“Trust but verify” takes on new meaning when dealing with self-directed retirement accounts.
Recently, I have started to notice a disturbing pattern: Service providers are destroying their clients’ individual retirement accounts (IRAs). Since nothing speaks so loudly as an example, I shall provide two that I have seen in the last year. I have edited the facts for the sake of privacy.
Example #1: ”Lazy Title Company”
In this example, a father and his four adult children each owned an IRA. Each IRA contained an average of more than $1 million in assets. “Dad” and the children were very savvy as far as IRAs go. They had first-class education and paid attention to details. They looked to enter into an out-of-state property purchase as Tenants in Common with each IRA owning a percentage of the property. Each IRA would own a percentage in the property commensurate with its dollar contribution. Such transactions are common, and if properly structured, legitimate.
Now, however, enter “Lazy Title Company.” True to its name, the company was too lazy to perform a legal transaction in the manner in which its clients requested. It did not fit their template, and they did not want to take the effort to adjust their model. At the last possible minute, they told the family to restructure the transaction as a loan from the childrens’ IRAs to their father’s IRA, which is a blatant prohibited transaction, meaning that the IRS considers it a violation of the regulations governing individual retirement accounts and will “punish” such transactions by assessing heavy taxes, fees, and penalties.
Much to their later regret, the family went along with the change. Under pressure from the title company, they opted to “pull the trigger” on the new transaction. A few years later when the IRS audited the IRAs, they caught the transaction and distributed the contents of the IRAs, meaning that they removed all tax benefits from the accounts and taxed them retroactively. About half of the balance in each account went to the government in the form of taxes. The case was black and white; they had undeniably committed a prohibited transaction. There was no point in fighting it in Tax Court. Due to “Lazy Title Company’s” laziness, a last minute rush, a desire to close the deal, and a moment of inattention by some normally very sharp people, millions of dollars were lost.
The Lesson: The vendor does not drive the deal. You do. Always remember that “no deal” beats “a deal that destroys your IRA” any day.
Example #2: ”The Dishonest Loan Broker”
In this example, an IRA owner is once again the unwitting victim of a prohibited transaction, this time created by a loan broker we’ll call simply, “Dishonest Loan Broker.” An IRA owner was set to close on a property. The deal had been vetted by a tax attorney. It was not simple, but involved a complicated ownership structure, the use of 1031 exchange proceeds, and leverage within the IRA. The debt was non-recourse as to the taxpayer and the IRA.
As a side note: I always prefer to see single IRAs do deals if at all possible since even correctly structured multi-account or multi-entity deals create complexity and associated risk.
At the absolute last minute, Dishonest Loan Broker, who had assured everyone he could come up with a non-recourse loan, stated that the taxpayer would have to guarantee the loan. This revelation came at the closing table: “Sign here now or lose the deal, no pressure.” The taxpayer had minutes to decide whether to lose the deal and forfeit a substantial deposit or to close on the property. The broker clearly wanted the sale and was willing to promise things he could not deliver to get the commission. The taxpayer signed the loan docs and closed the deal. The problem? His signing personally for the loan may be viewed in a future audit as an “extension of credit” from him to the IRA, and it could distribute (and destroy) his IRA.
That well-researched (albeit complicated) deal became a possible prohibited transaction because the loan broker did not do what he was supposed to do and did not admit his failure until the last possible moment. The taxpayer was not in control of the deal.
The Lesson: The vendor does not drive the deal. You do. Stay on top of all the players. Push for information and results, stay in control. Trust but verify.
You must remain alert in the management of your retirement account or you risk losing control of your money and even suffering crippling blows to your investing portfolio and even the account itself