November 7, 2014
Authored by: Kathy Sherby and Stephanie Moll
The provisions of IRC § 408 do permit investment of IRA assets in any kind of asset other than those specifically prohibited, such as life insurance and collectibles. Therefore, it was somewhat reasonable for Guy Dabney to conclude that he could invest his IRA account assets in real estate. However, the Tax Court in Dabney v. Commissioner took Mr. Dabney to task for failing to follow the terms of the IRA Account Agreement that governed his IRA.
In this case, Dabney wanted to use his IRA assets to purchase a piece of undeveloped land in Utah that he considered to be priced below its fair market value. So he did what a lot of us do when we want to learn something new—he went to the Internet. Based on his Internet research, Dabney concluded that IRAs were permitted to invest in real property.
Dabney was smart enough to know that he should delve further in his research than just the Internet. Next, he contacted his CPA, who told him that he didn’t have any training in retirement account rules, but based on Dabney’s research confirmed that he could invest IRA assets in real property.
Here’s where Dabney went wrong, however.
Dabney was told by a Charles Schwab customer service representative that Charles Schwab did not permit investment in alternative investments such as real property in their IRA accounts. Schwab would, however, follow Dabney’s direction to wire the funds to the title company.
Dabney instructed the title company to title the real property in the name of the Guy M. Dabney Charles Schwab & Co. Cust. IRA, and initiated a withdrawal of $114,000 from his IRA to be wired to the title company to close on the purchase of the property. Dabney did not consider this to be a taxable withdrawal.
Due to a bookkeeping error, the property was accidentally titled in Dabney’s own name. As soon as Dabney discovered the error, he contacted the title company and corrected this “error”.
When Dabney received the Form 1099-R from Schwab (which Dabney does not recall receiving), he did not include the withdrawal as income on his tax return. The IRS audited his return and issued a deficiency for failure to pay the tax on his $114,000 withdrawal used to purchase the Utah property.
Dabney argued that he had not really made a withdrawal of these funds, but rather acted as a conduit through which the property was purchased in his Schwab IRA. While § 408 authorizes real property to be held in an IRA, Charles Schwab had a policy prohibiting alternative investments in their IRA accounts, and the Code does not require the IRA trustee or custodian to give an IRA owner the option to invest in such property.
IRA custodians have broad latitude to determine what investments are acceptable in their IRA accounts and can prohibit investment in certain types of assets even though otherwise acceptable investments in IRAs generally.
Because of Schwab’s rules, Dabney could not have acted as a conduit to invest in the Utah property in his Schwab IRA. Further, Dabney could not simply title property in the name of the IRA without having that property managed inside the IRA by Schwab as the IRA custodian. Dabney’s investment in the Utah property was outside of his IRA and his withdrawal from his IRA to complete that purchase was a taxable withdrawal subject to income taxation in the year of the purchase.
But wait, it gets worse for Dabney. In addition to being taxable income, the distribution was also subject to the 10% additional tax because Mr. Dabney was under age 59 ½.
Luckily for Dabney, the Tax Court refused to uphold the 20% accuracy penalty on the return because Dabney honestly believed that the investment was inside his IRA. It is ok for the taxpayer to have an inflated view of his sophistication as an investor and of his tax knowledge, as long as he honestly believed, in good faith, that he was right.
Lessons to be learned from poor Dabney:
(1) Don’t believe everything you read on the internet.
(2) Don’t rely on the advice of a CPA who says he is not familiar with the tax rules applicable to retirement benefits.
(3) When your IRA custodian tells you the account does not permit certain investments, believe them. The IRA account agreement of the IRA custodian always controls the rules applicable to the IRA accounts the IRA custodian administers.