© 2012 Ed Slott, CPA October 2012

ED SLOTT’SIRA ADVISOR

Tax & Estate Planning For Your Retirement Savings

To Order Call: (800) 663-1340 ED SLOTT’S IRA ADVISOR • OcTObER 2012 1

WHAT’S INSIDE?

Deadline to Recharacterize 2011 Roth Conversions is Near - October 15, 2012 • What'sDifferentAbout2011RothRecharacterizations?

• Recharacterization and Reconversion

• LateRecharacterizations• TheRightWaytoRecharacterize

- Pages 1-3October 31st Trust Deadline for Inherited IRAs

- Pages 3-4Early Distribution due to Hurricane Ike is Not an Exception to the 10% Penalty• Carter v. Commissioner• FactsoftheCase• TheCourt'sDecision• QualifiedHurricaneDistributions• QualifiedDisasterRecovery

AssistanceDistributions• IRSCanPostponeDeadlinesfor

DisasterAreas• StoppingaBadSituationfrom

GettingWorse

- Pages 4-5Guest IRA ExpertCurtis L. DeYoungAmerican Pension Services, Inc.®Riverton, UT

Making the Most (And Avoiding the Worst) of Self-Directed IRAs

- Pages 5-7

October15,2012marksthelastdayon which clients with 2011 Roth IRAconversions can reverse the conversionandgetbackany taxespaidasaresult.ThemoreformalnameforthistransactionisaRothrecharacterization,butformostclients, it’s simply the way they werepromisedthattheycouldundotheirRothIRA conversion, and the resulting taxconsequences.

TheRothrecharacterizationdeadlineisnothingnew,butlikeamodernremakeof a classic film, this latest versionhas the same overall message, with aslightly different twist. Helping clientsand prospects to understand the subtlewrinkles that make this year’s Rothrecharacterization deadline unique canhelp advisors solidify themselves asexperts who maintain a solid handleon the ever-changing economy, stockmarketandtaxlaws.

What’s Different About 2011 Roth Recharacterizations?

Sowhat’sdifferentaboutthisyear’srecharacterization deadline? Well,one big factor in determining whether

or not clients should keep their Rothconversions intact or recharacterize isthe performance of their investmentswithin the Roth IRA after conversion.IfthevalueoftheRothIRAconversionhasdeclinedsubstantially,itoftenmakessense to recharacterize the conversionto recoup the tax paid on value thatno longer exists, perhaps with an eyeon reconverting in the future. Partialrecharacterizationscanalsobedone.

Thisyear,forthefirsttimesincethefloodgates opened onRoth conversionsin 2010 (when the Roth conversionrestrictionswerepermanentlyrepealed),the majority of Roth IRAs beingevaluated for recharacterization shouldbeupinvalue.

Since the start of 2011 throughthe first two-thirds of 2012 (the endof August), the S&P 500 index is uproughly 12%. In contrast the S&P 500was down roughly 6.5% from January2010 through the end of August 2011(andwas still down about 2.5%on theOctober 15, 2011 recharacterizationdeadline for2010conversions).For themost part, the market has cooperated

Deadline to Recharacterize 2011 Roth Conversions is Near - October 15, 2012

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2 ED SLOTT’S IRA ADVISOR • OcTObER 2012 To Order Call: (800) 663-1340

since2011,sofewerrecharacterizationswillbemadeasa resultof lostvalue.That’sgoodnewsforclientswhoseethepotentiallong-termbenefitsoftheRothIRAandgoodnewsforadvisors,whomaybeabletocut-downonpaperworkasopposedtothistimeayearago.

Anotherpotentiallyuniqueaspectofthisyear’sRothrecharacterization deadline is that the favorable “low”federalincometaxratesclientshaveenjoyedfor10yearsmaysoonbecomingtoanend.Asitstandsnow,incometaxratesaresettoincreasein2013,withthetoprategoingfromthecurrent35%upto39.6%.Addinthe3.8%surtaxon net investment income also slated to kick in at thestartof2013andhigh-incomeclientscouldpayasmuchas43.4% in federal income taxon their net investmentincome.

Recharacterization and Reconversion

Arecharacterizationcouldmakesenseforclientsforanynumberofreasons,but theyshouldstillbemindfulsuchatransactionmightultimatelyleadtoagreatertaxburdeninthefuture.

