The Internal Revenue Code does not describe what a Self Directed IRA can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain type of transactions. The purpose of these rules is to encourage the use of IRAs for accumulation of retirement savings and to prohibit those in control of IRAs from taking advantage of the tax benefits for their personal account.
The foundation of the prohibited transaction rules are based on the premise that investments involving IRA and related parties are handled in a way that benefits the retirement account and not the IRA owner. The rules prohibit transactions between the IRA and certain individuals known as “disqualified persons”. The outline for these rules can be found in Internal Revenue Code Section 4975.
In 2008 Mr. Dabney rolled over funds from an individual retirement account (IRA) at Northwest Mutual into a preexisting self-directed IRA he had with Charles Schwab & Co., Inc. (Charles Schwab). Sometime thereafter he learned of a piece of undeveloped land in Brian Head, Utah (Brian Head property), that was for sale, and which he believed was priced below its fair market value.
Mr. Dabney conducted some Internet research and came to the conclusion that IRAs are permitted to hold real property for investment. He then set out to have his Charles Schwab IRA purchase the Brian Head property. Mr. Dabney also contacted is CPA. The Schwab customer service line told Mr. Dabney that he would not be able to make the real estate investment with his IRA at Charles Schwab as they did not permit such investments with IRA funds. On the basis of his telephone conversations with the Charles Schwab customer service representative and his CPA, as well as his own research, Mr. Dabney arranged what he believed to be a viable way to have his Charles Schwab IRA purchase the Brian Head property, even though Charles Schwab did not allow alternative investments. 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.
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’s CPA prepared his 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. Mr. Dabney did not report the withdrawal on their Form 1040.
The Court confirmed that an IRA is allowed to hold real estate, but that the IRC does not require 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, such as real estate. The Court further held that the withdrawal of the IRA funds from Schwab was not considered a tax-free direct rollover.
What Can We Lean From The Case?
The Dabney case is a perfect example of why you want to use a special self-directed IRA custodian, such as IRA Financial Trust Company, when making alternative asset investments with an IRA. The traditional financial institutions and banks (IRA custodians), such as Charles Schwab, Vanguard, Fidelity, Bank of America, etc., don’t make money when you invest your IRA funds in alternative asset investments, such as real estate, and as a result, will not permit you to do so. The Court was clear in stating that an IRA custodian is not required to provide its IRA clients with the ability to invest in all IRS permitted investment options, which is the main reason why there are custodians, such as IRA Financial Trust Company that exist in the marketplace. The case is a good example of what could happen if one attempts to make a self-directed IRA investment without using a self-directed IRA custodian that specifically allows for the intended IRA investment.