken out incrementally over a period of years to lessen the immediate tax burden.  This strategy is a subject unto itself but it has been done.  A few parting thoughts on this:  1) a self directed Roth IRA would allow distribution after 59.5 years of age without tax consequences and 2) the IRS requires that when you turn 70.5 years of age you MUST take distributions from a traditional IRA.  

Your 401(k) From a Past Employer

Some of our New Direction IRA clients do not know that #401(k) plans from former employers can be rolled directly into a self-directed IRA.  If you currently have an IRA with us and funds are still in a former employer’s 401(k) plan, these funds can be rolled into your account and self-directed.  The good thing about rolling these funds directly into an IRA, this is technically called a 401k #roll over is that you will not be subject to the 20% #withholding which occurs when taking the funds as a distribution would cause.

In addition to 401(k) plans, #457 and #403(b) plans may also be rolled into a self-directed IRA.  Again, these plans must be from former employers in order to roll them over.  We frequently get the question “can I take 401(k) funds from my current employer and self-direct?”  The answer to this is nearly always no.  Under some rare circumstances these plans may provide “in service” distributions or you may be the trustee of the plan yourself and have the ability to change the plan, but this is rare.

Does your spouse have an old 401(k) plan?  Consider a self-directed account for your spouse to roll the these funds into and consider the partnering yours and your spouse’s IRA funds in a larger investment.   Take advantage of the investment power and economy of scale available in a larger investment.

Self-direction of your retirement plan provides flexibility and nearly endless choices of investments.  Maximizing your IRA through consolidation of old 401(k) plans, making your annual contributions and being vigilant regarding innovative investments will make your retirement years comfortable and fun if you have the money available.

Obama is going to take my IRA! The sky is falling!

I heard this from several people who stopped by our booth last weekend in Chicago at the coin/gold convention.  This is the follow up to “the government is going to take all my gold if I don’t store it under my bed”.  As an IRA administrator I am interested in anything that affects IRA law but, really, only when it becomes law.  I perused the internet and came upon a number of histrionic articles that talked about the government taking our retirement plans and at least one used the example of the country of Cypress.  As in “if it can happen to the Cypriots it can happen to us”.  I have not yet found the connection between Cypress and US policy that allows this claim.  Some of the confusion is that what is currently in the works does NOT involve actually "taking" money away from the IRA or individual.  What is proposed is removing the tax deferred status on some IRA money thus forcing the individual to take a taxable distribution. Besides this, I also found theses additional items of interest (note: if you have less than /$3.4 million in your retirement account(s) skip items 1 through 4 and jump to item 5):

1. This is still in the negotiation stage and is not yet a law.
2. If you have $3.4 million in your IRA/401k you would be affected.
3. If you are fortunate enough to have $3.4 million in your account, you would:

• not be allowed to make further contributions to the account
• have to distribute that amount necessary to bring it to the $3.4 million level (to yourself, not the US government) and,  
• have to pay taxes on the amount distributed.

4. The $3.4 million threshold would change annually in proportion to the cost of annuities
5. If you have less than the $3.4 million threshold you can be affected by:

• Company 401k plans could be disbanded if the Plan can no longer shelter the retirement savings of the more successful retirement investors.  
• As a sub “$3.4” individual you may end up in an individual retirement plan with smaller contribution limits.

6. The current 3.4 cap would affect only 0.1% of those 60 or over.
7. On the bright side, one proposal would exempt IRA accounts worth less than $75K from the required minimum distribution at 70 ½ which is currently in place.  This is a good thing.

Why IRAs and retirement plans?  Why not your personal non-sheltered savings?

The reason is taxes.  You have not yet paid taxes on your Traditional IRA and Traditional 401k money and won’t be taxed you take the money out.  If anything illustrates the value of tax advantaged plans like IRAs and 401ks it’s this: the IRS is willing to allow special tax treatment on these accounts so that earnings inside the accounts can grow, untaxed, until withdrawn; but in the future they not be willing to allow this non-taxed money to stay in unlimited balances, untaxed for years.

At New Direction IRA we have very very few accounts that would be affected by the proposed law, if it actually becomes a law.  I don’t think very many people realize and utilize the power of a tax sheltered account yet.  I can only hope that this latest proposal to limit IRAs, will make people realize how precious and powerful the IRA (and 401k) can be.  Especially the money is self-directed into investments that the IRA holder understands.

Using Self Directed IRAs Creatively

Lending to Fund Non-Profit Organizations

Or How to use your IRA Creatively and Mindfully

Private schools, churches and other non-profit entities, regardless of focus or denomination, frequently have difficulty borrowing funds for building projects.  The addition of classrooms, labs, a new steeple, additional capacity added to an existing facility, or even remodeling of an existing space all take money.  The use of building fund drives has long been the method of fundraising, requiring significant long term planning and the uncertainty of consistent results.  New Direction IRA has seen alternatives to this fundraising approach among its clients.

There is another way.

