Aside from life insurance and the prohibited investments listed in Internal Revenue Code Section 408, individual retirement accounts can invest in just about anything. But IRA ownership of alternative investments can introduce complications. Depending on the type of investment, these obstacles can include obtaining valuation opinions, needing additional legal work, encountering difficulty in making required minimum distributions (RMDs), paying the unrelated business income tax (UBIT) and avoiding IRA-killing prohibited transactions.
Avoid These Investments
There are certain assets that IRAs are specifically prohibited from owning.
Collectibles. An IRA or Roth IRA can’t own collectibles.1 Investment in a collectible causes a deemed distribution of that item as of the day the investment is made. Impermissible collectibles are: art, antiques, rugs, stamps, alcoholic beverages, gems, coins and metals. But, an IRA may hold certain gold, silver or platinum coins, as well as certain gold, silver or platinum bullion. The coins or bullion must be in the custody of the IRA trustee or custodian.
S corporations. S corporations are corporations that make an election to tax corporate income to its shareholders, rather than to the electing corporation. Holding all of an S corporation in a Roth IRA would mean tax-free operations for the corporation. But, according to Internal Revenue Service Revenue Ruling 92-72, IRAs may not invest in S corporations.2 The U.S. Court of Appeals for the Ninth Circuit has affirmed that revenue ruling, holding that a Roth IRA can’t be an eligible S corporation shareholder.3
If RMDs can bring on a headache, the combination of alternative investments and RMDs can bring on a migraine.4
Annual RMDs, generally, must begin by April 1 of the year after an IRA owner attains age 70½. Because each year’s RMD amount is equal to the value of the IRA as of Dec. 31 of the previous year, divided by the applicable distribution period, the value of the IRA must be determined to calculate each year’s RMD.5 Failure to distribute any part of the RMD results in a 50 percent penalty on the RMD shortfall.6
Alternative investments that aren’t actively traded are hard to value, making it difficult to properly calculate the RMD. Valuation opinions are costly in both time and money and are subject to challenge by the IRS.
Here’s a possible solution: Distribute a fraction of each hard-to-value alternative investment equal to one, divided by the RMD applicable divisor. In addition, distribute that same fraction of the aggregate value of all of the other (easy-to-value) IRA assets.
By distributing a fraction of each hard-to-value asset, the risk that valuation disputes could lead to a 50 percent RMD shortfall penalty will be eliminated. But, there still could be a risk that the amount of the distribution will be incorrectly reported due to a valuation error, so a reliable valuation is needed.
While fractional distributions of property may solve RMD calculation problems, other issues could arise. For example, once a distribution of a fractional interest in rental real estate has occurred, the IRA and its owner will have to share the costs of maintaining and managing real estate. Furthermore, at the time when real estate is divided, there will be both prepaid expenses, such as insurance, and accrued liabilities, such as real estate taxes. Tracking these details and divvying costs between the IRA and its owner would require meticulous recordkeeping. Failing to properly allocate and the sharing of such costs between the IRA and its owner could also be viewed as violations of the prohibited transaction rules, discussed below. Forming an entity, such as a limited liability company (LLC), to hold and operate the real estate might simplify co-ownership by centralizing ownership and management, while minimizing prohibited transaction risks. (For more information on IRAs investing in real estate, see “Real Estate and the Self-Directed IRA,” by Michael Held, p. 43 in this issue.)
RMDs of an IRA owner can be avoided by making a Roth IRA conversion because Roth IRAs aren’t subject to RMD rules during the Roth IRA creator’s lifetime. But, this just kicks the can down to the death beneficiaries. After the Roth IRA creator dies, RMDs must be paid annually to the Roth IRA’s death beneficiaries.
IRC Section 4975 imposes a tax on prohibited transactions. This tax, however, doesn’t apply to IRAs; instead, the IRA is disqualified if it engages in a prohibited transaction.7 If an IRA is disqualified, the entire IRA is deemed to be distributed and income taxes and other applicable taxes (such as the early distribution penalty of IRC Section 72(t)) will be due. The same rules apply to Roth IRAs.8 The term “prohibited transaction” includes, but isn’t limited to, lending of money and any direct or indirect sale, exchange or leasing of any property between a plan and a “disqualified person.”9
No headache is worse than the one brought on if the IRA is deemed terminated and completely distributed because a prohibited transaction has occurred between the IRA and a disqualified person. Prohibited transaction risks can be limited to any alternative investment of concern by isolating that investment in its own IRA. Other investments that have little or no prohibited transaction risk can be housed in a separate IRA, safely away from any such risks.
It’s not hard to inadvertently run afoul of the prohibited transactions rules. For example, suppose Doug’s IRA purchases a vacation condominium located on Maui, Hawaii. The IRA manages and rents out that unit. Doug has been told by his tax advisor that, to avoid violating the prohibited transaction rules, he can’t stay there, nor can his wife, any of his children (or their spouses), any of his descendants (or spouses) or any of his ancestors (or spouses). Doug takes that advice to mean no free nights for his family and wrongly believes his daughter and her husband can stay there for fair market rent. Based on that belief, Doug allows them to do so. Doug’s IRA terminates and is considered fully distributed in a taxable distribution as of Jan. 1 of the year Doug’s daughter and her husband stayed over because they’re disqualified persons and renting IRA assets to them fits the prohibited transaction definition.
