A new year begins with celebrations, resolutions, and dual IRA opportunities. Most workers and their spouses have until April 18, 2017 (April 19 in some states), to contribute to an IRA for 2016. At the same time, contributions to 2017 IRAs are now permitted; the earlier money goes into the account, the more time for tax-deferred investment buildup.
While you consider IRA contributions, you should also take this time to review IRA investments. Virtually any investment can go into an IRA, other than life insurance and collectibles. In recent years, questionable outlooks for stocks, bonds, and savings accounts have encouraged many IRA owners to consider—or put money into—nontraditional IRA assets.
Consequently, IRA owners can invest in real estate, venture capital pools, even their nephew’s Internet startup that hopefully will become the next Google. Such outlays may or may not prove to be good uses for retirement funds. In any case, however, some tax-related issues will arise.
IRAs must be valued for certain purposes, and illiquid assets are not as easy to value as listed securities or mainstream savings instruments. The IRS, which views undervaluation as a potential problem, has made some changes in reporting requirements, in order to spotlight alleged transgressions. IRA owners face painful consequences if they trigger IRS displeasure in this area.
Lower value, less tax
IRAs need to be valued for purposes such as required minimum distributions (RMDs) and Roth IRA conversions.
Example 1: Bill Carson, an experienced real estate investor, has most of his traditional IRA money in private real estate partnerships. Now that he is past age 70½, Bill must take RMDs from his IRA each year and pay tax on the distributions. The lower the value of the real estate, the less tax Bill will pay on his RMDs.
There is no readily visible market for the properties held by these private partnerships, and, thus, no way to easily value Bill’s IRA. The IRS may suspect Bill of lowering the valuation to reduce taxable distributions.
A similar situation may appear if Bill wants to convert his traditional IRA to a Roth IRA. Converting a traditional IRA with $500,000 in mutual funds to a Roth IRA will generate $500,000 of income to be taxed, but how much income will be generated when an IRA holding real estate assets is converted?
To prevent undervaluation that can lead to tax underpayments, the IRS is requiring more information from IRA custodians on Forms 5498 and 1099-R for 2015 and later years. On Form 5498, which is filed annually with information on IRA account value and whether a distribution is required, IRA custodians must reveal the presence of hard-to-value assets and the asset type. The same information is required on Form 1099-R, which reports the amount of any IRA distribution. (For Form 1099-R, this rule affects in-kind distributions of hard-to-value assets.)
With this information, the IRS will be able to focus on IRAs that hold illiquid assets, which are subject to RMDs. The agency can follow up to see if the reported valuation was arrived at fairly.
Impact on IRA owners
Individuals who want hard-to-value assets in their IRA, for their growth potential, should be vigilant about providing reliable valuations.
Example 2: Bill Carson’s IRA holds $100,000 in liquid assets as well as private real estate investments. Bill’s IRA custodian has listed Bill’s cost—$400,000—as the value of the real estate.
This year, Bill will be 71, so the IRS Uniform Lifetime Table gives him a “distribution period” of 26.5 years. Using the historical $400,000 cost of the real estate, Bill would divide the total account value ($500,000) by 26.5 to get an RMD of $18,868.
Now, however, Bill’s IRA custodian requires him to get a current appraisal of the real estate holdings in the IRA. Suppose the appraiser finds the real estate interests in Bill’s IRA are worth $750,000. This would drive the account value up to $850,000, as reported on Form 5498, and the RMD to more than $32,000. If Bill withdraws less, he could owe a 50% penalty on the shortfall.
For IRA owners, finding an IRA custodian that will hold hard-to-value assets can be a challenge. Once that’s accomplished, the next step may be discovering the custodian’s valuation policy. A custodian could require an IRA owner to provide a valuation once per year, from an independent source. A valuation might come from the sponsor of the deal, from an executive of a private company with stock in the account, or a reputable third party. For real estate, an annual comparative market analysis might be required.