Using IRAs to invest in unconventional assets
April brings more than showers. Typically, it brings spring break, Easter, and of course, the end of tax season. Tax season brings about many things for accountants’ long days, unique tax situations and working through shoeboxes and lots of data. This often includes information on retirement accounts owned by taxpayers.
Retirement accounts are often a significant asset for many individuals. In recent years, there has been a trend with using Individual Retirement Accounts (IRAs) to invest in assets not traditionally invested in such accounts. These investments can bring about a number of considerations for the owner of the account. This can include tax and non-tax items.
I first took note of this trend many years ago when I became aware of partnership K-1 reporting forms started showing up in tax return information. The partnership investment is often held by the IRA and not directly by the IRA owner. Ownership of such an investment in an IRA account implicates a number of tax considerations, including unrelated business income tax considerations and the possibility of filing a tax return for the IRA for the income activity of that investment.
The trend has expanded in recent years to other types of investments. In December 2016, the General Accounting Office (GAO) issued a report — titled “Improved Guidance Could Help Account Owners Understand the Risks of Investing in Unconventional Assets” — detailing a number of observations about IRA accounts and the holding of certain assets, which can be found on the GAO website.
The 51-page report covers a number of areas. It focuses on the investment in unconventional assets. These types of investment choices have grown in recent years and are similar to what some of the large pension plans invest in for a portion of some of their respective investment portfolios. The investment examples cited in the GAO report includes mention of such assets classes as: energy investments, equipment leasing, foreign-based assets (including currency and foreign property), farming interests, precious metals, private equity, secured and unsecured promissory notes, real estate, tax liens and virtual currency.
IRA custodians are required to submit annually a Form 5498 to the Internal Revenue Service. The annual reporting to the IRS includes contribution information as well as information regarding the fair market value of assets in the IRAs. Starting in 2015, the IRS required reporting by custodians of specific information with respect to some of the assets in the IRA. The reporting includes reposting of the aggregate value of investments falling into certain categories for unconventional assets. The Form 5498 reporting is in addition to any Form 1099-R reporting for distributions from an IRA to the account owner.
Retirement plans, including IRAs, also are subject to other rules and regulations, IRA owners and custodians also need to consider specific rules with respect to self-dealing and prohibited transactions. IRAs involved with such transactions can face significant penalties.
IRA accounts may also face an income tax liability on income generated from investments held in the account. This may seem odd, as an IRA typically is a tax-deferred investment vehicle that generally is not taxable on its investment income. However, certain investment income can be taxed if earned by the IRA. This can often happen with unconventional asset holdings. The two classes of income that give rise to taxation are called unrelated business income and unrelated debt financed income. Understanding what types of income an IRA investment may generate will help mitigate the risk of having the IRA being subject to federal income tax on either unrelated business taxable income or unrelated debt financed income. Generally, a Form 990-T is the income tax return used to report such income and to compute any tax liability on such income. State income tax reporting may also be required.
The IRS recently has begun to accumulate information on unconventional assets within IRAs as a result of the requirement of reporting unconventional asset information on Form 5498 for 2015 and years after. The GAO report indicates that nearly 500,000 IRA accounts reported investments in unconventional assets for the 2015 reporting year. As more investment offerings and opportunities arise, this number may increase in future years. This trend also may grow as more individuals retire and roll their 401(k) balances into IRA accounts.
Investment in unconventional assets can present some interesting issues to IRA owners. Once an account holder reaches the age of 70 and a half, required minimum distribution rules apply to account owners and the distribution amount is based on the fair market value of the assets held in the account. Holdings by an IRA in non-public unconventional assets present issues with respect to how to determine the fair market value of account assets used to determine the actual required minimum distribution amount. Determining fair market values for untraded and illiquid investments may prove difficult and burdensome (and potentially expensive) for IRA owners and custodians.
William Roth is a tax partner with the local office of international accounting firm BDO USA LLP.