| EXECUTIVE SUMMARY | |
| |
| ROBERT PRESTON, CPA, is a sole practitioner in Danbury, Connecticut. His e-mail address is rpreston@prodigy.net . |
RA investors today have literally hundreds of investment
options available to them ranging from the stock, bond and mutual fund
offerings of Wall Street to gold coins, real estate and derivatives.
The decision to purchase one or more of them is one an investor often
makes with the advice of his or her CPA. Investment decisions can be
more complicated when the client intends to hold the investment in an
IRA. The law does not allow taxpayers to put certain investments in an
IRA; despite such limitations, there remain some attractive,
little-publicized and less-known investment opportunities. CPAs should
be familiar with them so they can give clients the best possible
advice on a confusing, and potentially risky, subject.
KEEPING WITH TRADITION
Most CPAs are aware of the traditional IRA investments—publicly traded stocks, bonds, treasury instruments, cash. But what about investments outside the United States or in private placements and real estate? Are these viable options for an IRA? How about limited partnerships or options? Can a client make these investments legally? Are commodities, personal loans or mortgages acceptable alternatives?
Unfortunately, there isn’t extensive guidance from federal regulators that answers these questions and provides a thorough overview of what investments are allowed in IRAs. CPAs, however, will find considerable guidance on IRA deduction limits and minimum distributions. The rationale for that is fairly obvious—Congress and other agencies put a priority on rules affecting revenue collection.
| Growth of IRA Assets |  |
| Sources: Statistical Abstract of the United States, 1997; Employee Benefit Research Institute Notes, December 1997 and May 1999. | |
While the Department of Labor (DOL) is the principal authority responsible for prudent, allowable investments and overseeing prohibited transactions in qualified plans, its interest in IRAs is minimal. In most instances, the DOL does not consider an IRA a pension plan and consequently it is not covered by Title I of ERISA; for the exceptions, see DOL regulation 2510.3-2(d). However, the DOL has principal authority for prohibited transaction issues (and granting exemptions) involving IRAs under IRC section 4975(e).
ERISA initiated the concept of asset guidelines as they apply to qualified plans (principally ERISA sections 404 and 406–408), but there are no asset diversification guidelines for IRAs similar to those in ERISA section 407 for qualified pension plans. Government agencies and the courts have provided follow-up guidance. IRAs originated with ERISA in 1974, but the Economic Recovery Act of 1981 gave them a big boost by relaxing the eligibility rules, allowing more individuals to participate, including those covered by employer-sponsored pension plans. While the Tax Reform Act (TRA) of 1986 added some restrictions, the 1997 TRA continued the liberalizing trend of the early 1980s. With the proliferation of large pension distributions being rolled over into IRAs, assets have mushroomed.
IRA INVESTMENT RESTRICTIONS
While Congress put strict prohibitions on some IRA investments (for example, insurance), it did not pay similar attention to other asset classifications. Because the account owner generally manages IRA assets, Congress and the enforcement agencies probably did not foresee the same need for supervision and guidelines as with pension assets, where the potential for abuse seemed greater.
What rules does an account owner have to follow when making IRA investments? The primary laws affecting IRA investments are IRC sections 219, 408 and 4975, along with the accompanying regulations. CPAs will find that IRA owners have considerable investment leeway based on what’s not addressed by any government body or area of law. Accordingly, the scope of permissible IRA investments is somewhat vague and subject to interpretation.
What is helpful is that IRA investment restrictions are relatively straightforward. Collectibles generally are not allowed, with a few exceptions—see section 408(m). There can be no “self-dealing” with IRA funds; that is, they cannot be used to further personal financial dealings—see section 408(e). And, as mentioned above, life insurance is not allowed.
As with many of the rules there is logic behind them. For starters, a certain degree of liquidity is important in retirement assets. If too much money is tied up in illiquid investments, such as collectibles or real estate, the required cash flow may not be available to participants during retirement, or for their heirs, to make required distributions. And since the regulations, supervision and enforcement procedures surrounding collectibles and other tangibles as investments are not as clear as the overall surveillance of securities and mutual funds by the SEC and other agencies, the latter offer more leeway for IRA owners.
When specific questions arise as to allowable IRA investments, it’s possible for the client to get an IRS letter ruling beforehand; one generally takes three to six months to obtain. When the client is considering an unusual commitment with IRA funds, it’s prudent for the CPA to review existing IRS letter rulings, DOL ERISA opinion letters and prohibited transaction exemptions to spot trends that could affect the client’s decision. These rulings are available on various electronic sources (both the DOL and IRS have exhaustive references on the Internet).
WHAT WORKS; WHAT DOESN’T
Following are some of the rules that apply to specific investments a client might use in IRAs as well as some important limitations.
