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Newsflash: Tax Court Deems Attempted IRA Investment To Be Taxable IRA Distribution

Posted on by George Munro

In order to invest in real estate, private placements, or other unique investments with your self-directed IRA, you must use an IRA custodian that allows specialized, self-directed IRA investments rather than a traditional IRA custodian such as Charles Schwab, Vanguard, etc.  On June 5, 2014, the Tax Court emphasized this point in Dabney v. Commissioner.  In the case, the Tax Court ruled that an investment into real property on behalf of a self-directed IRA was actually a distribution from the IRA and subsequent personal investment.  The ruling was based on the fact that Schwab’s boilerplate IRA trust language did not allow for investments into real property.

Case Summary:

Prior to his real estate investment, Mr. Dabney held his IRA funds with Charles Schwab.  After Schwab informed Mr. Dabney that alternative IRA investments such as real property investments were not allowed with Schwab IRAs, Mr. Dabney nevertheless used $114,000 from his Schwab IRA to purchase real property, ostensibly on behalf of his IRA.  Schwab treated the transaction as an early IRA withdrawal, and issued Mr. Dabney a 1099 reflecting the same.  When Mr. Dabney, failed to report the 1099 income on his tax return, the IRS issued a deficiency notice, and Mr. Dabney challenged the deficiency at Tax Court.

Mr. Dabney made two primary arguments on why no IRA distribution had occured, but the Tax Court ultimately disagreed with both of his arguments.

First, Mr. Dabney argued that the $114,000 real estate investment was a purchase by his IRA.  In regards to this argument, the Tax Court ruled that the Schwab IRA did not purchase the property.  IRAs must be governed by a written document, and the Schwab IRA trust document did not allow the IRA to invest in real property.  Because the Schwab IRA trust document did not allow real property investments, Mr. Dabney’s real property acquisition could not have been purchased by the IRA.  Therefore, the Schwab IRA did not purchase the property.

Second, Mr. Dabney argued that the property acquisition was a transfer between IRA trustees.  The Tax Court disagreed, saying that Mr. Dabney was not the trustee of any IRA or other qualified retirement plan.  Because Mr. Dabney was not, there was no trustee-to-trustee transfer.  Because there was no trustee-to-trustee transfer, the entire distribution was fully taxable to Mr. Dabney.

The full Tax Court opinion can be viewed at: http://www.ustaxcourt.gov/InOpHistoric/DabneyMemo.Vasquez.TCM.WPD.pdf.

Dabney v. Commissioner stresses the vital importance of properly structuring any self-directed IRA transaction.  While Mr. Dabney was correct that IRAs can hold real estate for investment, Mr. Dabney did not properly structure the transaction by rolling the funds over to a willing, self-directed IRA custodian.  Because the transaction was not properly structured, Mr. Dabney ended up with a large, avoidable tax bill.

 

George A. Munro is a tax attorney with Amicus Law Group, PC.  Amicus is a law firm in Seattle, Washington that focuses on tax planning and compliance, business planning, estate planning, and self-directed IRA consulting.  George can be reached at george@amicuslawgroup.com.