Ask the members to lend funds from their IRA and other tax-advantaged plans!  Self-directed plans may lend funds and can benefit both the organization and the IRA holder.  IRA lending using a self-directed IRA administrator allows the individual to choose their own investments, one of which can be a loan to the organization.  These loans, for example, could be:

• In the form of a Note
• Can be secured by the organization’s property
• Would represent an investment for the IRA and would have to reflect a reasonable rate of return.
• Would pass the benefit of interest on principal and fees to the IRA account as opposed to an outside lender.

Consider these examples:

The Youth Center

An inner city church has decided to add a teen social center in an existing space currently used for storage.  The 1000 square foot area needs new flooring, painting, drywall partitions and restrooms.  In addition, the furniture and equipment for Friday night movies and a pool table will be purchased.  The cost of this project is estimated to be approximately $50,000.   The youth group will charge for movies and food purchased at the location. 

Funds are raised by creating a $50,000 note which will pay 5.5% interest annually.  The note will be amortized on a 5 year schedule and the investors will be church members’ IRAs.  Let us assume that 5 individuals come forth, each lending $10,000 from their IRA accounts using a self-directed administrator who is responsible for maintaining the tax-deferred status of the IRA accounts.  Principal and interest flow back to the IRA account.  The IRA holder has made a retirement investment that is secure and feels good too. 

The Theatre

A small private school would like to have a venue for school assemblies and theatrical productions.  It is anticipated that this new facility will boost enrollment as the Board has decided to focus on the arts in their curriculum.  They have the room to expand on their current property and approach a local bank to fund the $500,000 price of this addition.  The bank is interested in the project based on the reputation of the school and the predictability of the annual tuition paid by the students but is not willing to provide 100% funding. 

With a $250,000 loan from the bank, the school trustees decide to issue “bonds” for the construction to interested parents and, possibly to alumni.  They structure the issue in $50,000 increments that will be offered in step with the construction.  The interest rate offered will be based on some margin over the T-Bill rate at the time the bonds are issued.  This allows them to only borrow the money when it is needed, thus controlling costs but to offer current competitive rates to their investors.

Wildlife Conservation

Your favorite charity, a bird rehabilitation facility would like to create an educational facility to educate the public on the importance of preserving the habitats of native birds.  The organization already has the land available to place a facility on its property but does not have the current cash flow necessary to secure a bank loan. You have an IRA which can lend 25% of the funds for the purchase of a prefabricated building in order to house the education center.  The remaining funds will come from cash donations and pledges from local businesses.  Ultimately the education center will charge an admission fee to the facility and provide special presentations for schools and other interested groups.  Payments from the organization will be made directly to the IRA and the loan can be structured in a way to both provide collateral for the loan and allow construction draws as the facility is being built.

Many individuals these days want their investments to in some way reflect their personal values.  The stock market does not necessarily speak to some individuals' viewpoints.  What better way to invest, not only in “what you know” but in what you believe as well.

Can I Live in a Property Owned by my IRA?

You have seen this on the Internet and wonder – is it possible to use your IRA to purchase real estate that you can actually live in?  We get this question all the time at New Direction IRA.  The answer to that question is NOT a simple “yes.”  There are many ways to buy real estate with your IRA, here are two of them:

#1    Purchasing as personal property but paid for with your account
The advertising that states you can buy real estate with your IRA and live in it is not actually referring to the purchase of real estate within the IRA.  What it is talking about is a little known rule for IRAs whereby you can take distributions from your Plan before reaching the age of 59 ½ years without penalty.  This type of transaction is called a “72(t) distribution.”

In IRS Publication 590, included in the list of allowed distributions without penalty, is one in which you establish an agreement with the IRS for you to take equal payments from your IRA account.  The IRS states:

Annuity: You can receive distributions from your traditional IRA that are part of a series of substantially equal payments over your life (or your life expectancy), or over the lives (or the joint life expediencies)  of you and your beneficiary, without having to pay the 10% additional tax, even if you receive such distributions before you are age 59 ½  You must use an IRS-approved distribution method and you must take at least one distribution annually for this exception to apply.

The payments under this exception must generally continue until at least 5 years after the date of the first payment, or until you reach age 59 ½  whichever is later. If a change from an approved distribution method is made before the end of the appropriate period, any payments you receive before you reach age 59 ½ will be subject to the 10% additional tax.

Those who sell annuities market primarily the 72(t) distribution concept.   The IRA is actually investing in an annuity that guarantees a series of payments, which are taken as distributions.  This is how it is used for real estate purchases:

• Sellers of annuity contracts will have the individual transfer their IRA into an IRA account, which in turn will purchase an annuity contract that guarantees a fixed payment in order to meet the required payment agreed to with the IRS
• The individual will find a piece of real estate and buy it using a mortgage guaranteed by their personal assets, with payments from the annuity used to pay the mortgage on the property.