Life insurance. Congress’ intent in not permitting life insurance was to have IRA funds invested so they would provide inflation-protected returns. Obviously, life insurance does not fit this goal. In addition, some congressional representatives perhaps conjectured that, with so much money potentially involved in IRAs, a total ban on life insurance was necessary to shield the average consumer from the intense marketing and sales pressure of the life insurance industry.
Collectibles. The IRC is specific as to what defines a collectible and lists the following items: art works, rugs or antiques, metals or gems, stamps and coins and any alcoholic beverage. Some notable exceptions are allowed for IRAs—in particular, certain gold (such as American Eagle) and silver coins and any coins issued by a state. Legislation in 1997 further liberalized the rules for IRAs by making reference to specific definitions of acceptable coins in USCS, title 31; IRC sections 5112(a), (e) and (k); the Commodity Exchange Act; and IRC section 408(m)(3). This change may result in a bonanza for individual collectors as well as coin and precious metal dealers (all of the coins allowed must be minted by the U.S. government or the states).
Foreign investments. With the exception of American Depository Receipts (ADRs) and domestically sponsored mutual funds that make overseas investments, IRA owners should restrict investments to the continental United States. An IRA can’t be used to transfer funds overseas. Anyone who has prepared a form 1040, schedule B, is familiar with the questions at the bottom of that form (items 11 and 12) concerning funds or trusts in foreign countries. Obviously, Congress wouldn’t want IRAs to circumvent IRS authority by placing IRA funds outside its control.
Real estate. While the guidelines on real estate, particularly leveraged real estate, are not as clear as some CPAs might like, clients should be able to use IRA funds to invest in real estate—a much overlooked and underused opportunity. While the brokerage, mutual fund and banking industries have fully exploited the IRA concept, the real estate industry seems to have missed the boat.
An IRA investor may be able to leverage real estate purchased in an IRA if the transaction is carefully structured. While it can be a problem for an IRA owner to borrow from an IRA, investing in leveraged real estate—with the IRA trust holding title to the assets—may be allowed if the property seller holds the mortgage in the IRA trustee’s name. In such situations the borrower of the funds is not the IRA owner but, rather, the IRA trust. In addition, the IRA owner cannot be held liable for additional recourse on leveraged assets held in the IRA. (The IRA trust agreement should make note of this fact.) Because this is an innovative approach not commonly practiced, a CPA should encourage the client to obtain a letter ruling from the IRS before purchasing real estate leveraged with IRA funds.
It’s important to remember that any debt in an IRA must be serviceable through liquid assets held in the IRA or through the $2,000 annual contribution. And although some of the tax advantages of real estate (deductible interest or depreciation) are lost in an IRA, IRA funds themselves are already tax-advantaged. In addition, deductions offset income, which helps in complying with the unrelated business income tax rules (IRC sections 512 and 514) applying to leveraged real estate. All gains are tax-free in an IRA—nothing is taxed until it is distributed. With a Roth IRA, even distributions are tax-free. This allows investment-oriented real estate to fulfill its growth potential unfettered by federal and state taxes.
The best types of real estate for an IRA are cash deals (transactions leveraged directly with the seller also might work), specialized real estate mutual funds and real estate investment trusts. Limited partnerships probably are not advisable (because of IRC section 511, discussed below). Rental property may be permissible as long as there is no personal use of the properties involved.
Real estate must be solely an investment; the taxpayer or related parties cannot use it in any way. The taxpayer should purchase the real estate so the trust holds title to the asset (some organizations will act as trustees for nontraditional IRA assets). Since the percentage of IRA assets that can be used for real estate has not been given a “bright line” test by the regulatory authorities, it seems safe to say any amount is acceptable.
THE SEARCH FOR A TRUSTEE
Many traditional IRA trustees (banks, brokerage houses and mutual funds) will not act as trustees for real estate or other unorthodox investments. This means the IRA owner must locate an independent trustee that offers such a service (for example, to hold title to the real estate, to collect rent).
Aside from asking other professionals for references, the CPA can help a client start such a search by using the Internet. A search for “self-directed IRAs” will locate many potential IRA trustees that will handle offbeat investments and enthusiastically seek such business. The IRS allows approved nonbank organizations to act as trustees for nontraditional IRA assets. Treasury regulations section 1.408-2(e) outlines the qualification requirements. Most of the entities are securities concerns licensed to sell ordinary stocks and bonds that also want to be able to act as trustees for real estate or exotic limited partnership investments. Offering these nonstandardized services is a way for them to differentiate themselves from their competition.
CPAs should check the credibility, professionalism and financial stability of any institutions they recommend by asking for references and recent audited financial statements as well as doing background checks on the principals. Helping a client with the due-diligence phase of checking independent trustees can be a niche opportunity for some CPAs. Choosing a reputable third-party trustee is very important. The wrong trustee can put the client’s IRA assets at risk. An appropriate screening should help eliminate any marginal candidates.
