Originally published on Forbes.com June 9th, 2014
Using IRA funds to invest in real estate can be a very good idea. Well, at least I know one person for whom it worked out. It did not, however, work out very well for Guy Dabney, who recently represented himself in Tax Court. Every once in a while, people will ask me questions about what their qualified plans or IRAs or 1031 intermediaries can or cannot do. Although I will often look into it, I always caution them that it does not really matter what I think, regardless of how thorough my research. What is important is how the custodian reads the rules and chooses to enforce them. Unless you are in a position to get a different custodian, it does not matter whether they are being too strict, you are stuck with their rules.
IRA Custodians Can Hold Real Estate
According to the Tax Court decision, Mr. Dabney rolled his Northwestern IRA into a self-directed IRA at Charles Schwab. He decided that he want to invest in some undeveloped land in Brian Head, Utah. He did some internet research and determined that IRAs could in fact own real estate. So he called up Charles Schwab to discuss the matter. He ended up speaking with a random customer service representative. Here is how the Tax Court relates the story
Before purchasing the Brian Head property Mr. Dabney called Charles Schwab’s customer service line. He did not have a dedicated customer service representative at Charles Schwab but instead spoke with whichever customer service representative happened to answer his call. During his telephone call a customer service representative informed Mr. Dabney that Charles Schwab did not allow alternative investments, which would include the purchase and holding of real property.
Mr. Dabney also made several telephone calls to Vincente Alvarez before purchasing the Brian Head property. Mr. Alvarez is a certified public accountant at the firm Breard & Associates, petitioners’ accountants at that time. Mr. Alvarez told Mr. Dabney that he did not have any training in retirement accounts and was not certain whether it would be possible to purchase or hold real property with an IRA. After Mr. Dabney shared the results of his Internet research with Mr. Alvarez, however, Mr. Alvarez agreed with Mr. Dabney that it would be possible for his Charles Schwab IRA to purchase the Brian Head property.
Many IRA Custodians Do Not Want To Hold Real Estate
I generally don’t second guess people, but it is kind of obvious what should have happened here. Mr. Dabney could have gone back to using his internet skills to find a different IRA custodian that would be willing to hold real estate. Alternatively, Mr. Alvarez could have done some networking in order to help his client find another custodian. The conclusion that Charles Schwab could organize itself to be a real estate custodian is merely of academic interest if Charles Schwab has decided not to do that.
There are entities that serve as IRA custodians that do allow real estate holdings to be included. Unfortunately, some of them are a little sketchy and I am not investing the time to separate the wheat from the chaff for purposes of this post. So many projects, so little time. It is also possible that Mr. Dabney’s deal which was just over $100,000 might have been on the smallish side for some of them. At any rate, that was more or less how it would have been reasonable to proceed. Mr. Dabney hit on a different plan, which was to have Charles Schwab serve as custodian without knowing that that is what it was doing.
His plan was to have funds wired directly from the IRA to the seller of the Brian Head property and to have title to the property placed in the name of “Guy M. Dabney Charles Schwab] & Co. Inc Cust. IRA Contributory”. He planned to then resell the property for a small gain and to contribute the proceeds of the sale back into the IRA. Mr. Dabney believed that the property would not need to be managed by a trustee as long as he did not use or enjoy the property.
Good Execution Does Not Salvage A Flawed Plan
You have to give Mr. Dabney credit, as did the Tax Court, for thoroughness in executing this plan.
Charles Schwab wired $114,000 directly to the bank account of Chicago Title Insurance Co., Service Link Division (Chicago Title), the company handling the sale of the Brian Head property. Mr. Dabney directed Chicago Title to name “Guy M. Dabney Charles Schwab & Co. Inc Cust. IRA Contributory” as the owner of the Brian Head property. However, because of a bookkeeping error by Chicago Title, title to the property was placed in Mr. Dabney’s own name.
