Self-directed IRA owners run into the same handful of questions again and again: who can contribute, how Roth conversions are taxed, whether an IRA can hold gold at home, when UBIT applies, and how far you can go with flipping before your IRA is running a business. These are real questions from investors, answered by self-directed IRA specialist Quincy Long.
The answers are education, not tax, legal or investment advice. They were written around 2014 to 2016, and several of the rules they describe have changed since. Dollar limits and deadlines are marked “at the time of writing,” so confirm the current rules with your own tax advisor before you act.
Contributing to a Roth IRA
An 85-year-old opening a Roth IRA
Q: A friend’s mother, who is 85, is thinking about opening a Roth IRA and investing in a note. What should we be aware of?
A: Other than the standard due diligence on any investment, the key concern is making sure she has compensation-type income (generally, income you pay Social Security and Medicare tax on) at least equal to the contribution, and no more than the maximum income limits.
At the time of writing (2016), a single person could make a full contribution with Modified Adjusted Gross Income (MAGI) up to $117,000 and a partial contribution up to $132,000. A married couple filing jointly could make a full contribution up to $184,000 and a partial one up to $194,000. If she is married and files jointly, her spouse can earn the income, as long as they stay under the limits.
A couple of other things come to mind. First, I would not spend every dime she has on a note unless you are really sure it will work out. If the Roth IRA owns the note and it goes into default, the Roth IRA must pay any foreclosure costs.
Also, even though she will never have to take Required Minimum Distributions (RMDs) from her Roth IRA, her beneficiaries will, unless she leaves it to a spouse who takes the account over as their own. Depending on who inherits, she may want to leave enough cash in the account to cover expected RMDs.
As a side issue, this looks like a great opportunity to set up a Roth IRA to be inherited by a younger person. Once the Roth IRA is seasoned, the person who inherits it can take tax-free distributions. So she will want to think carefully about who receives this precious asset. No one likes to think about their own mortality, but to fail to plan is to plan to fail. Personally, I would rather leave this earth with a smile on my face, knowing I have done everything possible to keep the government’s grubby hands off my hard-earned wealth.
Too much income for a Roth contribution
Q: My son opened a Roth IRA in December 2015 and earned interest from January through April 2016. While doing his 2015 taxes, filing married filing separately, we found out he is ineligible to contribute to a Roth because he earned over $10,000. He is eligible to contribute the full amount to a traditional IRA, since he has no employer retirement plan. Can we open a traditional IRA and recharacterize his original $5,000 contribution? And how should he handle the roughly $259 of interest he earned? His tax software won’t let him recharacterize more than the original contribution. Later, we would like to convert the traditional IRA back to a Roth and pay the taxes due.
A: Your son may certainly open a traditional IRA and recharacterize his contribution from the Roth IRA to the traditional IRA. When you recharacterize, the net income attributable (NIA) to the contribution must also move to the traditional IRA. Here the calculation is easy if that’s all the money in the account.
I can’t say why the tax software won’t allow recharacterizing the full amount, so you’ll need to take that up with the software company. His Form 5498 will show a contribution of $5,000, so that needs to match. He will receive a 2016 Form 1099-R showing the recharacterization into the traditional IRA for the full amount. The IRS understands its own rules on NIA, so this should not be a problem.
Finally, he should be able to convert the traditional IRA back into a Roth IRA, but at the time of writing he had to wait at least 30 days after the recharacterization to do so.
Roth conversions and the five-year clocks
The back-door Roth and the pro rata rule
Q: In December 2015 I made a non-deductible IRA contribution and converted it to my Roth IRA, because my income is too high to contribute to a Roth directly. But I already have traditional IRAs worth about $500,000. Will the IRS treat the conversion as taxable on a pro rata basis ($5,500 of $505,500), so only about $60 is non-taxable? If so, what are my options for recharacterizing back to a traditional IRA?
A: Your understanding is correct. After-tax basis in all your traditional IRAs combined comes out of a traditional IRA distribution on a pro rata basis.
At the time of writing, you could recharacterize a Roth conversion back into a traditional IRA up to your tax filing deadline, including extensions. So if you changed your mind, you could still reverse the 2015 conversion.
Withdrawing converted money before 59½
Q: I converted $18,000 from a traditional IRA to a Roth IRA in 1998. I also contributed $20,000 between 1998 and 2010. Last year I took a $38,000 distribution. I am under age 59½. Do I owe any tax or penalty?