THE RULES AGAINST SELF-DEALING
Self-dealing—where the IRA owner uses the account for personal enrichment or to satisfy self-indulgent financial objectives in a way that goes beyond the intent of the tax law—is a nebulous area. When an IRA transaction doesn’t fit precisely into preestablished guidelines, the IRS or the DOL scrutinizes the “facts and circumstances” to determine whether it passes muster. The IRA owner or a “disqualified person”—anyone with control over the assets, receipts, disbursements and investments or who has the ability to influence investment decisions, including members of the IRA owner’s family (spouse or lineal descendants)—can initiate a prohibited transaction.
Self-dealing can taint any transaction that seems to promote self-interest. Transactions must be at arm’s length, which is what generally occurs between a willing buyer and a willing seller with no undue influence from outside sources. Here are a few examples of what the IRS or DOL may consider self-dealing with IRA funds:
- Purchasing stock in a closely held corporation in which the IRA owner is an officer or has a controlling equity position.
- Using IRA funds to buy a vacation home the IRA owner or his or her family will use.
- Purchasing restricted stock from a relative.
- Issuing a mortgage on a relative’s new residence.
- Granting a child a second mortgage for the down payment on his or her first home (although the 1997 TRA now allows certain distributions up to $10,000 for first-time home purchases).
- Buying stock from the IRA owner (any transaction involving IRA funds and a “party in interest” is prohibited).
In sum, anything that smacks of self-interest or occurs between parties in interest has the potential to be considered a prohibited transaction. To be safe CPAs should emphasize investment vehicles for which established markets exist such as stocks, mutual funds, bonds, bank certificates of deposit, annuities (although these may not be best for an IRA since IRA funds already are tax-sheltered), real estate and select coins.
If a taxpayer violates the prohibited transaction rules, he or she jeopardizes the IRA’s tax-free status. In a worst-case scenario, the entire IRA becomes taxable based on the total account value as of the beginning of the year in which the transaction took place. A 10% early withdrawal penalty also may apply. This is much harsher than the penalties applied to qualified plans, which generally are restricted to a 10% penalty on the prohibited amount.
If a fiduciary (a trustee or money manager) other than the owner or beneficiary of the IRA participates in a prohibited transaction, a 15% excise tax on the amount involved can be assessed on that individual. This tax can increase to 100% if the illicit transaction is not corrected within the initial taxable period in which it occurred. The penalty tax is onerous to motivate third-party fiduciaries to handle IRA funds with extreme care.
Based on these rules, the following investment scenarios should generally be acceptable:
- Using a self-directed brokerage account to invest in an initial public offering (unless the IRA owner or his or her family members own or manage the company).
- Investing in stocks, bonds or mutual funds.
- Purchasing properly leveraged real estate, including rental property, when the entire transaction takes place within the IRA trust (the CPA should encourage the client to obtain an advance ruling).
- Purchasing puts on stocks.
- Private placements when no element of self-dealing is present or can be inferred.
UNRELATED BUSINESS INCOME
With certain investments, IRA owners face other risks. The IRS can use portions of the IRC (sections 511–514) to tax a not-for-profit or a tax-exempt entity that conducts business unrelated to its original purpose. The rules cover income-producing “businesses” in tax-exempt entities, including trusts (IRA trusts under section 408(e)(1) that are considered businesses). Investments can lose their tax-exempt status and be taxed as business entities even though they operate in a tax-exempt environment. These rules relate only to investments the IRS considers “profit- producing” and camouflaged by tax-exempt entities such as using IRA funds to buy an interest in a cattle-breeding operation or to invest in a hedge fund that uses leverage to purchase securities. Both transactions generate unrelated business taxable income (UBTI).
Rents from real property are excluded in the definition of income under unrelated business income, so purchasing rental real estate in an IRA and collecting rents is an acceptable investment. Under section 512(b)(3), however, taxpayers must exercise caution if the rental property is leveraged. In such instances the net rents are limited to a $1,000 exemption.
The CPA should recommend restraint when an IRA client wants to make nontraditional investments, such as in a mutual fund owned or managed by the IRA owner, in an active marina or in a commercial building where an outside third party—not the seller—holds the mortgage. The IRS may consider all to be separate business enterprises.
Offbeat investments are at risk in two ways:
- Being construed as a prohibited transaction so the IRA risks its entire tax-exempt status.
- Contributing UBTI, which generally is taxable.
Unconventional investments must surmount both hurdles so they are sure not to jeopardize the IRA’s tax-exempt status.
SENSIBLE INVESTING
The overriding theme of the rules surrounding IRA investments is that Congress wants IRA money to be used for retirement and invested sensibly so it will be there when it is needed. To circumvent this rationale is inviting trouble as well as jeopardizing a client’s retirement security. As more money pours into IRAs on a daily basis, financial services companies have created investments specifically tailored to these accounts. The result is that most clients’ investment goals can be easily satisfied without the risk of investing in something that is not IRS approved.