Key Point: If a recharacterization of a 2011 Rothconversionmakes sense now, but the Roth IRA is stilldesired long-term, clients can still lock in the currentlow tax rates. Any 2011 Roth conversionrecharacterized by the October 15, 2012deadlinecan laterbe reconvertedback toaRothIRAin2012,guaranteeingthatthetaxontheconversionwillresultinnomorethana35%federalincometaxhit.

Don’t reconvert right away though! A2011 conversion recharacterized in 2012can only be reconverted back to a RothIRA after 30 days have passed since therecharacterization.

There’snoneedtowaituntilthelastminutetoactifthisstrategymakessensebut technically,as longasthefundsaredistributedfromthetraditionalIRAin2012,itwillbeconsidereda2012conversion,evenif thefundsdon’tgetintotheRothIRAuntil2013.Theusual60-daywindowappliesforrolloversfromanIRAtoaRothIRA.

Youmightbe thinking toyourself, “What’s thebigdeal?Congressmightextendthecurrentincometaxrateslaterthisyear.”That’strueanditmayverywellhappen,but the opposite is also true.Congressmay bicker andargue so much that nothing gets done at all, in whichcasehigher ratesareon theway.Sowhynot reconverttoaRothIRAthisyearandbesafe?Afterall,what’stheworstthathappens,right?Theworstcasescenarioisthatyoudecidetorecharacterizeagainnextyear.

While there are a variety of reasons for clients toconsider forgoing a recharacterization, there are also

a number of reasons a recharacterization might makeperfectly good sense. Maybe they had an unexpectedyearofhigh-incomein2011pushingthemintoahigher-than-expected tax bracket. Maybe they ran into somehardtimesandcouldnotcomeupwiththemoneytopaythetaxontheconversion.Or…gasp…perhapstheyhadRothinvestmentsthatwentdowninanupmarket.

Another reason some people may want torecharacterizeisbecausetheymayhaveforgottenaboutthe2010Rothconversiontheydid.Iftheytookthe2-yeardeal,asmostdid,their2011taxreturnmayincludemoreincome than they countedon andnow they cannot paythetaxonboththefirsthalfofthe2010conversionandthe2011conversiontheydid.Theycannotundothe2010conversion. Even though that income now appears ontheir2011taxreturn,thedeadlinetorecharacterizea2010conversionwasOctober 15, 2011. The 2011 convertedfundsthoughcanstillberecharacterized.

Recharacterizations May Produce Tax Refunds Whateverthereasoning,ifyourclientrecharacterizesthey should be sure to get any tax paid as a result ofthe conversion back. Contrary to some clients’ beliefs,they are actually responsible for notifying IRS of therecharacterization.Thisisgenerallynotadifficultprocessand,inmostcases,takeslittlemorethananoteattached

totheappropriatetaxreturn.

Ifyourclienthasalreadyfiledtheir2011tax return, they should contact their taxprofessionalandhavethemfileanamendedreturn.Uponfilinganamendedreturn,yourclientwill receive a refundof anyoveragepaid, plus interest. That’s not a bad dealwhenyourealizetheapplicableinterestratethrough thefirst threequartersof2012hasbeen an annualized 3%.That’s even better

thanmost5-yearCDratesthesedays!

While the Roth recharacterization deadline for2011 Roth conversions is October 15, 2012, taxpayersgenerally have three years from the date they initiallyfiledtheirreturnortwoyearsfromthetimetheypaidthetaxowed–whicheverislonger-tofileanamendedtaxreturn.Therefore,taxpayerswhofiledbytheoriginalduedatetypicallyhaveuntilApril17,2015tofileanamended2011taxreturn,whilethosewhofiledtheirreturnsafterfirst filing an extension could have longer. But let’sthinkaboutthisforasecond…ifyourclientisfilinganamended return to receive a tax refund as a result of aRoth recharacterization,don’tyou think they’llwant tofilethatreturnsoonerratherthanlater.Don’tforgettofileanamendedstatetaxreturntooforanyrefundsapplicablethere.

If,forwhateverreason,yourclienthadnotyetfileda return, they must simply file their normal return bytheOctober15,2012deadline.Theymustattachanote

If a recharacterization

of a 2011 Roth conversion makes sense, clients can

still lock in the current low tax rates.

