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George F. Bearup, J.D. Senior Legal Trust Advisor

28-Oct-17

Self-Directed IRA’s – Tax Losses

Take-Away:  A IRA’s investment losses cannot be claimed by the IRA owner on his or her personal income tax return.

Background:  IRAs are generally tax-exempt. IRC 408. But some self-directed IRAs can also produce taxable (not tax deferred) income on which a current income tax will be owed.

  • IRA Taxable Income: An IRA can be subject to income taxes imposed on any unrelated business taxable income (UBTI) earned by the organizations held in the IRA. UBTI usually occurs when the IRA is self-directed and it invests in business organizations or partnerships. If the IRA has invested in organizations that report UBTI the IRA will be subject to income tax. IRC 408(e)(1) and IRC 511.
  • IRA Tax Losses: The Tax Code provides that UBTI deductible losses may be carried forward or backward to offset those losses against gains experienced within the IRA. IRC 512(b)(6); Treas. Reg. 1.512(b)(1)(e)(1.) For example, a net operating loss deduction under IRC 172 is allowed in computing the unrelated business taxable income of the organization held in the name of the IRA.
  • Loss Pass-Through: UBTI losses are not, however, passed through to the owner of the IRA and used on his or her Form 1040 tax return.

Example: IRA owner, Mr. Fish, invested in two partnerships in the name of his IRA. The partnerships show a loss for the year. Mr. Fish deducts the losses sustained by the partnership interests held in his IRA account on his 1040 income tax return. The IRS disallows the loss deduction and asserts a tax deficiency and an accuracy-related penalty when he claimed the deduction on his 1040 income tax return. Mr. Fish loses in both the Tax Court and the Court of Appeals. Both Courts found that the Tax Code does not permit a pass-through of UBTI losses to the IRA owner. IRC 51113. The loses can be used, but only to offset past or future taxable income of the business interests held in the IRA. Fish v. Commissioner, No. 15-73389, Affirmed, Ninth Circuit Court of Appeals ( October 17, 2017).

Conclusion: Clearly repeating myself from some earlier missives, investing in closely held businesses or real estate in the name of an IRA is very dangerous in light of the broad scope and application of the IRS’ self-dealing and prohibited transaction rules. One misstep and the entire qualified status of the IRA is lost. Then there is the added danger of actually having to pay income taxes on UBTI earned by the businesses held in the name of the IRA. Most promoters of self-directed IRAs tend to gloss over these dangers.