Doug also can’t provide goods or services to the condo, nor can any other disqualified person. That means the IRA will have to hire non-family professionals to repair, maintain or improve the unit.
But, some family members are conspicuously absent from the list of disqualified persons. Doug’s IRA could rent the condo to his brother or sister, their spouses or their children.
Doug’s IRA will also have to avoid engaging in transactions with any entities that are at least 50 percent controlled by him and/or other family members, as well as officers or directors of certain entities.
A more subtle violation might occur because of valuation discounts. One class of prohibited transaction is “a transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan.”10 As the IRA owner’s fractional ownership interest in property increases through annual IRA distributions, the valuation discounts that apply to the IRA owner’s interest in the property will decline, while discounts that apply to the IRA’s interest in the property will increase. This shift in value from the IRA to the IRA owner because of shifts in valuation discounts could be viewed as creating an instance of “use by or for the benefit of” the IRA owner, thus causing a prohibited transaction. For this reason, it may be advisable to house the alternative investment in an LLC having an operating agreement that defeats valuation discounts of LLC ownership interests. In addition, co-ownership of an asset between the IRA and the IRA owner might lead to an inadvertent prohibited transaction violation.
If there’s any question that owning the alternative investment within the IRA will violate the prohibited transaction rules, we highly recommend that you request an exemption on your client’s behalf from the Department of Labor.11
Some investments require investors to make capital calls, requiring them to make capital contributions on demand, up to a stated amount. If an IRA owner, rather than the IRA, makes good on a capital call, the IRA owner has made an IRA contribution. If that contribution exceeds the year’s contribution limits, an excess contribution has been made. Excess contributions not withdrawn by the due date of the IRA owner’s income tax return plus extensions will incur an annual 6 percent penalty tax.12
Any entity exempt from income tax, which engages in a trade or business not directly related to that entity’s exempt purposes, must pay UBIT. The UBIT rules were established to level the playing field when exempt organizations engage in a business that’s typically the realm of for-profit organizations. For example, if a charity begins to sell greeting cards in competition with Hallmark, the income earned on the cards would be subject to UBIT. IRAs are subject to that tax at trust income tax rates.13 There’s no credit for that tax when distributions are made.
Partnerships or other passthrough entities owned by an IRA can generate UBIT. We’ve seen cases in which an investment prospectus announced that no UBIT would occur, but, a few years after the investing entity is established, investment policies changed and, with no advance notice, such income was generated. While rental income is generally excluded from UBIT, if the real estate that’s producing the rental income is debt-financed, the debt-financed portion of such income isn’t excluded from UBIT. Therefore, unless the real estate in the IRA is completely paid for, some or all of the rent will most likely be subject to UBIT.
Distributions Before Age 591/2
A 10 percent tax applies to IRA distributions before the IRA owner attains age 59½, unless an exception applies.14 A series of substantially equal periodic payments is one of the exceptions. Computation of the payment amount is based on the value of the IRA. As is the case with the calculation of RMDs, hard-to-value IRA assets can make it difficult to comply with the rules.
As an alternative to selling off hard-to-value investments, a separate IRA could be set up before determining the amount of the series of substantially equal periodic payments. The separate IRA can receive a trustee-to-trustee transfer of cash and actively traded securities and no hard-to-value assets. The payments would then be determined based on the value of the separate IRA containing the easy-to-value assets.
Finding a Custodian
Finding an IRA custodian who will accept non-traditional investments as IRA assets can also be difficult, although such custodians certainly exist. It’s important to find a reputable custodian who specializes in holding non-traditional investments in an IRA and all the potential problems it can create. It’s advisable to read the alternative investment’s prospectus or offering circular prior to directing the IRA custodian to make any investment on behalf of an IRA. It may also be essential to determine if the company offering the investment will act as custodian for the non-traditional investment.
Comprehensive Analysis Required
With today’s growing awareness of alternative investment opportunities, more individuals are looking at alternative investments for their IRAs. All of the above issues illustrate that, although owning such assets in an IRA is an important investment strategy to consider, it’s essential that advisors be open to a comprehensive analysis to determine if such an investment is the best course of action for clients.
1. Internal Revenue Code Section 408(m); see also Internal Revenue Service Publication 590.
2. Revenue Ruling 92-73, 1992-2 C.B. 224.
3. Taproot Administrative Services, Inc. v. Commissioner, No. 10-70892 (March 21, 2012), affirming No. 15396-07, 133 T.C. 202 (Sept. 29, 2009).
4. New Oxford American Dictionary defines a migraine as “a recurrent throbbing headache that typically affects one side of the head and is often accompanied by nausea and disturbed vision.”
5. Treasury Regulations Sections 1.408-8 and 1.409(a)(9)-5.
6. IRC Section 4974.
7. IRC Sections 4975(c)(3) and 408(e)(2).
8. Treas. Regs. Section 1.408A-1 Q&A 1(b).
9. See IRC Sections 4975(c) and 4975(e)(2).
10. IRC Section 4975(c)(1)(D).
11. IRC Section 4975(c)(2) gives the Secretary of Labor the power to grant a prohibited transaction exemption.
12. IRC Section 4973.
13. IRC Section 408(e)(1).
14. IRC Section 72(t).