To Order Call: (800) 663-1340 ED SLOTT’S IRA ADVISOR • OcTObER 2012 3

detailing the date and amount converted and the dateand amount recharacterized. In all likelihood, if properguidancewas given, even though these clients had notfiledareturn,theyhadmadeapaymentbyApril17,2012largeenoughtocovermostorallofthetaxowedontheir2011returninordertoavoidanyunderpaymentpenaltiesand/orinterest.Filingtheactualreturnnowshowingtheproperless-than-previously-expectedincomewillentitletheclienttoarefundofanyoverage.

Late Recharacterizations

The October 15, 2012 deadline to recharacterize a2011conversion is afirmdeadline,butnot anabsoluteone. Under the law, IRS has the authority to grant anextension to recharacterize when there are extenuatingcircumstances, such as advisor error. Getting such anexceptionisneithereasynorcheap.

IRS has been taking a tougher stance on grantingextensions now that conversions no longer have tobe recharacterized (since there are no conversionrestrictions)andtheIRSfeealoneforsucharulingruns$4,000–a“bargain”ratewhenyouconsiderthetypicalIRA ruling runs $10,000. And remember, the IRS feedoes not include professional fees, which could easilydouble the cost. Therefore, advisors and clients shoulddo whatever necessary to make sure anyrecharacterizationsof2011Rothconversionsarecompletedfarenoughbeforethedeadlinetodealwithanyunforeseendelays.

The Right Way to Recharacterize

Itshouldalsobenotedthatwhilesomeof the discussions surrounding theOctober15,2012deadlinewillbeuniquetotheissuesofthemoment,muchofthebasicsregardingrecharacterizationsremainunchanged.Assuch,advisorsandtheirclientsshouldmakesuretofollowthegeneralRoth recharacterization rules, such as making sure therecharacterizationiscompletedbythedeadline,thatthefundsgobacktoanIRA(orinheritedIRA)onlyandnevertoaplan,andthatthefundsaremovedfromtheRothIRAtotheIRAinatrustee-to-trusteetransfer.

If the recharacterization is not done correctly,clientscanendupowing income taxandhavenoRothIRA–orIRAfor thatmatter.Forexample, if thefundsarewithdrawn from theRoth IRA and "rolled over" toa traditional IRA instead of being directly transferredbacktoatraditionalIRAbythecustodian(s), it isnotavalidrecharacterization.Thetaxontheinitialconversionmust still bepaid, even though the fundsareno longerRothIRAfunds.Tomakemattersworse,dependingonthe situation, clients could get hit with the 6% excesscontribution penalty and/or the 10% early distributionpenalty. Be sure to recharacterize correctly and avoidthesecostlyerrors.

A see-through trust allows the trust to stretch

distributions over the age of the

oldest applicable trust beneficiary.

TheOctober15thdeadlineforRothrecharacterizationsmaygetmostof theheadlines, but there’s another IRAdeadlineinOctoberthat,forsomeclients, isevenmoreimportant. October 31, 2012 is the documentationdeadlinefortrustbeneficiaries,ofIRAownerswhodiedin2011,toqualifyassee-throughtrusts.

AnytrustcanbenamedasthebeneficiaryofanIRA,butwhatmakesasee-through(a.k.a.look-through)trustsodesirableisthatitallowsthetrusttostretchdistributionsfromaninheritedIRAovertheageoftheoldestapplicabletrust beneficiary. In comparison, non see-through trustsare treated as non-designated beneficiaries and mustwithdraw inherited IRAfunds in justfiveyearsoroverthe owner’s remaining life expectancy, had they lived,dependingonwhetherdeathoccurredbeforeoraftertheowner’s requiredbeginningdate (RBD).Preserving thestretch over the oldest trust beneficiary’s life typicallyresultsinsmallerinheritedIRAdistributions,keepingthetaxbitelowerandmaximizingtax-deferredgrowth.

There are, obviously, some rules that need to befollowed in order for trusts to be qualifiedsee-through trusts. In fact, the IRSRegulations outline four such rules.UndertheRegulations[Section1.401(a)(9)-4,A-5(b)],asee-throughtrust isonethat isvalidunderstatelaw,hasidentifiablebeneficiariesandis irrevocableatdeath.Thefourthruleisarecordkeepingrequirementthatsimplystates a copy of the trust (or, a list of thetrustbeneficiaries,includingcontingentandremainder beneficiaries and the conditions

ontheirentitlement)mustbeprovidedtoanIRAcustodian(or plan administrator) by October 31st of the yearfollowing the year of an IRAowner’s death.Generallyit’sbesttoprovideacompletecopyofthetrusttomakesurealltherequiredtrustdocumentationisprovided.

