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In a recent column for InvestmentNews, IRA expert Ed Slott highlighted the potential problems of holding alternative assets in IRA accounts. [Ed. Note: The term “alternative assets” generally refers to illiquid assets, such as real estate, artwork, collectibles and non-publicly traded investments.]

Slott explained that, in a recent case involving the estate of the late actor James Caan, several mistakes were made, resulting in approximately $1 million paid in taxes and penalties.

The primary issue stemmed from the nature of assets within the IRA account. Caan had multiple IRA accounts, one of which contained hedge funds.

Custodians must report the year-end valuation for all IRA accounts. However, valuing illiquid alternative assets within these accounts poses challenges. This is particularly problematic when a required minimum distribution (RMD) necessitates a year-end value.

In Caan’s case, the custodian was unable to report to the IRS the year-end value of the IRA account holding hedge fund assets.

In addition, the financial adviser Caan was using left the firm that was holding Caan’s IRAs, and convinced Caan to transfer some of his holdings to a new financial institution. However, because of the valuation problem, that account was not actually transferred to the new financial firm.

Because the original custodian had not been able to obtain a year-end valuation of the IRA with hedge fund assets, the custodian made an “in-kind” distribution of the funds in the IRA to Caan, and subsequently issued a 2015 1099-R listing its year-end 2013 value. Caan did not report the distribution as taxable income, as required.

In December 2016, long after the 60-day rollover deadline had passed, Caan asked the hedge fund to liquidate his holding and roll over the proceeds to the new custodian recommended by his adviser.

The IRS notified Caan that he had an income tax deficiency for 2015 of approximately $780,000 because the hedge fund distribution was taxable, and also assessed approximately a $156,000 penalty for substantially underestimating his 2015 taxes.

Caan asked the IRS in a private letter ruling to waive the penalty associated with the rollover, but the IRS did not waive the penalty, and an appeal to the tax court also failed.

After Caan died in 2022, his estate also tried to obtain a favorable tax appeal but failed. The tax court ruled that Caan’s attempted rollover did not work because it violated the “same property” rule that requires that the property distributed from the IRA must be the same property that is rolled over.

Caan received a distribution from a hedge fund and rolled over cash. The judge also found that the rollover was not completed within the 60-day required time frame.

Bottom line: It is ill-advised to hold illiquid alternative assets, such as real estate, in your IRA due to the challenges in obtaining a year-end valuation.

Moreover, when transferring assets from one IRA to another, you must adhere to the same-property rule and finalize the transfer within 60 days.

Noncompliance with these rules can result in taxation and penalties from the IRS, and tax courts are unlikely to be sympathetic to any appeals. For investments in illiquid alternatives, it is generally safer to invest through non-IRA accounts.

Elliot Raphaelson welcomes your questions and comments at raphelliot@gmail.com.

© 2024 Elliot Raphaelson. Distributed by Tribune Content Agency, LLC.