Court Rules in Favor of Self-Directed IRA Real Estate Investor in Prohibited Transaction Case

by | Jun 29, 2015 | Prohibited Transactions

A recent Bankruptcy Court decision dealt with prohibited transaction claims against a self directed IRA owner who was using their IRA to flip real estate for profit. The claims were brought by a bankruptcy trustee who argued that the protected IRA was no longer an IRA because it engaged in a number of prohibited transactions. If the trustee is successful in disqualifying the retirement account because of a prohibited transaction, then the funds and assets held in such retirement account are no longer protected from creditors and may be used to pay debtors involved in the bankruptcy. While most prohibited transaction cases arise in Tax Court, I’m seeing more cases on prohibited transactions in Bankruptcy Court as trustees are becoming more aggressive and as self directed IRAs are becoming more popular.

The case in question is known as In re Cherwenka, Case 13-57592-MGD (Bankr. N. D. GA 2014). The case included two important prohibited transaction analysis that are helpful to IRA owners.

Court Rules No Prohibited Transaction When Managing IRA Investment Properties Without Compensation

The first significant ruling from the Court was that there was no prohibited transaction when the IRA owner completed the following tasks related to the IRA owned property.

  • Research and identified properties to buy
  • Appointed and approved work on the properties
  • Oversaw payments on the property for work from the self-directed IRA.

The Court reasoned that these actions do no constitute a “transaction” as defined in IRC § 4975 and as a result they cannot constitute a prohibited transaction. The Court further stated that, “…self-directed IRAs as qualified IRAs, necessarily implies that a disqualified person (the owner as fiduciary) will make investment decisions regarding the plan. The Court distinguished this case from In re Williams, 2011 WL 10653865 (Bankr E.D. Cal 2011) a similar case in which the self-directed IRA owner was managing properties owned by the IRA because in Williams the IRA was paying the self-directed IRA owner for the services. The court stated that it was the payment from the IRA to the IRA owner in Williams that caused the prohibited transaction and not the mere provision of managing the IRAs investment owned by the IRA.

Court Ruled That No Prohibited Transaction Occurred When IRA and Owner Invested Into Property Together

The second significant ruling from the Court was that there was no prohibited transaction when the IRA owner and the IRA co-invested into a property together. The property in question was owned 45% by the IRA and 55% by the IRA owner. The Court rejected the bankruptcy Trustee’s argument that such co-investment purchase resulted in a prohibited transaction and stated that the interests appeared to have been treated distinctly and that the HUD documents from the sale of the property show that the IRA and the IRA owner’s proceeds from the sale were treated separately and that they were apportioned properly. As a result, the Court concluded that no prohibited transaction occurred since there was no evidence of un-fair benefit between the IRA owner and his IRA. In its reasoning, the Court referenced DOL Opinion 2000-10A which addressed an IRA and the IRA owner co-investing into a partnership. In the Opinion the DOL states that, “a violation of section 4975 (c)(1)(D) or (E) will not occur merely because the fiduciary [IRA owner] drives some incidental benefit from the transaction involving IRA assets.” The Court referenced this opinion and stated that unless there is evidence of some un-fair benefit that no prohibited transaction occurred merely because of co-investment into the same property.

There are two key take-away’s for self-directed IRA investors from this case.

First, never take compensation or payment from the IRA for services rendered. It is clear that the Courts will find a prohibited transaction if you do and that you will no longer have an IRA.

Second, if you are buying property or others assets (e.g. LLC interests) between your IRA and yourself personally (or another disqualified person) those interests must be carefully calculated and treated such that there is no benefit going unfairly between the IRA and the disqualified person (e.g. IRA owner). In sum, get advice and plan carefully as there are many land-mines you could encounter when investing IRA funds with your own personal funds. Bottom line, it can be done but it can easily be done incorrectly.

Buying Real Estate With Your IRA and a Non-Recourse Loan

by | Feb 13, 2015 | Investing

Comprehensive Webinar: Buying Real Estate with Your IRA and a Non-Recourse Loan Mat Sorensen from Mathew Sorensen on Vimeo.

