If you’re an active real estate investor or have attended several real estate meet-ups to learn more, investing in real estate using your retirement funds must be a familiar topic. Over the past couple of years, self-directed retirement accounts have gained popularity and along with them the news of their alternative investing capacity. As a retirement solution company, we suggest our clients to diversify their assets but not at the expense of having the US Tax Court after them.
Here is a case study that will have you understand the importance of thorough research before accessing your 401k funds.
The US Tax Court Vs Guy M. Dabney
Guy M. Dabney opened a self-directed IRA at Charles Schwab, rolling over funds from his previous IRA. He decided to purchase an undeveloped land using his retirement funds, as his online search revealed that retirement funds could invest in real estate.
In order to confirm the findings of his online research, he called Charles Schwab but instead of talking to a dedicated retirement executive, he spoke to any available customer representative. The customer representative informed Mr. Dabney that Charles Schwab doesn’t allow alternative investments, including purchasing or holding of real estate in the IRA.
Mr. Dabney spoke to a certified public accountant to inquire about the same; however, the accountant had limited knowledge of handling retirement accounts. Mr. Dabney shared his online search results with the accountant and took him in confidence.
Following this conversation, Mr. Dabney had Charles Schwab wire money directly to the company handling the sale of the property in 2009. Further, he had the title company issue a title in the name of “Guy M. Dabney Charles Schwab & Co. Inc Cust IRA Contributory,” making his IRA the owner of the property.
Later, Mr. Dabney sold the property for a profit in 2011 and directed the money to the IRA account as a rollover contribution. Charles Schwab accepted the contribution.
So far, everything seems alright, so how did it all turn against Mr. Dabney?
- The first mistake Mr. Dabney committed was not ensuring whether Charles Schwab allowed alternative investments or not. There are several custodians offering alternative investments for self-directed retirement account holders but not Charles Schwab. Further, he didn’t talk to a dedicated expert and trusted hearsay findings.
- Secondly, Mr. Dabney completed the transaction by requesting a withdrawal from his IRA and indicated that the transaction was an “Early Distribution, no known exception”. As a result, Charles Schwab did send Form 1099-R to Mr. Dabney for 2009, which he should have included in his tax returns. According to Mr. Dabney, he never received the form from Charles Schwab.
How Did IRS Find the Mistake?
IRS looks thoroughly through Form 1040 and Mr. Dabney didn’t report the withdrawal on his 1040 form. Matching it with the 1099-R form sent by Charles Schwab, the IRS had no trouble identifying the transaction.
However, the IRS acted in favor of Mr. Dabney by taking off 20% accuracy penalty, thanks to the thoroughness practiced by him. The IRS came to the conclusion that because of a limited knowledge of tax and accounting, Mr. Dabney acted in good faith and hence he was not liable for the accuracy-related penalty.
Mr. Dabney’s withdrawal was considered as an early distribution, and a 10% early distribution penalty along with applicable income taxes were due on the transaction.
What Do We Learn from Mr. Dabney?
What we can learn from this case is that there are financial instruments available in the market that allow real estate investing using retirement funds but, it is the sole responsibility of the account holder to confirm the same.
If Mr. Dabney did more research, he could have found out about the option called truly self-directed IRA, also known as Checkbook IRA LLC. With this structure, the plan owner truly has the ability to invest in real estate and other alternative assets, without going through the custodian. A knowledgeable custodian would also advise him to make a direct investment from the plan, instead of requesting a withdrawal.
Before you decide to invest in real estate with your IRA, consult a retirement expert and make sure that the transaction is structured correctly to allow these benefits.
You can read the entire case here.