This fourth requirement really could not get mucheasier,andyet,all toooftenfailure tocomplywith thisrequirement is theonlyreasona trustfails toqualifyasasee-throughtrust.Why?Well,foronething,everyonethinks it’s someone else’s responsibility. The financialadvisor thinks the CPA is following up on it, the CPAthinks the lawyer is taking care of everything and thelawyer thinks the financial advisor is handling it sincethetrusthastobegiventotheIRAcustodian.Theironyof the situation is that technically, it’s none of theirresponsibilities.

Truth be told, it’s the trustee of the trust’sresponsibilitytodothis.However,thattrusteeisusuallya familymember, like the surviving spouse or a child,

October 31st Trust Deadline for Inherited IRAs

4 ED SLOTT’S IRA ADVISOR • OcTObER 2012 To Order Call: (800) 663-1340

Carter v. Commissioner T.c. Summ. Op. 2012-33, April 17, 2012

As Hurricane Isaac recently reminded us, MotherNaturecanbeacruelanduncompassionatefoe.Inwhatseems like theblinkof aneye,homesand livescanbeirrevocablyalteredordestroyed.There’snoquestionthatsome hurricanes areworse than others and causemoredamageonagrandscale,butshouldthelossofanyoneman’shomeasa resultofonehurricanebe treatedanydifferentlythanthelossofanotherman’shomeasaresultofadifferentstorm?Well,thankstoaTaxCourtdecisionearlierthisyear,weknowthatintheeyesoftheIRSandTaxCourt,theanswerisanemphatic“yes.”

Facts of the Case

OnSeptember13,2008,HurricaneIkemadelandfallas a category 2 storm. Hardin County, Texas was inthe hurricane’s path andwas later designated a federaldisaster area.As a federallydeclareddisaster area, IRShadtheauthoritytogivetheresidentsofHardinCountymore time to complete certain acts such as completingIRA rollovers, correcting certain excess contributions,andfilingcertaintaxreturns.

WhenHurricaneIkehit,JeffreyCarterandhiswifelived inHardinCounty.Later thatsameyear, they tooka $20,000 early distribution from Jeffrey’s qualifiedretirementplantorepairpropertydamagedbythestormandtosupplementincomelostbecauseofthestorm.Theyproperlypaidfederalincometaxontheearlydistributionbuttheyclaimedanexceptiontothe10%earlydistributionpenaltyforadistributionmadepursuanttoHurricaneIkeby filing IRS Form 5329.The IRS disagreed, claimingthere was no such exception, and determined that theCartersweresubject to the10%penalty.When the twosidescouldnotagree,theyendedupinCourt.

Early Distribution due to Hurricane Ike is Not an Exception to the 10% Penalty

whoisrelyingontheprofessionalsaroundthemtoguidethemappropriately.Sowhile technically if the requireddocumentation is not provided to the custodian in atimelymanner it’s the trustee’s fault, advisors shouldn'tbesurprisedtofindsomevery,dissatisfiedclientsif thedeadlineismissed.

Anotherquestion that clients andadvisors typicallyaskis“Can’tIjustgivemycustodianacopyofthetrustnow?”There’snoformalguidanceon thisquestionandinformally,positionsseemtohavevariedovertheyears.Butwhythisshouldevenbeaproblemisbeyondme.IfyourclientdiesonDecember31,2012,thatstillleavestenfullmonthstogetacopyofthetrusttotheIRAcustodian(January1,2012–October31,2012).Nodoubtthatmany

advisorshavedemandingschedules,buteventhebusiestofadvisorscansurelyfindfiveminutesatsomepointinthosetenmonthstoforwardonacopyofthetrust.Thisway,therearenoquestionswhatsoever.

Themost prudent of advisorswill send the trust tothe custodian via certifiedmail or through an alternatecarrier thatprovides a trackingnumber.Or evenbetter,confirmationcanberequesteddirectlyfromthecustodianthatsuchdocumentationhasbeenreceivedandisonfile.

Makesureyouidentifyeveryclientwhodiedin2011andnamedatrustastheirIRAbeneficiaryandmakesurethe October 31st trust documentation deadline is notmissed.Thiswouldbeacostlyoversight.

