Upside down Real Estate held in a Retirement Plan
An individual holds Real Estate in his self-directed retirement plan with an independent Custodian. The property was purchased with a mortgage secured by the Plan. Property is now worth less than the debt and there are the other assets in the plan are limited. Plan owner now wants to refinance the loan, but would have to deposit funds to pay down the loan amount. Since this would mean contributing funds in excess of his annual contribution, this is not an option. Custodian believes that the real estate can be distributed to the plan owner and that this distribution would not be taxable since the debt is in excess of the value of the property and the owner would also assume the debt once the property was distributed to him. Custodian feel strongly that this is the Plan owner’s best option since the plan owner has other real estate in his own name (not in the plan name) that he can use to help refinance the distributed property.
Plan owner’s CPA is not certain that this is a wise course of action, but does not want to disagree with the Retirement Plan Custodian, as this is his area of expertise.
Anyone want to weigh in on this?
Permalink Submitted by Alan Spross on Tue, 2011-10-25 17:26
Sounds like the distribution value of the IRA would be -0-. But the IRA custodian should be consulted to verify that -0- is the amount that will be reported on the 1099R. Is IRA owner using a recognized self directed IRA custodian such as Pensco or Guidant? If so, these custodians are familiar with these issues, although it is rare that a non recourse loan used for IRA property would exceed much more than half of the FMV at the time of the loan? Has this property lost half it’s value?
Is this an IRA or another type of plan?
Similarly, if a prohibited transaction has occurred that would result in automatic distribution of the plan, the FMV should still be -0-.
Permalink Submitted by mk foss on Thu, 2011-10-27 22:38
I was afraid to tackle this question. If someone were to give away a property with debt in excess of basis, it would be a taxable transaction. It would be a part gift/part sale or the income would be from cancellation of indebtedness. Since the Unrelated Business Income Tax applies to debt financed property, I wasn’t certain whether this transaction would incur some tax or not.
A distribution is obviously the only way to make the problem go away. The fair market value at distribution as reported on the 1099R would be the basis for the recipient so there would be no depreciation on the property going forward.
Permalink Submitted by Patricia Pick on Mon, 2012-03-05 22:17
Thought this question had been resolved, but as it turns out, the Retirement Plan owner is still struggling with the solution to his problem. I appreciate the attempts to assist with this, and thought I should provide more detail.
The property in question is held in a Defined Benefit Plan. The two plan participants are husband and wife. Both are in their 70s. The property in question was originally purchased for $1.7 million and is now worth about $1 million. The mortgage on the property is held by the plan and totals $1.4 million. There are two additional pieces of real estate (undeveloped land) in the plan that are worth less than the original purchase price. There is no debt on these parcels. In addidion, there is $500,000 in liquid assets in the DB Plan.
The Custodian of the Plan is not Pensco or Guidant, but a local company that claims to specialize in this sort of self-directed Retirement Plan owning real estate. He claims that a distribution of the property from the DB Plan to the participants (husband and wife) would not result in a taxable distribution because the debt ($1.4 million) exceeds the current market value ($1 million) of the property.
This just doesn’t seem right to the Pension owner’s CPA – does it sound correct to the experts out there? Also, would you advise the pension owner to hire someone else to make sure he is getting good advice? If so, would you recommend he seek the advice of another Custodian (Pensco or Guidant) or an attorney of some sort?
Permalink Submitted by Jose Morales on Tue, 2012-03-06 16:59
Personally, I wouldn’t even attempt to enter the world of “Self-Directed” retirement investments without the following:
– ERISA Lawyer
– a lawyer that specializes in the type of investment to be held
– a CPA that specializes in or has proven to be extremely knowledgable of retirement plans
– a well grounded and helpful Custodian/Administrator that specializes in “Self Directed” retirement investments with many years of experience
To date, I have not seen one person that ventured into these types of investments that was truly willing to prepare themselves properly for the task. Every single one has felt strongly that their Custodian/Administrator would answer any question that arose and provide the due diligence necessary for non-traditional investments. I find the behavior of the “Self Directed” retirement “facilitators” (which I will not name) to be the most disturbing. They seem to only want to paint a picture of instant riches with minimal work on the part of the individual.
Permalink Submitted by Bruce Steiner on Tue, 2012-03-06 17:13
The lawyer should look at the prohibited transaction rules in Section 4975.
Permalink Submitted by mk foss on Tue, 2012-03-06 22:19
If the property were to be distributed – it would not be a prohbited transaction. The distriubted property would need to be appraised – if the appraisal took into account the debt in excess of the value, it may have no value for distribution purposes. That may be what you’re hearing as to no tax consequences. However, the retirement plan has debt forgiveness income – which would likely be UBI and tax would be owed on that. Retirement plans pay taxes using trust rates – which are the highest rates around.
So I think the custodian is correct about the taxability of the distribution but that’s only half of the story. Forms 990-T for retirement plans are normally prepared by the custodian. It would be a prohibited transaction for the plan participants to pay the UBIT. Have they considered the tax liability of the plan?
Permalink Submitted by Patricia Pick on Tue, 2012-03-06 23:04
Thank you to everyone for their responses, and I couldn’t agree more with “urusei2.” There are supposed “experts” out there who have no business providing advice. This is a situation that came to my attention long after the problem existed. The Plan owner has been advised to seek a second opinion from another, more experienced IRA custodian and an ERISA attorney to be certain that he understands the potential consequences of what he has been advised by his present Retirement Trust Administrator.
Thanks again for all the comments. Glad to know that there are so many people out there that understand the potential pitfalls of this complicated situation!
Permalink Submitted by Alan Spross on Tue, 2012-03-06 23:20
THe IRA custodian should be asked what amount will be entered in Box 1 of the 1099R (FMV of the property distributed). With the posted example:
1) Property value 1,000,000
2) Outstanding non recourse loan 1,400,000
I suspect that Box 1 will still be 1,000,000, not -0-.
If you take a 401k loan, the loan is considered a taxable distribution if it is not paid back regardless of gains or losses in the underlying assets. While non recourse loans were typically limited to around 60% of the FMV of the property, the real estate meltdown proved those requirements to be too liberal.
If correct, the client should not distribute the unencumbered properties along with the encumbered property since that will just inflate the Box 1 figure. The proceeds from selling the other properties after distribution may barely cover the tax bill for the total distribution values.
I would verify all these presumptions with one of the large Self directed custodians because they probably deal with a few underwater properties in their IRA accounts and have probably issued 1099R forms reporting in kind distributions of property.