The Tax Court ruled that an individual had a taxable IRA distribution when he tried to get around his custodian’s policy of not allowing real estate as an IRA investment. The Court said the custodian didn’t have to offer real estate as an investment, even though the Tax Code allows it.

As a result, the individual was not acting as an agent for the custodian when he bought a property with his IRA money and tried to title it in the IRA custodian’s name. (Guy M. Dabney et ux. v. Commissioner; T.C. Memo. 2014-108; No. 14566-12 June 5, 2014)

Guy M. Dabney had an IRA with Schwab and wanted to buy a piece of undeveloped land in Utah with his IRA funds, but Schwab, like many IRA custodians, did not allow alternative investments (like real estate) to be held in their IRAs. They do not have to allow it, even if the law allows it.

But Dabney did it anyway and the Court ruled that the $114,000 IRA distribution used to buy the land was a taxable distribution, plus a 10 percent early withdrawal penalty because Dabney was under age 59 ½. The IRS also sought the 20 percent accuracy-related penalty, but the court declined to impose that because the court found that Dabney acted with reasonable cause and actually believed the IRA land purchase was appropriate.

In March 2009 Dabney proceeded with the purchase of the property by having $114,000 wired from his Schwab IRA directly to the seller of the property and titling the property in the name of “Guy M. Dabney Charles Schwab & Co. Inc Cust. IRA Contributory.” This did not make the property “IRA” property.  In fact, due to a bookkeeping error the property was titled in Mr. Dabney’s own name (however, that error was corrected in 2011).

Dabney’s plan was then to sell the property at a gain and contribute the sales proceeds back into his IRA, but he could not find a buyer until 2011. He then sold the property for $127,226 and had those funds wired into his Schwab IRA in January 2011. He marked the deposit as a rollover contribution and Schwab accepted the IRA deposit.

For his 2009 taxes, Dabney received a 1099-R from Schwab for the $114,000 IRA distribution, also showing an early distribution with no exceptions applying. He did not report the distribution on his 2009 tax return.

End result:The $114,000 IRA distribution was taxable and subject to the 10 percent early withdrawal penalty, but no 20 percent accuracy-related penalty due to reasonable cause.

What went wrong here

This was not a purchase of an asset by Dabney’s IRA, because his custodian did not allow land in their IRAs. This was a taxable distribution, and subject to the 10 percent penalty. Dabney was advised of this but went ahead with the transaction anyway (based on his own online research).

Dabney argued that the IRA purchased the property and that this was not an IRA distribution. But since the custodian would not allow this, his IRA could not have purchased the property. Instead this was a distribution.

The court stated 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.”

The court also pointed out that Dabney could have done a rollover or transfer to another IRA custodian who would allow the IRA to purchase the property (for example, a self-directed IRA), but Dabney did not do that. That was good advice, but it was too late now.

What about the $127,226 rollover into Dabney’s Schwab IRA in January 2011?

The court noted that the contribution of funds back to the IRA in 2011 was not a valid rollover since it occurred nearly two years later, but the court did not address the excess IRA contribution problem Dabney now had. When Dabney rolled the $127,226 sales proceeds into his Schwab IRA, it became an excess contribution subject to an additional 6 percent excess contribution penalty for each year the excess funds remained in the IRA. That’s roughly another $7,000 in penalties each year. To make matters worse, if the 6 percent penalty is not timely reported and paid on Form 5329, the three-year statute of limitations does not start running.

Real estate is a valid investment inside an IRA and there certainly are IRA custodians that allow it (self-directed IRA custodians).  However, many, if not most, custodians don’t allow real estate as an IRA investment.

Lessons Learned

Before investing IRA funds in an alternative investment, check to see that the IRA custodian is willing and able to accept it. If not, find a custodian who will.

Make sure all IRA assets are purchased by and held inside an IRA. Simply titling an asset in the name of an IRA does not mean the asset is actually held by the IRA. That’s what happened in this case and an intended IRA investment became a taxable distribution.