The Court’s Decision

The Tax Court ruled in favor of IRS and againstJeffreyCarter and hiswife, finding that they owed the10%penalty.Carterargued,unsuccessfully,thatbecausethe Government exempted the 10% early distributionpenaltyforHurricanesKatrina,Rita,andWilmaandforthe2007and2008stormsinKansasandtheMidwest,itwasonlyfairthattheybegiventhesameexemption.

AlthoughthecourtsympathizedwiththeCarters,theycouldnotwaivethe10%penalty.HardinCounty,TexaswasnotincludedintheMidwesternDisasterAreafor2008whenJeffreyCartertookhisearlydistribution,despitethefact that theareawasafederallydeclareddisasterarea.SinceCongressdidnot explicitlyextend the taxbreakstoHurricaneIkevictims,theearlydistributionwasnotaqualifieddisasterrecoveryassistancedistribution,sothe10%penaltyapplied.NomatterhowmuchsympathytheTaxCourtmayhavefelt for theCarters, itshandsweretied.Itsimplyhadnoauthoritytowaivethepenalty.

Qualified Hurricane Distributions

While Jeffrey Carter’s situation may have endedunfavorably, over the years other clients in a similarposition,asaresultofanaturaldisaster,havebeenabletotakedistributionsfromtheirretirementaccountswithoutincurringthe10%penalty.Onetypeofreliefcameintheformofaqualified hurricane distribution.

Qualified hurricane distributions were distributionsfromanIRAduringspecificdatesandforthreespecifichurricanes, Katrina, Rita, and Wilma. For example,a qualified hurricane distribution was permitted forHurricaneKatrinathatdevastatedNewOrleansinAugust2005.DistributionstakenbyaffectedtaxpayersbetweenAugust 25, 2005 andDecember 31, 2006were exempt

Guest IRA ExpertCurtis L. DeYoungAmericanPensionServices,Inc.®Riverton,UT

Making the Most (And Avoiding the Worst) of Self-Directed IRAs Forbes has reported that 97% of Americans' IRAmoneyisheldbycustodianswhoallowonlyconventionalinvestments such as stocks, bonds, funds and bankaccounts. That may be true, but the other 3% is heldbycustodianswhoallowIRAownerstoventureoff thebeatenpathinsearchofhigherreturns.

According to theTaxCode, your clients can investIRAmoney in virtually anything,with two exceptions.IRA money can’t be used to buy collectibles or lifeinsurancepolicies.Inaddition,Scorporationrulesprevent

anIRAfromowningstockinScorporations,but other than these three restrictions, IRAowners pretty much have free reign. Thatleaves alternatives beyond securities, bankaccounts and annuities. Increasingly, IRAownersareturningtoso-calledself-directedIRAsforout-of-the-mainstreaminvestments,fromlocalrealestatetostartupsocialmediawebsites’closelyheldstock.

Self-directed IRA investments maygenerateexcitingreturns,especiallyinthese

timesofvolatilestockmarketsandlow-yieldingincomevehicles. However, advisors and clients must proceedcautiously to avoid not only poor investments but alsotaxes,penalties,andpossibleIRAdisqualification.

Ground Rules

Theassetsinaself-directedaccountmustbeheldbyacustodianoratrustee.Clientscan’tsimplybuyacarwashwithfundsdistributedfromanIRAandsay,“That’smyIRAinvestment.”

Moreover, a custodian that agrees to hold self-directed, non-traditional IRA assets typicallywillworkwithanIRAadministrator.Theadministratormayhandlemanytasksforthecustodian;ifanadvisorhasaquestionaboutwhatcanorcan’tbedonewithaself-directedIRA,an experienced IRA administrator probably will be avaluablesourceofinformation.

To Order Call: (800) 663-1340 ED SLOTT’S IRA ADVISOR • OcTObER 2012 5

According to the Tax Code, your clients

can invest IRA money in virtually anything, with two

exceptions.

fromthe10%earlydistributionpenalty,taxedoverathreeyear period, and repaymentswere allowedwithin threeyears. In order to qualify for these special breaks, theindividualmusthavesufferedaneconomiclossasaresultofthehurricane.ThesetaxbreaksappliedtodistributionsfromemployerplansandIRAs.