Your IRA can buy real estate using its own cash and a loan/mortgage to acquire the property. Whenever you leverage your IRA with debt, however, you must be aware of two things. First, the loan your IRA obtains must be a non-recourse loan. And second, your IRA may be subject to a tax known as unrelated debt-financed income tax (UDFI/UBIT). This comprehensive webinar explains the non-recourse loan requirements, as well as the non-recourse loan options, and goes into detail on how UDFI tax may be applied and how it is calculated. Below are the slides from the presentation as well as the recorded video presentation of the webinar. Note that page 27 in the pdf slides below was up-dated from the webinar as I made a calculation mistake on the debt owed. The final tax numbers were still correct though. Thanks to Roger St.Pierre, Sr. VP at First Western Federal Savings Bank for co-presenting the topic with me.

buying-real-estate-with-ira-and-non-recourse-loan

 

IRAs and Annuities: What You Need to Know

by | Jan 20, 2015 | Investing

IRAs are the most commonly held retirement account and annuities are one of the most popular investments for retirees. Despite the popularity of each, the two concepts shouldn’t ordinarily be combined together. On the topic of IRAs and annuities, I am routinely asked the following questions.

  1. Can I buy an annuity with my IRA?
  2. Should I buy an annuity with my IRA?
  3. How do I get out of an annuity I bought with my IRA?
  4. Can I roll-over my annuity IRA to a self-directed IRA?

In this article I’ll answer each question, but before I do, let me first explain how an annuity works as it is essential to understanding the questions and your options. IRS Publication 939 is helpful in explaining the annuity tax rules and can be found here.

Annuity Basics

An annuity is an insurance product you can purchase whereby you invest funds with the annuity insurance company and they agree to make payments to you for the rest of your life or for a set period of years. The typical candidates of annuities are retirees seeking a guaranteed steady stream of income. The retiree gives up their cash now in exchange for payments back from the insurance company over time. There are many different types of annuities but the two most common are fixed annuities and variable annuities. In a fixed annuity, the insurance company agrees to pay you back based on a fixed payment schedule. Under a variable annuity, the insurance company agrees to pay you back based on the performance of the annuity investment (you have some limited choices in how those funds are invested in a variable annuity).

An annuity can begin paying you back immediately or it can be invested over a period of time and grow tax deferred and then later pay you out at retirement age. The income from an annuity is taxed as it is received by the annuity owner. Typically, when you receive payments from an annuity you personally own (outside a retirement account),  a portion of the payment is taxable (the income/growth part) and the portion that is a return of your investment or premium is not taxable. The portion of the annuity payment that is taxable is subject to ordinary income tax rates.

Tax Deferral

One of the benefits of an annuity is that the funds grow in the annuity tax deferred with the funds compounding and without having to pay tax on any income the IRS. When you start receiving payments from the annuity, the funds you invested into the annuity are not taxed but the earnings are taxed.

No Contribution Limits

When you purchase an annuity outside of a retirement account such as an IRA, you can invest as much money as you want and you are not limited to annual contribution limits like you are with IRAs or 401(k)s. So, for example, if you want to buy a $250,000 annuity with $250,000 of cash, then you can make that investment all in one-year. You are not subject to $5,500 annual contribution limits.

Early Penalty

If you take funds from an annuity before you’re 59 ½, you’re subject to a 10% early withdrawal penalty on any taxable earnings. Any investment gains (above your initial investment) are also subject to tax and must be included as regular income on your personal tax return.

Surrender Charge

When you own an annuity you will typically have an account value for that annuity and if you decide to “cash-out” the annuity, instead of receiving the scheduled payments, you will likely be subject to a surrender charge. The surrender charge differs amongst annuity products and companies but the most common penalty is a 7% surrender charge during your first couple of years and then it goes down 1% each year until it is removed. So, if you have only had an annuity for a few years it is likely that you will have to pay the insurance company a surrender charge in order to “cash-out” the annuity. If you have had an annuity for ten years or longer, you are likely able to “cash-out” the annuity without penalty.

IRAs and Annuities

Now that we have the basics of annuities out of the way, let’s get to the questions about annuities and IRAs.

1. Can I buy an annuity with my IRA?

Yes, you can purchase an annuity with your IRA. However, just because you can doesn’t mean that you should. In my opinion, annuities can be part of a well structured financial plan but should be purchased with non- retirement plan (e.g. IRA) funds.