How is this different from real estate held in your IRA?  The substantial differences are:

1. You must have enough wealth to guarantee the mortgage on the property to begin with.  
2. This is not an IRA investment.  The real estate is outside of your IRA.  Sale of the property, unless it is your primary residence, will follow all the rules of any investment sale.
3. The IRA is being liquidated to make the distribution payment.  You may not put those funds back into the IRA after taking them out.
4. There is generally little flexibility on the rate of return or how you invest the IRA after the annuity is purchased and the 72(t) distribution election is made.
5. You will be taxed on the distributions at your current tax rate rather than at your tax rate at retirement.
6. You have a mortgage on your credit rating as well as the need to come up with a down payment.

#2   Purchasing real estate as an investment within your self-directed account
Using a “Self-Directed” custodian, you may, if you choose, buy and sell real estate within your IRA. The proceeds of each sale go back into your account, tax-free, to be used for the next purchase.  There is no time limit on how long real estate is held, nor is there any requirement for “like kind” purchases with the proceeds as there is in a Section 1031 Exchange.  Taxes occur when you take distributions from the IRA at age 59 ½ or later, at which time they are taxed at your income tax rate at that time.  With this type of investment, however, there is a requirement that this be an investment and that the IRA owner cannot use it personally while it is still in the IRA.

Which method or real estate purchase is right for you?
If your intent is to use your IRA now for the purchase of, most likely, a second home to use now, the 72(t) option could be for you.  If your attraction to real estate is for building wealth within a tax-deferred account by buying and selling for a profit and growing your IRA, then a 72(t) is probably not what you want.  The tax-deferred status of IRAs is specifically designed for the purpose of tax-free growth.  You lose this status when the real estate is purchased outside the IRA and funded with taxable distributions from an annuity.

Are there other options available?
Must you purchase an annuity contract in order to take a 72(t) distribution?  The answer is no.  It is possible to do a 72(t) distribution from any IRA, regardless of the assets held.  For ease of distribution, the investments in the IRA should have sufficient liquidity available to make the mandatory distributions.  You need only to be able, or to have an adviser able, to make the calculation of the required annual distribution amount.   It is a relatively simple calculation, and most tax advisers can advise you.  Your self-directed custodian can hold any investment of your choosing for the purposes of the 72(t) distribution.  Purchasing mortgages, income property, or any cash-producing asset can be used.  Consider that the purchase of an appreciating asset that also produces cash flow sufficient for your distributions may allow the account to grow for your future retirement needs while still funding the 72(t) distribution.   Making your investments inside a self-directed account allows you to keep maximum flexibility rather than locking you into the purchase of annuity contract..  As an example, consider the following for your IRA:

1. Purchase a condo for cash within your IRA for $150,000
2. Your IRA rents the condo for $800 per month, which nets $700 per month cash flow into the IRA.
3. You determine that the required monthly distribution for a 72(t) will involve taking $700 per month from your IRA account.
4. You use the $700 to make payments on your “second home” mortgage.
5. The condo appreciates at a rate of 5% per year, making your IRA worth $190,000 in five years even while paying out the required distributions.
6. Your IRA is going up in value because it contains real estate.
7. You have your second home to use now.

Conclusion
Choosing the right option is important when one of the choices is electing a 72(t) distribution which involves a commitment to the IRS to take mandatory distributions.  Seek input from your tax and financial advisers before embarking on investments either inside or outside of your IRA in order to quantify the tax consequences of the various options.  For information on self-directed IRAs and the IRS rules applicable to those types of investments contact your local self-directed IRA administrator.

Money Smart Colorado Week Kickoff!

Last night I attended the kickoff dinner for “Money Smart Colorado Week” at the Federal Reserve Bank in Denver.  Money Smart Colorado is an organization that promotes financial literacy across all ages and ethnic groups in Colorado.  New Direction IRA is proud to be one of the partners in this effort and as such will be teaching classes about self directed retirement investing and how it relates to saving money and investing for the future.

The evening was very upbeat mostly because of the collection of passionate people who are the Money Smart organization and made this coming week a reality.  The panel of speakers who presented covered a spectrum of professionals:  educators, library/information science, financial planners organization, and community outreach.   Also represented on the panel was The Jump$tart Coalition for Personal Literacyâ, as stated in their About Us page “an organization of organizations that share an interest in advancing financial literacy among students in pre-kindergarten through college”.

One of the high points of the evening was the key speaker Todd Salzman, retired after 30 years in the US Air Force, now relationship manager for Ent Credit Union.   He is a powerful and engaging speaker.  The title of his talk was “Making Your Financial Flight Plan”.  A great analogy and a great talk aimed at helping people plan for their financial future.  A humorous and thought provoking presentation, I’m sure everyone there would agree.

I’m glad we’re part of the Money Smart Colorado effort and have the opportunity to spread the word on self direction and true diversification of retirement accounts.  New Direction IRA will be providing relevant classes and we are looking forward to being a partner in this exciting endeavor, financial literacy now and in the future!.