A: No, as you describe it. Regular contributions come out first, followed by Roth conversions, and finally profits. The rules for calculating any taxable amount from a Roth distribution are in IRS Publication 590-B, Distributions from Individual Retirement Arrangements (IRAs), available at irs.gov. You will need to attach some tax forms to your return to claim this treatment, and if you’re not sure how to complete them, a tax professional can help.
Many tax preparers get confused because two different five-year clocks apply to Roth IRAs.
The qualified distribution clock. A Roth must have been established somewhere for your benefit at least five years before the distribution, and you must also be (1) over 59½, (2) totally and permanently disabled, (3) deceased, with the distribution going to your heirs, or (4) taking no more than $10,000 for a first-time home purchase. A qualified distribution carries no tax and no penalty. Once you are taking qualified distributions, the conversion clock becomes irrelevant.
The conversion clock. This is the one that applies in your case. It decides whether you owe the 10% premature distribution penalty if you are under 59½ and don’t meet another exception. It has nothing to do with taxation of the distribution, only with the penalty.
Roth distributions come out of the account in this order:
- Regular contributions
- Taxable Roth conversion contributions
- Non-taxable Roth conversion contributions
- Profits on all contributions
In the first three categories, taxes have already been paid, so the only question is the penalty. If you get into profits and the distribution is not qualified, taxes are owed on that portion.
Regular Roth contributions are never taxed or penalized when withdrawn, even if you are under 59½ and meet no other exception. With taxable conversion contributions, the penalty applies if you withdraw the money within five tax years of the conversion; after that, no penalty. Since you converted in 1998, the money has been in the Roth for more than five tax years, so no penalty should apply even though you are under 59½. Each conversion has its own five-year clock, and conversions are withdrawn first in, first out.
The conversion clock exists to prevent abuse. Say I’m under 59½ and do a Roth conversion. I pay tax on the conversion but no penalty. Without the clock, I could then withdraw the money from the Roth and avoid the 10% penalty I would have owed if I had taken it from the traditional IRA. The rule recaptures that penalty.
Understanding the background of a rule often makes a confusing rule clearer. If your tax preparer follows the calculations in Publication 590-B, that should resolve any doubts.
Precious metals and “home storage” IRAs
Q: I asked earlier about holding gold in a self-directed IRA with home storage, and I understand you don’t support home storage. If not at home, how is gold stored and managed in a self-directed IRA? And what are the caveats of home storage? Another company is still pushing it.
A: We have simply used one of the gold depositories. A number of them store physical gold for custodians.
In general, Internal Revenue Code Section 408(m)(1) treats an IRA’s investment in collectibles, including metals, as a distribution from the account. Section 408(m)(3)(B) contains the exception: it applies “if such bullion is in the physical possession of a trustee.”
I assume, and I may be wrong, that the home storage companies have you open an LLC or other entity that you manage. They then argue that your IRA’s investment is not in metals directly but in the shares of an LLC that owns metals, which they believe gets around the requirement that the trustee or custodian physically possess the metals.
We have found it administratively infeasible to hold investments the way we understand the home storage companies propose. In any self-directed IRA, it is up to you to decide whether a proposed investment is acceptable for an IRA. If you go down this path, look carefully at the documents to satisfy yourself that the method will pass IRS scrutiny. Perhaps the company even has a ruling you can review.
UBIT, debt-financed property and seller financing
Depreciation, nightly rentals and acquisition debt
Q: A guide to nonprofit taxation (the 2009 Multistate Guide to Regulation and Taxation of Nonprofits by Steven D. Simpson) says Arkansas doesn’t adopt Internal Revenue Code sections 501 to 529 but does tax unrelated business income attributable to Arkansas, so I assume there is no state tax on UDFI. That book seems a good starting place for UDFI and UBIT rules in all 50 states. I have three more questions:
- If you pay UDFI on the sale of a depreciated rental property, do you also recapture depreciation at a 25% rate?
- If my IRA buys a condo for nightly rental using debt, will it owe UBIT on the nightly rental and UDFI on the debt-financed share of the profit?
- UDFI applies to acquisition debt. If I pay cash for a house and borrow against it later, is there no UDFI?