Although he had hoped to sell the Brian Head property sooner, Mr. Dabney was unable to find a buyer until 2011. It was then that Mr. Dabney discovered that the property was incorrectly titled in his own name. Upon discovering the bookkeeping error, Mr. Dabney promptly sought and received a scrivener’s affidavit from Chicago Title in which the company admitted fault for the error. Mr. Dabney sold the Brian’s Head property and received $127,226 on the sale, after taxes and fees. That amount was wired directly into the Charles Schwab IRA on or around January 28, 2011. Mr. Dabney marked the deposit as a rollover contribution, and Charles Schwab accepted the deposit as such.
When it came to return preparation, there was less thoroughness.
Breard & Associates prepared petitioners’ Form 1040, U.S. Individual Income Tax Return, for 2009. Charles Schwab issued Mr. Dabney a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for 2009, although Mr. Dabney does not recall ever receiving it. The Form 1099-R stated that he had received a $114,000 early distribution from his Charles Schwab IRA and that no exceptions to the early distribution penalty applied. Petitioners did not report the withdrawal on their Form 1040.
It is possible that if the 1099 had been reported on the 1040 as non-taxable, regardless of how Schwab had characterized it, that the whole plan might have worked or at least seemed to have worked. Unfortunately for Mr. Dabney, there is a lot of stuff that gets by the IRS, but when it comes to 1099s, they are good at matching them and generating notices.
The IRS did not buy the plan and the Tax Court backed them up. Mr. Dabney compared his case to the of Robert Ancira, who had acted a conduit in purchasing closely held stock for his IRA.
Mr. Dabney argues that the facts of his case are similar to those in Ancira and that a distribution did not occur in this case for similar reasons. He argues that Charles Schwab does not permit its IRAs to invest in real property as a matter of policy and not because of any statutory prohibition. Consequently, Mr. Dabney contends that if title to the Brian Head property had been placed in the name of “Guy M. Dabney Charles Schwab & Co. Inc Cust. IRA Contributory”, as intended, the purchase would have been virtually indistinguishable from that in Ancira. Respondent argues that, even disregarding any typographical errors, Charles Schwab’s policy in itself distinguishes this case from the facts in Ancira. We agree with respondent.
……we are not aware of any provision in the Code that requires an IRA trustee or custodian to give the owner of a self-directed IRA the option to invest IRA funds in any asset that is not prohibited by statute.
We find that, in its role as an IRA trustee, Charles Schwab had the power to prohibit the purchase and holding of real property and that Mr. Dabney’s Charles Schwab IRA was not capable of holding real property.
On The Bright Side
The IRS pretty routinely assesses the 20% accuracy penalty if the dollar threshold is met. This case was no exception. The Tax Court looked kindly on Mr. Dabney’s thoroughness even though he came up with the wrong answer.
Mr. Dabney is not a sophisticated taxpayer, and he has no background in tax or accounting. Although he was ultimately unsuccessful, Mr. Dabney went to great lengths in attempting to ensure that the purchase of the Brian’s Head property using funds from his IRA would qualify as a nontaxable event. He performed independent research on the Internet to confirm, correctly, that IRAs are generally permitted to hold real property, and he spoke with a Charles Schwab customer service representative and his accountant, Mr. Alvarez, on multiple occasions regarding the purchase.
Mr. Dabney honestly believed that the purchase was appropriate, even going to the trouble of obtaining a scrivener’s affidavit when he discovered that the property had been titled in the wrong name. He ensured that the funds were wired directly from the Charles Schwab IRA to Chicago Title when he first purchased the Brian’s Head property and directly back into the IRA after he had sold the property. Furthermore, the property was undeveloped, and Mr. Dabney ensured that it was being held solely for investment purposes.
Although he was mistaken in his understanding of the law, it was reasonable under the circumstances for Mr. Dabney to believe that he had not received an land.We find that he had reasonable cause for failing to report the distribution on his return and acted in good faith. Accordingly, we hold that Mr. Dabney is not liable for the accuracy-related penalty.
Getting out of the penalty was nice work for a pro se litigant, even though the planning had been flawed.
The Moral Of The Story
There are many tax-favored transactions that people are not generally aware of. If you learn of one and decide that it might fit your needs, find somebody who has done a couple of them to help you.
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