Qualified Disaster Recovery Assistance Distributions

In2008,Congressexpandeditsrelieftoothernaturaldisasters, such as tornados and flooding. As a resultof significant tornados in Kansas in 2007, the specialtax treatments previously given to qualified hurricanedistributions were extended to the Kansas DisasterArea.SincethenthesetaxbreakswerealsogiventotheMidwestern DisasterArea of 2008. Those distributionswere known as “qualified disaster recovery assistancedistributions.”

IRS Can Postpone Deadlines for Disaster Areas

The IRS can postpone certain tax deadlines forindividualsaffectedbyfederallydeclareddisasterareas.The relief includes more time to complete certain actssuch as rollovers or recharacterizations, correctionof certain excesses, making plan loan payments, andextending tax filing deadlines such as the deadline forfiling individual income tax returns andmakingIRAcontributions.Whenadeadlineispostponed, the IRS issuesanews releaseorotherinformationintheInternalRevenueBulletin and on its website. In fact, IRSrecentlyissuedNewsRelease2012-70whichalertscertainvictimsofHurricaneIsaac(nottobeconfusedwithHurricaneIke)thattheymaybeeligibleforsomerelief.

The authority to extend tax deadlinesdoesnotgrantIRSunlimitedpowerthough.Forinstance,itcannotexemptcertaindistributionsfromthe10%penaltyjustbecauseitfeelslikeit.SuchachangewouldrequireachangeinthelawandcanonlybemadebyCongress.

Stopping a Bad Situation from Getting Worse

Don't assume that clients who suffer an economiclossasaresultofafederallydeclareddisasterareawillautomaticallyqualifyforthespecialtaxbreaksthatapplytoqualifieddisasterrecoveryassistancedistributions.Ifclientsneedadditionalfundstomeetexpenses,advisorsshould try and seek other, more tax-friendly, forms ofcapital. If, however, retirement fundsare theonlyassetthe client has, there’s not much an advisor can do. Insuchcases, theadvisorshouldsimply tryandminimizeanypenaltiesbytakingonlyasmuchasneededfromtheIRAandseeingifoneoftheotherexceptionstothe10%penaltymightapply.

6 ED SLOTT’S IRA ADVISOR • OcTObER 2012 To Order Call: (800) 663-1340

The self-dealing rules are not limited to the IRA owner and his or her IRA

assets.

Both clients and their advisors are responsible forseeing that all the IRA rules are followed. IRA assets,includingself-directedassets,mustbevaluedandreportedat their fairmarketvalue forpurposes suchas requiredminimumdistributionsandRothIRAconversions.

Invest In What You Know

The IRA rules permit a great deal of latitude inchoosing investments.Thatmayopenupopportunities,especiallyforclientswhohavespecializedknowledge.

Forexample,supposeBobisarealestateagentwhohasspent20yearsworkingmainly inhishomecounty.He'sbeeninvolvedinthepurchaseandsaleofrealestate,bothresidentialandcommercial.WhyshouldBobinvesthisIRAmoneyinstocksorfundsheknowslittleabout?BobhasabetterchanceofenjoyingsubstantialreturnsifheputshisIRAmoneyintolocalpropertythathebelieveshasgreatpotential.

Justtonameonealternative,BobmightputhisIRAmoneyintotaxliens,ifhehasbecome familiar with the process and isconfident that his IRA is likely to makemoneythatway.

Manyclientswillhavesomefamiliaritywith real estate, especially local markets,but the possibilities for self-directed IRAsdon’tstopthere.Engineersmightbeabletoinvestinpatents;lawyersmightknowhowtoparticipateinjudgmentsforcollectionor“structuredsettlements,”inwhichalump-sumpaymentismadeinreturnforastreamoffuturepayments,perhapsfromapersonalinjuryaward.

Ofcourse,virtuallyanyclientmighthavetheinsidetrackonapromisingbusinessjustgettingunderway.Allof these alternative investments may produce superiorreturns for clientswhocanuse their uniqueknowledgeandexperiencewhenmakingselections.

Avoid Making Critical Mistakes

That said, self-directed IRAs are not for everyone.Duetothespecializednatureoftheseaccounts,feesmaybecomparableor slightlyhigher than, say,putting IRAmoneyintoanS&P500indexfund,andthere’sgenerallymoreriskofatotalloss.(Nevertheless, thereisalowerrisk of total loss when investing in what you know,becauseofyourspecializedknowledge.)

Practical difficulties may arise, too.As mentioned,IRAsneedtobevaluedattheirfairmarketvalue,buthowcanyouputanannualvaluationonawarehouse?