A: Thanks for the reference. As for your questions:
1. Depreciation recapture. I believe the IRA would owe this tax, but I have heard different arguments. It wouldn’t make sense to deduct depreciation from current UDFI and then escape it when the property is sold. However, one CPA told me that if the property had been paid off for more than 12 months, so there was no capital gains tax, there wouldn’t be depreciation recapture either. I think that rests on the theory that depreciation recapture is really another form of capital gain, technically called “unrecaptured section 1250 gain.” To be honest, I just don’t know.
2. Nightly rentals. Running a hotel is considered a business operation rather than just rental income, so I see why you could assume the nightly rentals would be UBI and not UDFI. If it is a business operation, probably all income from that business would be UBI. I don’t think you can split off the capital gains and call them UDFI, but I’m not confident. If it were me, I would probably report it as UDFI and see if the IRS disagreed. There is a lot of ambiguity in this area.
3. Borrowing after the purchase. This one I can help with. Acquisition indebtedness is debt incurred:
- When acquiring or improving the property;
- Before acquiring or improving the property, if the debt would not have been incurred except for the acquisition or improvement; or
- After acquiring or improving the property, if the debt would not have been incurred except for the acquisition or improvement and incurring it was reasonably foreseeable when the property was acquired or improved.
So in your scenario, the debt would most likely still be acquisition indebtedness.
Here’s a brain twister: say my IRA owns land with no debt that produces no income but is expected to sell within a year. My IRA borrows money to buy bank stock, which it will hold for several years. Which property is debt-financed, the land or the bank stock? If it’s the bank stock, can the IRA escape tax entirely on the stock’s gains, because the debt will have been paid off from the land sale more than 12 months before the stock is sold?
Buying property with seller financing
Q: We plan to buy a tenant-occupied investment property through our self-directed Roth IRA, putting $20,000 down with seller financing for the balance. The property is in a land trust, and the seller wants to use a land contract. Is that kind of sale considered non-recourse? And from the buyer’s side, what do you think of buying on a land contract?
A: Whether the debt instrument is a land contract, a deed of trust or a mortgage, it has to be made clear that the only thing the lender can do is take the property back from your IRA. The land contract needs language making this clear, generally a short paragraph.
As for land contracts, in some states they are a very common way to sell property, while in others, such as Texas, they are fairly rare. You’ll need local advice on that.
The only other thing that comes to mind is that the financing may cause your IRA to owe unrelated business income tax (UBIT) on the profits from this property, under the rules for debt-financed property in an IRA.
Flipping, options and the line between investing and services
Assignment fees for a real estate dealer
Q: My client is a HomeVestors franchisee, in the business of real estate. Would doing a contract assignment within a Solo 401(k) be subject to UBIT? I’m worried his status as a real estate dealer could make his other plan activities taxable too.
A: You’re right that assignments, or even buy, fix and flip, are a lot trickier for franchisees and other real estate dealers. The easiest way to think about when UBIT attaches is to ask how the income would be taxed outside the IRA or 401(k). For a franchisee, a house is inventory sold to customers in the ordinary course of business, which is the very definition of unrelated business income here.
Another challenge is a possible excess contribution, or even a prohibited transaction (by providing services to the plan), when the owner uses his company’s resources to find the deals his plan invests in. There is a better argument that it was purely an investment if a different franchisee happens to find the deal. Add to this that a 401(k) plan has a much higher chance of audit, so caution is warranted in the plan’s investments.
I had one real estate dealer whose plan was audited a few years ago. The IRS let him get away with some flipping in his plan, but did charge him some UBIT. The old adage applies: piglets get fed, but hogs get slaughtered. You may get away with some of this activity, but the more you do, especially if it’s your only type of investment, and the more money you have for the auditor to be jealous of, the greater the chance of a bad result.
Optioning a note to resell it
Q: If my self-directed Roth IRA options a note with the intent of finding another buyer, how much earnest money does it have to put down to stay in compliance? The Roth won’t be keeping the note. I assume the same applies to real estate.
A: Unfortunately, there is no good answer. But I would be a little concerned with your wording. Optioning a note “with the intent of finding another buyer” sounds like note brokerage, not an investment. Note brokerage is a service, normally subject to self-employment tax outside an IRA. If so, it is a service inside an IRA as well, so there is a dual risk: it could be called unrelated business income, which is taxable to your IRA, or worse, a prohibited transaction because you are providing services to your IRA.