2. Should I buy an annuity with my IRA?

Probably not. One of the benefits of an annuity is that it gives you tax-deferral on the income that is being generated and as a result, using an IRA where you already obtain tax-deferral just doesn’t seem to make sense. If you like the annuity concept of fixed and guaranteed payments, albeit with modest gains from your principal, then you should consider an annuity with your non-retirement plan funds as those dollars aren;t getting any special treatment under the tax code when they are invested. If you already have a large nest-egg of retirement plan funds, why use that set of tax favorable funds to buy an investment product that you could buy with non-retirement plan funds and receive the same tax-treatment. Some say that buying an annuity with an IRA is like wearing a belt and suspenders since your money is already tax-deferred in a traditional IRA. Secondly, annuities are subject to surrender charges and as a result you are locked into that investment and face surrender penalties at the investment level (let alone the account level) if you want to get money out of the annuity to invest in something else or for personal use.

3. How do I get out of an annuity bought with my IRA?

You can usually “cash-out” your annuity owned by your IRA, however, cashing out the annuity to the account value will typically cause a surrender charge. Most annuities have a surrender charge during the first 7 years or so, whereby the penalty is 7% for the first year or two and then decreases 1 percent each year until it is removed. Check with you annuity company or financial advisor in your specific situation though as the products and surrender charges do vary. If you “cash-out” an annuity owned with IRA funds and if those funds are returned to an IRA, then there is no taxable distribution or tax penalty. The only “penalty” would be the surrender penalty by the annuity insurance company. If you take the cash personally though, instead of sending it to your IRA, then those funds are subject to the regular IRA distribution rules and as a result you could be subject to taxes and early withdrawal penalties on the amounts received.

 4. Can I roll-over my annuity IRA to a self-directed IRA?

Yes. You can roll-over your annuity IRA to a self-directed IRA. You’ll need to “cash-out” the IRA, pay any applicable surrender charges, and then instruct the annuity company to process a direct roll-over of the funds to your self-directed IRA custodian as a direct rollover. This rollover will NOT be subject to taxes or penalties. Keep in mind though, there may be a surrender penalty though with the annuity company. If there is a surrender penalty, you’ll want to determine whether the benefit and payments owed under the annuity are worth hanging on to the annuity investment or if you are better off simply paying the penalty and moving on to other investment options.

Unfortunately, the annuity and IRA rules can be a little tricky, but once understood you can make informed decisions about how to best use and invest your retirement dollars.

2014 Retirement Plan Contribution Deadlines: Start Planning Now & Don’t Get Left Behind

by | Nov 25, 2014 | News

Retirement account/plan contributions are one of the most powerful tax strategies you can implement but you’ve got to make them by the deadline so that they can reduce this years tax liability. With the end of the year fast approaching, now is the time to make certain you are maximizing this important tax strategy for your 2014 tax planning. Please find below a table outlining the deadlines for 2014 retirement plan contributions according to your type of retirement account.  If you are self-employed, you’ll notice the deadline also may depend on the type of company you own (e.g. s-corp or LLC)  but also whether you are making contributions as an employee of your company and/or as the employer. First, let’s summarize the IRA contribution deadlines.

IRA Contribution Deadlines

Type of IRA Contribution Type Deadline Details
Traditional IRA Traditional, Deductible April 15, 2015, Due Date for Individual Tax Return Filing (not including extensions).  IRC § 219(f)(3); You can file your return claiming a contribution before the contribution is actually made.  Rev. Rul. 84-18.
Roth IRA Roth, Not Deductible April 15, 2015, Due Date for Individual Tax Return Filing (not including extensions). IRC § 408A(c)(7).
SEP IRA Employee N/A; employee contributions cannot be made to a SEP IRA plan.
Employer Contribution March 15/April 15th, Due Date for Company Tax Return Filing (including extensions).  IRC § 404(h)(1)(B).
Simple IRA  Employee Elective Deferral January 30, 2015.  IRC § 408(p)(5)(A)(i).
Employer Contribution March 15/April 15, Due Date for Company Tax Return Filing (including extensions).  IRC § 408(p)(5)(A)(ii).

 

In summary, for traditional and roth IRA contributions you have until the individual tax return deadline of April 15, 2015 to make 2014 contributions. SEP and SIMPLE IRA contribution deadlines are based on the company tax return deadline which could be March 15th if the company is a corporation and April 15th if it is a sole proprietorship or partnership. Keep in mind that this deadline does NOT include extensions so even if you extend your personal tax return filing to September 15, 2015, you still have a April 15, 2015, contribution deadline for Roth and Traditional IRAs.

