I frequently receive this question:  When using my IRA to invest in real estate, do I withdraw my IRA funds to buy property?  Well, only if you want to be taxed on the amounts taken out of your IRA.  Do NOT withdraw funds from an IRA to purchase real estate, use a third-party custodian such as NuView IRA, Equity Trust or Pensco.  Here is a common misunderstanding with using an IRA to buy real estate….

Overview:  The Tax Court has determined that a taxpayer’s IRA withdrawal, that was used to buy real property, was a taxable distribution, rejecting the taxpayer’s argument that it was essentially an investment that he purchased on the IRA’s behalf.   In so concluding, the Court found it significant that the financial institution maintaining the IRA didn’t permit “alternative investments” such as the purchase in this case, and further found that the financial institution was within its authority in having that policy. Accordingly, the withdrawal was included in the taxpayer’s income and was further subject to a 10% early withdrawal tax under Code Sec. 72(t).

Background: Code Sec. 408(a) requires that an IRA be a trust created and governed by a written instrument that meets various requirements. A custodial account may be treated as a trust for purposes of qualifying as an IRA under Code Sec. 408(a) if the account otherwise meets the requirements laid out in that subsection. When a custodial account is treated as a trust, the custodian is treated as a trustee.

A trustee administering a trust typically has broad powers that are only limited by statute or the terms of the trust. Thus, IRA trustees and custodians generally have broad latitude to direct or limit the investment of funds in an IRA.

Generally, amounts distributed from an IRA are includible in a taxpayer’s gross income.  However, a distribution is not includible in gross income if the entire amount of the distribution an individual receives is paid into an IRA or other eligible retirement plan (“rolled over”) within 60 days of the distribution.  As an alternative to a rollover contribution (and its 1-per-year limitation), the owner of an IRA may direct the IRA trustee to transfer funds directly to the trustee of another IRA.  Because the funds are never paid or distributed to the IRA participant, no rollover contribution or taxable distribution occurs in a direct transfer between trustees.

The Tax Court has ruled that no distribution occurred when a taxpayer who maintained a self-directed IRA, in order to invest in the stock of a company that the IRA could hold but that the custodian wouldn’t buy because it wasn’t publicly traded, had the custodian issue a check to him, which he delivered to the company. The Court found that the taxpayer acted as an agent for the custodian. The Court further held that the fact that the issuing company didn’t send the stock certificate to the IRA custodian was a mere bookkeeping error that didn’t alter the IRA’s ownership of the stock.

Facts. In 2008, Guy Dabney rolled over funds from an individual retirement account (IRA) at Northwest Mutual into a preexisting self-directed IRA he had with Charles Schwab (the IRA).  Sometime thereafter he learned of a piece of undeveloped land (property) that was for sale for an amount that he believed was below its fair market value. After conducting some internet research, Mr. Dabney concluded that IRAs are permitted to hold real property for investment and set out to have the IRA purchase the property.

Before purchasing the property, Mr. Dabney spoke with a Charles Schwab customer service representative and was told that Charles Schwab did not allow alternative investments, which would include the purchase and holding of real property. Mr. Dabney also made several telephone calls to a CPA before purchasing the property. The CPA told Mr. Dabney that he did not have any training in retirement accounts and was not certain whether it would be possible to purchase or hold real property within an IRA, but after Mr. Dabney shared the results of his research with him, he agreed that it would be possible for the IRA to purchase the property.

On the basis of these conversations and his research, Mr. Dabney arranged what he believed to be a viable way to have the IRA purchase the property. On Feb. 6, 2009, Mr. Dabney signed a contract to purchase the property. A month later, he initiated a withdrawal of $114,000 from his IRA by filling out a distribution request form provided by Charles Schwab. He checked the box indicating that the withdrawal was a distribution that occurs before an account holder reaches the age of 59 1/2 where none of the exceptions under Code Sec. 72(t) apply. However, he believed that the withdrawal would not actually be considered an early distribution. The distribution request form did not indicate that the requested funds were to be used to invest in property on behalf of the IRA.

Charles Schwab wired $114,000 directly to the bank account of the company handling the property sale. Mr. Dabney directed the company to name “Guy M. Dabney Charles Schwab & Co. Inc Cust. IRA Contributory” as the owner of the property, but because of a bookkeeping error, title to the property was placed in Mr. Dabney’s own name.

Although he had hoped to sell the property sooner, Mr. Dabney was unable to find a buyer until 2011, at which time he discovered that the property was incorrectly titled in his own name. He then requested and received an affidavit from the company admitting fault for same. He sold the property and received $127,226 on the sale, after taxes and fees, which was wired directly into the IRA on or around Jan. 28, 2011. Mr. Dabney marked the deposit as a rollover contribution, and Charles Schwab accepted the deposit as such.

Charles Schwab issued Mr. Dabney a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for 2009, although Mr. Dabney does not recall ever receiving it. The Form 1099-R stated that he had received a $114,000 early distribution from the IRA and that no exceptions to the early distribution penalty applied. Mr. Dabney (on a joint return filed with his wife) did not report the withdrawal on Form 1040.

Parties’ arguments. Mr. Dabney argued that the $114,000 withdrawal from the IRA wasn’t a taxable distribution because it was either: (1) a purchase made by the IRA, or (2) a transfer between IRA trustees. In his first argument, Mr. Dabney essentially claimed that he acted as a conduit through which the IRA purchased the property—thus, it was the IRA that purchased the property, and the withdrawal wasn’t a distribution.

IRS argued that (1) the IRA didn’t purchase the property because Charles Schwab’s policies don’t permit the purchase or holding of real property, and (2) a trustee-to-trustee transfer didn’t occur.

Tax Court sides with The Tax Court first concluded that the IRA didn’t purchase the property. The Court distinguished its holding in the Ancira case, above, based primarily on the fact that although IRAs are generally allowed to hold real property, Charles Schwab’s policies don’t permit IRAs maintained by them to do so. The Court then found that Mr. Dabney failed to show that these policies violated any statutory provision or the terms of the IRA’s trust instrument, and further concluded that, in its role as an IRA trustee, Charles Schwab had the power to prohibit the purchase and holding of real property.

Thus, even if the property had been titled as intended, the IRA couldn’t hold it and wouldn’t have accepted ownership of it. So, Mr. Dabney did not act as an agent on behalf of Charles Schwab, and the IRA did not purchase the property.

The Court also rejected Mr. Dabney’s argument that the withdrawal was a trustee-to-trustee transfer. The Court found that, if Mr. Dabney had instead initiated a rollover or a trustee-to-trustee transfer of funds from the IRA to a different IRA—one permitted to purchase and hold real property—he would have achieved his goal (of increasing the value of his IRA by investing in real property using funds in it) without any unintended tax consequences. However, what he actually did was direct Charles Schwab to wire the funds from his IRA directly to the company handling the sale of the property. Mr. Dabney did not have an IRA (or other eligible retirement plan) with this company, and there was no evidence to suggest that it was an IRA trustee.

Thus, the transfer wasn’t a transfer between IRA trustees, and the $114,000 withdrawal was a taxable distribution made to Mr. Dabney includible in Mr. his gross income. And, because the distribution was made before he obtained the age of 59 1/2, and no exception was shown to apply, the distribution was subject to the 10% addition tax under Code Sec. 72(t).

However, the Court declined to impose an accuracy-related penalty, finding that Mr. Dabney went to “great lengths” in attempting to ensure that the purchase would be nontaxable and honestly, albeit mistakenly, believed the purchase was appropriate.

© 2014 Douglas Rutherford, CPA, CGMA.  All Rights Reserved.  Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA.

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