This brings to mind a bankruptcy case in Atlanta, Georgia (Cherwenka v. RES-GA Gold, LLC). A house flipper was accused of entering into a prohibited transaction by providing “services” to his IRA. He won in bankruptcy court and kept his IRA by arguing successfully that all he did was make investment decisions. It’s not a Tax Court case, so it carries less weight than we would like, and I’m not sure it would have turned out the same way in Tax Court. But it frames the argument nicely and is worth reading.
The important point: you may make great investments in your IRA. You may not provide services to your IRA, or make an excess contribution, whether through services or by manipulating paperwork to get a grossly undervalued asset into the account, especially from related parties. The Tax Court can look at the substance of a transaction over the form of its documents. Always structure transactions in your account as investments. For that reason, I generally encourage people to stay in the deal in some way, so it is more easily understood to be an investment.
This is fun to discuss academically, but in the real world you must be practical. Weigh risk against reward. The size of your IRA and the nature of your transactions will influence the IRS position in the unlikely event of an audit. Check with knowledgeable tax or legal counsel before entering into this kind of investment.
Flipping real estate options
Q: Can a self-directed IRA flip real estate options several times a year without being classified as a dealer? Since they are options rather than physical real estate, does dealer status not apply? If the flipping is frequent, will I owe UBIT for carrying on an active business? Are there ways to avoid UBIT and still do multiple option flips?
A: The key to the self-directed IRA rules is that an IRA is for investment purposes only. People often make the mistake of effectively running a business with their personal services for the benefit of their IRA, which is a prohibited transaction. The Tax Court has given the IRS a win in a number of cases where people have done this.
IRS Publication 598 may help with the UBIT question. It describes unrelated business income as income from a trade or business regularly conducted by an exempt organization and not substantially related to its exempt purpose. So the question for options is whether the activity is a “trade or business” that is “regularly conducted.” One way to gauge it: ask your CPA how he would report the income on your personal return if you did it outside the IRA. If the answer is Schedule C, it almost certainly will cause the IRA to owe UBIT, and may cause more problems depending on the circumstances.
On options specifically, Publication 598 excludes from UBI any gain from the lapse or termination of options to buy or sell securities, but only if the option is written in connection with the organization’s investment activities. The exclusion is not available if the organization is in the trade or business of writing options, or holds them as inventory or for sale to customers in the ordinary course of business. That isn’t precisely about real estate options, but it is pretty clear: trade options at a level where they look like inventory and the IRA will owe tax. It’s analogous to a real estate flipper. To a franchisee of a company that buys ugly houses, a house is just inventory, because they are a dealer.
So how many options can you do before you are providing services to your IRA instead of merely making investment decisions? That can’t be answered with certainty. Buying and selling an option on real estate once is most likely not a business activity. Do the same transaction 25 times in a year in the same account and it changes character. Where the line falls, I can’t tell you.
The best guideline is to structure and treat every IRA transaction as an investment, not the resale of inventory. Remember that you can self-direct a traditional IRA, Roth IRA, SEP IRA, SIMPLE IRA, individual 401(k), HSA and Coverdell Education Savings Account, and you may have multiple accounts for you and your family. Unless you are very active, you should generally have no problem with your IRA becoming a dealer in options. Keep a mix of different types of investments in your IRA, and if some of them are home runs, that’s great for your retirement.
Partnering accounts and Coverdell ESA withdrawals
Q: I have contributed $2,000 a year to a Coverdell ESA for my child for three years, $6,000 in total. Can I withdraw the $6,000 of contributions and leave the gains? Are there tax consequences? Second, can my Roth IRA and my HSA partner to buy or option a note and share the profits? Or can the Roth buy an option and sell it to the other account at a profit?
A: For the Coverdell ESA, see IRS Publication 970, Tax Benefits for Education, free at irs.gov. Distributions are taxed on a pro rata basis: each distribution normally contains part of your after-tax contributions and part of the gains. Unlike a Roth IRA, your basis does not come out first. Any taxable portion that exceeds your adjusted qualified education expenses (AQEE) also owes a 10% penalty. To the extent you have enough AQEE, there is no tax and no penalty.
Partnering your Roth IRA and your HSA is the same as partnering two IRAs. They are disqualified persons to each other, so you can’t invest in any way where one benefits disproportionately. Arguably they could partner on equal terms, though you’ll want to be cautious about how you handle the investment. The most conservative answer is not to partner disqualified persons at all, although many people choose to partner their accounts anyway.