401(k) Contribution Deadlines

Solo 401(k) Business Structure Type of Cont. Deadline Details
401(k), including self-directed Solo 401(k) (plan must be adopted by 12/31/14) Sole Proprietorship Employee Elective DeferralContribution April 15, 2015, contribution deadline is Due Date for Employer Tax Return (including extensions) but compensation must have been earned by December 31, 2014 and election should be made by December 31, 2014; IRS Publication 560.  Rev. Rul. 76-28; 90-105.
Employer Profit Sharing Contribution April 15, 2015, Due Date for Company Tax Return Filing, including extensions, however employee compensation must have been earned by December 31, 2014.  IRC § 404(a)(6).  Rev. Rul. 76-28; 90-105.
S-CorporationOr C-Corporation Employee Elective Deferral contribution March 15, 2015 (corporation filing deadline), contribution deadline is Due Date for Employer Tax Return (including extensions) but compensation must have been earned by December 31, 2014 and election should be made by December 31, 2014;  IRS Publication 560.  Rev. Rul. 76-28; 90-105.
Employer Profit Sharing Contribution March 15, 2015, Due Date for Company Tax Return Filing, including extensions, however employee compensation must have been earned by December 31, 2014.  IRC § 404(a)(6).  Rev. Rul. 76-28; 90-105
Partnership (e.g. partnership LLC) Employee Elective Deferral Contribution April 15, 2015 (partnership return filing deadline), contribution deadline is Due Date for Employer Tax Return (including extensions) but compensation must have been earned by December 31, 2014 and Election should be made by December 31, 2014;  IRS Publication 560.  Rev. Rul. 76-28; 90-105.
Employer Profit Sharing Contribution April 15, 2015, Due Date for Company Tax Return Filing, including extensions, however employee compensation must have been earned by December 31, 2014.  IRC § 404(a)(6).  Rev. Rul. 76-28; 90-105.

 

There are a few important things to keep in mind regarding 401(k) contributions.

401(k) Contribution Deadlines Can Be Extended

First, the contribution deadline for employer and employee contributions is the company tax return deadline INCUDLING extensions. So, if you have a solo 401(k) you can extend your company tax return and your contribution deadline is also automatically extended. For example, if you have a solo 401(k) plan adopted by your s-corporation, then your s-corporation tax return deadline is March 15, 2015, but that can be extended 6 months until September 15, 2015, upon filing an extension to extend the company tax return with the IRS. If you do this, you’d have until September 15, 2015, to make the 2014 employee and employer contributions. That being said, the employee contributions are taken from your salary/wages and if you make traditional 401(k) employee contributions those amounts are reported on your personal W-2 and reduce your taxable wages. The W-2 is effectively where your tax deduction for traditional employee contribution arises is it reduces your taxable wages on your W-2.  As a result, you’ll need to make or at least know the amount you intend to make for employee contributions by January 31, 2015 as that is the W-2 filing deadline for 2014.

New 401(k)s Must Be Adopted by December 31st

Second, if you are establishing a new Roth or Traditional IRA, you can create that new account at the time of the IRA contribution deadline. However, if you are establishing a new solo 401(k) plan, you must have the plan established by December 31, 2014. Because there are a number of documents and procedures required to create a new 401(k) plan, this is not something that can be left to the last minute and you should start immediately if you intend to open a 401(k) this year.

Make 2014 Contributions in 2014

And lastly, while the deadlines for most 2014 retirement plan contributions for IRAs and 401(k)s runs into 2015, to keep things simple and stress-free we recommend making 2014 contributions by December 31, 2014, when possible.

As you can see, the contribution deadlines vary depending on the type of account/plan but also on the type of contribution.  With respect to contributions to a self-directed solo 401(k), the contribution deadline also varies depending on the type of company you own that has adopted the plan.  Therefore, it is important that you understand these deadlines and don’t miss out on an opportunity to maximize your tax deductions.  For guidance on the contribution limits in 2014, please click here.

As previously stated, it is not too late to setup a retirement account/plan if you have not done so already.  The deadline to set up a 401(k) and to make contributions for 2014 is typically the last day of the year, although I wouldn’t wait until the last day or even the last week of the year to do so.  If you are interested in setting up a self-directed solo 401(k), please contact us immediately as we are helping clients establish these and so that we can get it set up before the end of the year.