Unconventional IRAs Popular
Under federal law, IRA owners have the authority to invest in a wide variety of assets. While many owners choose traditional investments, such as mutual funds, stocks, bonds, and cash, it is becoming more popular for taxpayers to put a portion of their retirement funds in non-publicly traded assets. At the end of 2015, over half a million unconventional IRA accounts were in existence, according to GAO’s survey. Account owners frequently roll over their accumulated traditional retirement savings into new accounts with a custodian that allows unconventional investment choices. Here’s a list of the types of assets commonly used in self-directed IRAs.
Examples of Unconventional Assets in Tax-Favored Retirement Accounts
- Energy investments
- Equipment leasing
- Foreign-based assets
- Farming interests
- Precious metals
- Private equity investments
- Secured and unsecured promissory notes
- Real estate
- Tax liens
- Virtual currency
Added Responsibilities for Owners
One problem with unconventional accounts is that the account owners have management responsibilities they may not understand. Account owners are responsible for the day-to-day management of their accounts and for ensuring that the account remains compliant with laws and regulations. For example, IRA owners investing in unconventional assets must locate an asset, determine its suitability for their retirement goals, and conduct due diligence on the investment and the investment sponsor. To finalize the purchase, IRA owners must collect, review, and prepare all purchase documents and give them to the custodian to execute the purchase. This level of involvement by account owners in the technical requirements of IRA investing can lead to errors and omissions, especially if the owners are not well-versed in the legal requirements. Thus, the GAO believes the IRS needs to do more to educate taxpayers about their responsibilities.
There are many things an IRA owner may not do when directing investments. Prohibited transactions are the biggest compliance risk associated with investing IRA savings in unconventional assets. Of these, self-dealing is the big no-no. Any action that provides the IRA account holder with a direct benefit is generally not allowed, such as borrowing money from the IRA, using the account to buy a vacation home, or buying property from a relative or any other “disqualified person.” In addition, account assets cannot be invested in a closely held corporation in which the IRA owner is an officer or has a controlling equity position, or in insurance contracts, gemstones, or collectibles.
Annual Valuations Required
The IRS imposes an annual fair market value (FMV) reporting requirement on owners of IRAs. Because unconventional assets can be hard to value, IRA owners can easily run afoul of these rules if they do not work to obtain accurate valuations. It gets more complicated if IRA owners do not report FMVs to custodians and, as a result, the custodians report last-known FMVs to the IRS. Any distributions made will be taxed on these last-known FMVs, even if they are out of date or the account has become valueless.
GAO Recommendations to IRS
The GAO reports recommends that the IRS take three steps to better advise taxpayers on how to manage unconventional IRA investments by:
• Providing guidance to IRA owners in IRS Publication 590 on the potential for the IRA generating unrelated business taxable income, which is income not related to the tax-favored purpose of the IRA.
• Developing guidelines on how to determine and document fair market value (FMV) for hard-to-value unconventional assets. For example, the IRS could give account owners examples of how to value different types of unconventional assets.
• Clarifying which model custodial agreements have been reviewed and approved by IRS and getting this information out to taxpayers.
The IRS has concurred with these recommendations, and, hopefully, will issue new guidance. For now, it is important that all IRA owners with unconventional investments consult with expert and independent tax advisors to make sure these self-directed IRAs comply with the current IRS rules.