IRA Valutions: Who Cares What It's Worth?

Not all IRAs are created equal (when it comes to providing an annual valuation, at least).

Consider the case of “Berks vs Commissioner of Internal Revenue.” In the case, Bernard and Claire Berks invested in notes with their IRAs but the borrowers either defaulted or their collateral did not adequately secure the debt. This resulted in the notes being worth zero. The IRA provider, over a period of several years, requested that the Berks provide an annual valuation. The Berks referred these queries to the investment provider who, allegedly, called the provider and told them that “the notes are worth zero.” No documentation supporting this assertion was provided. The Berks requested that the assets be valued at zero and that the provider terminate their accounts. In accordance with the provider’s policy, the assets were distributed from the IRA holder’s account to the IRA holder at the last recorded book value of the asset. In other words, the IRA holder received a 1099-R (form for reporting distributions from pension plans) for the full amount of the account using the original face value of the notes.

The Berks took the case to tax court challenging the valuation of the IRA at the time of distribution. The IRS did not see this situation the same way as the Berks did.  Not only would the IRS not accept the opinion of the Berks that the IRA was worth zero, they penalized them 20 percent of the account value for their “negligence” in failing to make a reasonable attempt to comply with tax laws, maintain adequate books and records or to substantiate items properly. They were also cited with the intentional “disregard” for rules and regulations. 

As is usual in tax cases, the burden of proof falls on the taxpayer. The Berks’ tax return claimed the IRA distributions were not taxable and therefore paid no taxes on the reported distribution. They blamed the preparer for this “oversight.” They blamed the IRA Provider for distributing the account at full value. In short, they took no responsibility for their account or their tax preparation and the court was not sympathetic.  In fact, the court found that these arguments actually proved the Berks’ negligence.

The case brings up a greater issue about the importance of valuations.

IRA holders whose accounts have alternative assets in them receive a request from their IRA providers every year to provide fair market value for their IRA’s assets. For most IRA holders, these annual valuations are of little importance because their IRAs are invested in publicly traded securities and their IRA providers will often prepare valuations for their clients at a fee. For reference, about 97 percent of IRAs are invested in publicly traded securities.

For the $126 billion invested in self-directed IRAs (SDIRA) however, valuations matter a great deal. The account holder, not the provider, is responsible for providing valuations every year on their assets.

This issue of determining fair market values for hard-to-value assets in SDIRAs has become a focal point for the IRS. The IRS is now paying attention to the fact that with many SDIRA assets, there is a wealth of taxes to either be reaped or avoided. 

So the Berks case offers several learning points. First, provide an annual valuation, with documentation, when the IRA provider requests it.  If the asset is worth zero, provide proof that the asset is worth zero. For those with publically traded IRA investments, much of the work is done for them by the IRA investment provider, usually at a fee (we don’t charge a valuation fee at New Direction IRA.)  SDIRAs give IRA holders entrance to every investment allowed by law, but the account holder must find and manage the investment and provide the value annually.  Those are the rules. With SDIRAs, investors receive unlimited possibilities but they are also expected to know and understand the rules.   

How does Unrelated Business Income Tax (UBIT) work?

Securities brokers and some accountants will be the first to tell you that you don’t want leveraged property in either a Traditional or a Roth IRA because you will have to pay additional taxes, specifically Unrelated Business Income Tax (UBIT).

How UBIT Works

UBIT was instituted as a way to level the playing field between non-profit and for-profit companies doing similar work.

For example: A Homeowners’ Association “Dairy Glen”, a non-profit corporation, has installed a pool and tennis courts for its residents. These facilities are supported by the HOA dues, paid by the residents of that neighborhood. At some point the HOA board decides that they are going to open the recreation facilities to the public and charge admission or offer memberships, all funds going back to the HOA accounts.

Down the road is “Muscle World, Inc.” a gym that offers similar facilities to their members. Muscle World pays taxes like any other corporation but has a tough time competing with Dairy Glen because they have to pay taxes. This is where UBIT enters. The government, in order to force fair competition levies UBIT on Dairy Glen because they are now in a business that is unrelated to the original business of maintaining neighborhood facilities.

So how does UBIT relate to IRAs?

The government will give you tax-deferred status on the income generated by whatever you have in the IRA. However, it is not willing to shelter the profits of the income generated by funds brought into the account in the form of a loan.