Ingeneral,arespectedthird-partymustbehiredtodoan annual valuation.Someappraisalsmaybe relativelysimple and inexpensive to obtain, such as letters from

a real estate appraiser, but business valuations can beexpensive.Thosecostsshouldbebuilt-intotheclient’slong-termreturnexpectations.

Beyond valuation, clientswith certain self-directedIRAs investments faceunexpected tax issues.Thatwillbe the case if their IRA invests in what is deemed anoperating business which generates unrelated businesstaxableincome(UBTI).Inessence,theunrelatedbusinessincome tax (UBIT) ismeant to level the playing field,when a tax-exempt entity, such as a university, charity,oranIRArunsabusinessthatcompetesagainsttaxableentities.

Owning rental property generally is not consideredoperatinganactivebusinesssoUBITwon’tbetriggeredif an IRA owns such real estate. If the IRA owns ahotel, though, that’s considered an active business anda supposedly tax-deferred IRA may owe current tax.

The taxmustbepaidby the IRA.MakingsuchanIRAinvestmentisadecisionthat’spossibly worthwhile, if the investment isgoodenoughtocoverthetaxobligation.

Inpractice,UBITistypicallyarelativelymodest outlay. Clients shouldn’t ignoreUBIT, though. They should determinethe headaches and expenses likely to beincurredanddecidewhetheraninvestmentthatwillgenerateUBTIisstilldesirable.

Beware of Prohibited Transactions

Other risks commonly associatedwith self-directedIRAscanbefarmoreserious.Forexample,someventuresmaylendthemselvestoself-dealing,whichisprohibitedforIRAs.Forsomeviolations,allthemoneyinanIRAwill be considered distributed and fully taxable. Otherunfavorable tax consequences, such as the 10% earlywithdrawalpenalty,mayapplyaswell.

Clients can’t buy real estate from their own IRAor sell personal real estate to their IRA. It makes nodifferencewhetherthetransactionisatfairmarketvalueornot.Suchtransactionsarealwaysoff-limits.

Clients also are prohibited from using IRA assetspersonally.Inonecase,ataxpayerusedherIRAmoneytobuyahomeintendedtobeusedasrentalproperty.Thatwas fine, but when she changed her mind and movedintothehome,usingitasherresidence,shecommittedaprohibitedtransactionandcreatedataxableevent.

The self-dealing rules are not limited to the IRAowner and his or her IRA assets. Spouses, parents,children, grandchildren, sons- and daughters-in-law areallconsidered“disqualifiedpersons.”Asa result,usingIRAmoneytobuyfromorselltoanyoftheserelativesorabusinesstheycontrolisprohibited.

To Order Call: (800) 663-1340 ED SLOTT’S IRA ADVISOR • OcTObER 2012 7

Any amount that is borrowed

from the IRA or improperly used

as loan collateral will be deemed a

distribution.

Keeping Self-Directed IRA Investments at Arms-length

Nothing prevents clients from investing IRAmoney in rental property but other “contributions” areprohibited.Suppose thatLen, a realtor, invests his IRAmoney in a home he rents to a third party.That's fine,butwhenLenstartstofixplumbingproblemsandmowthelawn,he’scrossingtheline.AstheIRSinterpretstherules,Len’seffortsarecontributions.Thiscanleadtoapenaltythatdisqualifies the IRA for self-dealing. Thesame consequences apply if Len’s son orgrandsondoesthelawnmowing.

What if Len is paid for propertyrepairs, landscaping, etc.? Will this solvethe problem? Unfortunately, not. Businesscannot be transacted between an IRA and a prohibitedparty.Inthisscenario,Lenwillhavetosetthepricehe’spaidbytheIRAforhisservices.That’sconsideredself-dealing,whichisnotallowed.

IfaclientwantstoinvestIRAmoneyinrealestate,the administrator of the self-directed IRAprobably canprovide guidance. Often, the safest course is to hirequalifiedprofessionalstomanagetheproperty.

Avoiding Common Debt Mistakes

Manyrealestatepurchasesandbusinessinvestmentsarefundedwithborrowedmoney.ThiscanbeaproblemforIRAs.ThebasicruleisthatanIRAowner(oranotherdisqualified person) can’t borrow from his or her IRA.Thiswilldisqualify the IRA.The IRAcan’tbeusedascollateral to secure a personal loan either.Any amountimproperly used as loan collateral will be deemed adistribution. The IRA owner will owe income tax andperhapsanearlywithdrawalpenalty.

