Roth Conversion Valuation for a worthless asset?
We invested in a Real Estate LLC under a self-directed IRA. The LLC managers embezzled the funds, encumbered the property and embezzled those funds, and resigned with the LLC in suspension and tax default. The District Attorney has refused to prosecute stating “the jury pool in xxx county is not sophisticated enough to prosecute white color crime”. The property was liquidated at a 96% loss and the residual has long since been consumed in legal fees.
The LLC is in litigation to try and recover investments. At his point, the LLC has a net negative valuation with the litigation costs fronted by two of the members. After two years and extra attorney fees, the IRA custodian has finally reduced the valuation to $0.
While the LLC has no value, the litigation requires it remains active as a protective claim. If the litigation is successful, the LLC may have a future value, if not it will default.
I am in the process of converting many of our IRA investments to Roth IRAs while this option is still possible. The custodian of the IRA states that an asset with a $0 valuation cannot be converted and states that it can only be converted once there is an award and all proceeds from the award would be fully taxable. This ignores the current value of the asset at the time the conversion is requested.
I cannot find any discussion on the conversion from a traditional IRA tto a Roth IRA that addresses an asset that is worthless but must be retained due to litigation. Forcing the deferral of the conversion would have significant tax consequences including the potential changes in congress to disallow ‘backdoor’ conversions.
Permalink Submitted by Alan - IRA critic on Fri, 2022-04-08 16:01
There was no proposed legislation to hinder Roth conversions of pre tax dollars. IRA basis could no longer be converted. Rather, the question is here is why the custodian is not willing to process the conversion of a worthless security. I am not aware of any tax code restriction for such a conversion, and a conversion is taxed in the same manner as a distribution to the IRA owner. So if a worthless security is distributed in kind, there would be no tax due, and likely no need for a 1099R. I would push back for a more detailed explanation from the custodian why they feel this security cannot be converted at the 0 value. Perhaps the restriction is affected by the legal situation for this holding rather than the 0 value.
Permalink Submitted by Dan Zaehring on Fri, 2022-04-08 17:32
One issue that needs exploring is the definition of worthless. Although the book value has disappeared, there apparently is perceived value if other members are willing to foot the bill for litigation and the client wants to do a conversion in the first place. The custodian does have an obligation to report “fair market value” to the IRS and without a professional appraiser they may be reluctant to do so. The IRS has rules for when a security can be declared “worhtless” and this may not meet those rules.