Inherited IRAs are not protected in bankruptcy
On June 12, 2014, the U.S. Supreme Court ruled unanimously that inherited Roth and traditional IRAs are not protected from creditors under the “retirement funds” exemption in the U.S. Bankruptcy Code. The case is Clark v. Rameker, Trustee, 573 U.S. ___ (2014).
How the case reached the Supreme Court
In 2001, Heidi Heffron-Clark inherited a traditional IRA worth about $450,000 from her mother, Ruth Heffron, and elected monthly distributions. In 2010 she and her husband, Brandon Clark, filed Chapter 7 bankruptcy and claimed the inherited IRA, then worth about $300,000, as exempt under Bankruptcy Code Section 522(b)(3)(C). The trustee and unsecured creditors objected that funds in an inherited IRA are not “retirement funds” within the meaning of the statute.
The Bankruptcy Court agreed and disallowed the exemption. The District Court reversed. The trustee, Rameker, appealed to the 7th Circuit, which reversed again and ruled the inherited IRA was not exempt, expressly disagreeing with the 5th Circuit’s ruling for the debtor in In re Chilton, 674 F.3d 486 (2012). The Supreme Court took the case to resolve the conflict.
When an individual files bankruptcy, his assets become part of the bankruptcy estate, but the Bankruptcy Code lets debtors exempt some limited property. The exemption here protects “retirement funds to the extent those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code” (Section 522(b)(3)(C) for state exemptions and 522(d)(12) for federal exemptions). Traditional IRAs are created under IRC Section 408 and Roth IRAs under Section 408A.
Why inherited IRAs aren’t “retirement funds”
The Court held that the ordinary meaning of “retirement funds” is money set aside for the day a person stops working. Justice Sotomayor, writing for the Court, pointed to three legal characteristics showing that inherited IRAs don’t hold such funds:
- The holder of an inherited IRA may never contribute additional money to the account.
- Holders of inherited IRAs must withdraw money from the account, no matter how far they are from retirement.
- The holder may withdraw the entire balance at any time and use it for any purpose, without penalty.
The Court said this reading fits the purpose of the exemption provisions, which balance the creditor’s interest in recovering assets against the debtor’s interest in protecting essential needs. Nothing about an inherited IRA prevents the owner from spending the entire balance right after bankruptcy. The Court was not persuaded by the Clarks’ argument that the funds were retirement funds because they had once been set aside for that purpose.
What the ruling means for heirs
A surviving spouse under 59½ would normally leave the IRA as an inherited (beneficiary) IRA rather than roll it into their own account. Distributions from an inherited IRA carry no 10% premature distribution penalty, and at the time of writing the spouse did not have to start withdrawals until the deceased spouse would have reached 70½. That gives the surviving spouse access to money they may need. But now an inherited IRA will not be protected in bankruptcy in most cases, so a spouse in financial difficulty may decide to roll it into their own IRA, where it at least has creditor protection.
A non-spouse beneficiary can’t roll an inherited IRA into their own IRA. At the time of writing, it had to be distributed entirely by the end of the fifth year after the year of death, or over the beneficiary’s life expectancy. If the beneficiary inherits directly, in many cases there will be no way to protect the IRA in bankruptcy. One solution some planners propose is to leave the IRA to a properly drafted spendthrift trust rather than to the beneficiary directly, which can keep the funds away from the beneficiary’s creditors. This ruling may be a boon to estate planning attorneys.
The news isn’t all bad. Some states, such as Texas and Florida, specifically protect inherited IRAs from creditors. Debtors in those states keep that protection outside bankruptcy and even in bankruptcy (if they meet the residency requirements) when they choose state exemptions over federal ones. But don’t assume a large IRA is safe just because you and your children live in such a state. The exemptions follow the residence of the debtor, not of the person who died, and people move. Where your beneficiaries live now may not be where they live after inheriting your IRA.
One thing is certain: estate planning for families with beneficiaries who are struggling financially has become even more important, and bankruptcy planning for anyone with a large inherited IRA just got more complex. You can read the Supreme Court’s opinion at supremecourt.gov. If you need help with estate or bankruptcy planning, consult a competent professional who practices in those areas.