OnesolutionisfortheIRAtouseanon-recourseloanto acquire property in the IRA. Such loans are backedonlybythepropertyandnotbytheIRAowner,sothey’renotprohibited. IRAsmay takeout loanswith recourse,but only when that recourse is limited to assets in theIRA.Also,theuseofdebttoacquireIRAinvestmentscanmaketheIRAsubjecttoUBTI.

What’smore,advisorsshouldtellalloftheirclientstobewaryofmarginaccountsforIRAs.Ifamarginaccountrequires investors to personally guarantee to cover anymargincalls,whichusuallyisthecase,justopeningsuchan account can be considered a prohibited transaction(IRSNotice2011-81mayprovidetemporaryrelief).

Keeping Clients From Pressing Their Luck

Some mistakes related to self-directed IRAs resultfrom carelessness or lack of knowledge.A client who

Curtis L. DeYoung founded American Pension Services, Inc.®, a neutral third-party self-directed IRA and 401(k) administrator, in 1982 for the purpose of allowing investors to self-direct their retirement funds as broadly as the law allows. He is also a nationally recognized speaker and educator dedicated to teaching both independent investors, and professionals about the opportunity to invest using Genuine Self-Direction®. Curtis is a member of Ed Slott’s Master Elite IRA Advisor Group, and has appeared on CNBC’s Power Lunch, in the Wall Street Journal and other financial publications. To learn more about American Pension Services, visit their website www.americanpension.com. Curtis can be reached at (801) 571-0667 or at Candace@americanpension.com.

invests in a restaurant, for instance, might co-minglepersonalmoneywithIRAmoney,generatingaprohibitedtransaction. However, some “mistakes” are clearlyintendedtobend,break,andbypasstherules.

One client, for example, deposited a few thousanddollarsinaRothIRAashisannualcontribution.Theclient

took $1,000 of that money and bought aninterestinalimitedliabilitycompany(LLC).Forty days later, the Roth IRA sold thatinterestintheLLCformorethan$500,000.

Obviously, this was an attempt toundervalueanassetwithalowcostbasis.BymovingthatassettoaRothIRA,theinvestorplanned to eventually withdraw the salesproceeds(includingtheprofit),tax-free.

In another attempt to skew valuations, a taxpayerhadhis IRAbuytworealestate lots forover$100,000.Oneyearlater,in2011,hereportedthoselotswithafairmarket value of $15,000 apiece. The local real estatemarketmighthavesufferedinayear,butnotthatbadly!

Thenextyear,in2012,thetaxpayerwrotebothlotsdowntozero.Again,thiswashardtobelieve.Asitturnedout, the taxpayer had used IRAmoney to buy the lotsfromhimself.Hereportednotaxablegainonarealestateinvestment,andhegothishandsonsomecash.

Bystructuringthedealasan“investment”withinhisIRA, the taxpayer did not report a taxable distributionwhenthemoneycameoutoftheIRA.Inthefuture,the“worthless” lots can bewithdrawnwithout triggering ataxable distribution. So this schemewas away to takemoneyfromthetaxpayer’sIRAwithoutpayingtax.

Suchployscanbackfirepainfully.Advisorswholearntherulesforself-directedIRAscanhelptheirclientsstayontheproperpath.

ED SLOTT’SIRA Advisor

Editor - in - ChiefEdSlott,CPA

Contributing WritersBeverlyDeVenyJeffreyLevine

JosephCicchinelli

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Ed Slott’s IRA Advisor has beencarefullyresearchedtoprovideaccurateand current data to financial advisors,taxpayers, and others who seek anduse the information contained in thisnewsletter. Readers are cautioned,however, that this newsletter isnot intended to provide tax, legal,accounting, financial, or professionaladvice. If such services are required,then readers are advised to seek theaidofcompetentprofessionaladvisors.This newsletter contains timelyinformation about complicated taxtopicsthatmayeventuallybechanged,outdated,orrenderedincorrectbynewlegislationorofficialrulings.Theeditor,authors, and publisher shall not haveliabilityorresponsibilitytoanypersonor entity with respect to any loss ordamagecausedorallegedtobecaused,directlyorindirectly,bytheinformationcontainedinthisnewsletter.

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