The IRA is treated like a non-profit but the additional funds brought in are not. This is because the IRS doesn’t allow unlimited ability to contribute to a tax-advantaged plan. The amount of money you can shelter within an IRA is limited by the annual contribution limits, so by taking out a mortgage, you are increasing the size of your IRA.

For example, if your IRA buys a home using a mortgage, UBIT will be assessed on the leveraged portion, not the portion that your IRA contributed. Thus as your IRA pays off the mortgage, the percentage that incurs UBIT will decrease.

UBIT is assessed at corporate tax rates.

Quick UBIT Facts

-          LLCs will not protect you from UBIT, it still applies

-          The IRA pays the tax, not you.

-          The IRA has its own tax return and this return does not affect your personal tax return

-          For most leveraged real estate deals, an IRA does not pay UBIT until somewhere between years 4 to 8 because of depreciation.

UBIT is generated by an IRA in three ways:

1.       The net income generated by the leveraged portion of an investment at trust rate.

2.       Proceeds of a sale taxed based on balance of debt at time of sale at capital gains rate (short term gains are taxed at the trust rate.)

3.       The IRA owns an operating business such as providing goods or services. Tax is on 100% of the net income using the trust rate. (This situation is not covered in this article.)

UBIT Illustrated

A good exercise is to take the same size IRA and calculate the gain on a property with zero leverage. Compare this property bought with varying degrees of leverage. Estimate the income generated by renting the property, and see what UBIT may be over the next 4 to 8 years.

Before someone talks you out of leveraging a property within an IRA, do the numbers and decide for yourself. It may or may not make sense to use a mortgage but at least you will understand the decisions you make when investing your IRA money.

Remember that a self-directed IRA is the only way you can purchase real estate AND have a mortgage on it. 

What motivates American to save for retirement?

Nearly half of American workers are not confident they will have enough savings to retire according to the Employee Benefits Research Institute’s 2013 Retirement Confidence Survey. Only 13% of those surveyed said they were “very confident” in a comfortable retirement, while 22% of people believe they’ll have to retire later than they planned due to the poor economy, inadequate finances and lack of confidence in social security—only 31% of workers think Social Security benefits will be higher than they are today.

That said, we don’t need a survey to tell us that retirement savings and social security are major issues for the massive generation set to retire within the next 20 years. Many employers no longer match 401(k) funds, further devaluing a 401(k) and demotivating the 401(k) holder. Many workers and financial professionals are clearly not confident that the federal government is prepared to support retirees in the future.

Preparing for retirement not only benefits you, but benefits the entire industry. If millions of Americans are not financially ready for retirement, those who do prepare to retire will be adversely affected by higher taxes or stress on the public safety net or some as-yet-unknown factor.

So how do motivate the millions of eventual retirees who haven’t started to think about their retirement? Is it fear? Is the best way to motivate workers to put a portion of their salary aside this year to paint before them a grisly picture of their golden years?

Let’s look at how fear effects action. If the fear is immediately apparent (say, a drooling bear moving rapidly toward you), it can be a great motivator. But how many of us think about retirement savings while working full-time or overtime, raising a family, practicing hobbies, enjoying friends – basically, while living a full life? Do we look at an unknown retirement as we look at a hungry bear? If the fear of a destitute retirement doesn’t inspire you to save and plan, then it’s not a good motivator.

Many people fear the unknown. EBRI reports that 44% of workers don’t know how much they’ll need for retirement. The numbers indicate, however, that ignorance may not be bliss. If half of all workers still don’t have confidence in the amount they’re saving, then they either must not fear the unknown or be adequately motivated by that fear.

Indeed, we may be motivated by a different kind of fear.

What is real to most of us is the fear of losing our money. What is real is watching the numbers fall every quarter, knowing that money you earned and saved is now gone, due to some individual or some company’s bad decisions or bad luck. Investors don’t always know all they’re options or they think alternative investments are too risky or too complicated to try. In short, they’re paralyzed.

If you’re reading this, you likely already hold a self-directed IRA or you are considering one. Maybe you were able to shake off the retirement paralysis, look at your statement, and do something to change the status quo. Now encourage others to do the same. The more workers who take control of their retirement funds, the better we will all be in the long run.