For many individuals, most of their wealth is in their individual retirement account (“IRA”) and the IRA can provide a great source of cash for investments such as real estate. However, the IRA owner has to beware of Section 408(e)(2) and Section 4975 of the Internal Revenue Code (the “Code”), in which the Internal Revenue Service (“IRS”) provides prohibitions against self dealing and other prohibited transactions between the IRA owner and the IRA. If there is a prohibited transaction between a disqualified person and the IRA, then the penalties can be steep, can cause the IRA to lose its tax deferral status and can cause income to be reported immediately. Further, in many states and in bankruptcy, the IRA is an exempt asset, protected from creditors. However, if the IRA engages in prohibited transactions, then the IRA will also lose this favorable exempt status.
In the recent case of Kellerman v. Rice, an IRA was determined to NOT be an exempt IRA in a bankruptcy proceeding because of the IRA owner’s dealings with the IRA. The Kellerman facts are as follows:
1. Barry Kellerman created a self directed IRA prior to filing for bankruptcy.
2. Kellerman and his wife each owned 50% of Panther Mountain.
3. The IRA and Panther entered into a partnership agreement in 2007.
4. The partnership agreement provided that the IRA would contribute real property and cash to the partnership
5. Kellerman instructed the trustee of the IRA to purchase the real estate and liquidate assets to contribute to the partnership.
6. The warranty deed for the real estate conveyed the the real estate to the IRA and Panther Mountain, with each owning 50%.
7. Subsequent to the purchase of property the IRA paid various business expenses to develop the property.
8. When Kellerman files for bankruptcy he states that the IRA is an exempt asset (and thus protected from creditors) under applicable federal bankruptcy law.
9. The bankruptcy trustee objected to the exemption of the IRA because the IRA lost its exempt status prior to bankruptcy because Kellerman engaged in prohibited transactions with a disqualified person.
The court determined that the IRA engaged in prohibited transactions in that
1. Panther Mountain used the IRA as a lending source for the purchase of the property in violation of Section 4975(c)(1)(B) of the Code.
2. Kellerman transferred or used the IRA’s assets for the benefit of disqualified persons and as a fiduciary dealt with the IRA’s assets for his own interest in violation of subsections 4975 (c)(1)(D)(E) of the Code .
The district court agreed with the bankruptcy court and denied the exempt status of the IRA in the bankruptcy proceeding.
ADVICE: Anytime you are dealing with investments in an IRA get competent advice. This is a disastrous area if you are engaging in prohibited transactions. You may create a large tax and penalty liability and a loss of creditor protection.
New Word of the Week: Negligence is a failure to exercise a duty of care that a normally prudent person would have exercised under the same circumstances. For example, if you are driving and see a stop sign, a normally prudent person would stop before entering the street. A negligent person would run the stop sign and may cause an accident.
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