The Self-Directed IRA is a useful tool for retirement savings. Like any good tool, it works best when you know how to work it. From time to time the investments our account-holders make go bad. It happens. Risk is always a part of investing. When this happens what should you do?
It’s not just a matter of sending an e-mail to your custodian saying the asset in your Self-Directed IRA has no value. The IRS is going to want proof that it’s valueless. Your Self-Directed IRA custodian cannot determine the value of your assets. You need a third-party valuator’s professional report.
We had an account holder (we’ll call him Fred) with such an asset. His IRA made a Note and the borrower did not repay the debt. After quite some time (and after receiving no account fees from him) we advised Fred we would distribute the asset to him at the last known value and close his account. Imagine that: Being taxed for the full value of an asset when that asset is actually worthless! Truth is, he wanted the account closed so this seemed to solve a problem for him, but the problem was not solved.
The rules are clear: assets must have a fair market valuation when taxable events occur. To get this kind of valuation you need to seek the help of a valuator. If the asset is real estate then often an appraisal will do. In lieu of this kind of third-party authenticated value all we can reasonably do is use the last known value. Keep in mind that the valuator needs to be “independent”. Using your personal CPA for the valuation is usually not considered to be independent enough. Additionally the report itself must have supporting documentation and computations attached to the report.
Fred did not want to have his IRA pay a valuator to have the situation properly handled. He put himself in a very bad position by not spending the money. The IRS will likely send him a nasty letter telling him that he owes taxes (because assets were distributed and 1099’d at the last known value).
Next Fred calls the IRS and they tell him to have the custodian correct the 1099. We won’t correct the 1099 because no valuation was received (and in this case no fees either). The IRS is not likely to take his word for what the value currently is. In fact they likely will not care because of crossing tax years. They will tell our account-holder to prove the Note was worthless back at the time it was distributed. That usually requires foreclosure/court documents or a valuation.
So, Fred gets caught in this endless loop.
Bottom line is that the possibility of needing a formal valuation of your assets should be factored in as the cost of doing business with a self-directed IRA. In fact, we include this information on the account agreement.
In the end Fred wished he had spent the money for valuation up-front instead of after his asset was disbursed and he was facing a taxable event. After some time he understood a valuation was required and why it was required. Fred said, “Thanks so much Kaaren that was quite helpful. If there’s any way you could resend the name of the company you use for proving a zero value I’ll get on this on get everything wrapped up. I’m so sorry for the trouble and the delay.”
Valuations aren’t just for worthless assets. Each year all Self-Directed IRA account-holders are required to provide a value for their assets to the custodian holding their account. Keeping these valuations up-to-date annually is important because we use that information when we report your account value to the IRS each year (on a Form 5498).
Any time there is a taxable event in your IRA such as a Roth conversion or a withdrawal the IRS is going to want proof of the asset value as well. A good valuator is a self-directed IRA’s best friend. We at uDirect IRA Services can certainly help you find one.