An inaccurate asset valuation can set back any IRA owner’s retirement plans. Today’s article talks about the most important things to consider for accurately valuing one’s IRA investments, especially alternative assets.
In this article:
- Importance of Asset Valuation
- Why the IRS Penalizes Inaccurate Valuation of Assets
- Complexity of Asset Valuation Process for Different Investments
- An Inaccurate Valuation of Assets Isn’t a Cheap Mistake
- Complicated Asset Valuations for Alternative Assets
- Important Appraisal Rules for Alternative Investments
Complex Asset Valuation for Self-Directed IRA Owners
Importance of Asset Valuation
IRA investing doesn’t just involve making regular contributions and managing one’s Traditional IRA portfolio. It also involves performing annual valuations of the financial assets that comprise it.
By properly estimating the values of the assets in one’s Traditional IRA, owners can avoid costly tax problems. The IRS requires Traditional IRA owners to keep updated portfolio valuations annually and they penalize those who fail to do so.
Why the IRS Penalizes Inaccurate Valuation of Assets
Undervaluation of assets inside an IRA portfolio can result in tax avoidance, which isn’t in the IRS’ best interests.
To get an idea of how an inaccurate valuation can result in tax avoidance, consider a real estate investment.
- A taxpayer has a real estate investment in a Traditional IRA, whose initial value was $200,000.
- If this taxpayer doesn’t hire a property appraiser even as the property’s value appreciates over time, the reported value of the property will remain at $200,000.
- If this taxpayer converts the Traditional IRA with this property investment into a Roth IRA, the IRS treats it as a distribution from the Traditional IRA. As a result, this taxpayer will need to pay taxes on the withdrawal and gains from this investment.
- If the property’s market value has appreciated to $300,000 during the backdoor Roth IRA, there would’ve been a $100,000 gain. But, since the taxpayer continues to report its value at only $200,000, there’ll be no taxes on the $100,000 gain.
As a result, the taxpayer would’ve had the benefit of receiving an un-taxed capital gain of $100,000 on the property. And, since qualified withdrawals from Roth IRAs are tax-free, this taxpayer could get away with the untaxed $100,000 gain.
Complexity of Asset Valuation Process for Different Investments
Stocks and Bonds
The asset valuation process for conventional IRAs focused on exchange-traded assets like bonds and stocks is very simple. This is because the closing prices of such assets are based on their last traded prices on their respective exchanges.
On the other hand, the asset valuation process for self-directed IRAs can be more complex, particularly for alternative assets. These assets include investments in precious metals, real estate, or actual businesses, which aren’t bought and sold as frequently as exchange-traded assets.
An Inaccurate Valuation of Assets Isn’t a Cheap Mistake
The IRS levies a substantial penalty for inaccurate asset valuations and not reporting valuations regularly. On top of the usual income taxes, it can impose a penalty of up to 20% of valuation shortfalls.
Consider the example earlier where a taxpayer undervalued a property investment by $100,000. On top of the income taxes due from the backdoor Roth IRA, the IRS may levy an additional $20,000 accuracy penalty, which is 20% of the $100,000 undervaluation.
Substantial Asset Depreciation
Undervaluation isn’t the only way a self-directed IRA owner can get inaccurately reported asset values. The other way is through substantial asset depreciation.
- Let’s say a self-directed IRA investor invested in a business, with a total value of $100,000.
- The business goes bankrupt, which means the value of this investor’s investment is wiped out.
- The investor instructs the broker to make the necessary adjustments in the portfolio’s value. However, this investor forgot to conduct an official appraisal of the bankrupt investment.
- If this investor closes the IRA without conducting an appraisal of the bankrupt business investment, its value will officially remain at $100,000 despite going bankrupt. As such, the IRA will tax this investor on the officially valued investment of $100,000.
The lack of an official appraisal of the worthless investment in the bankrupt company meant that the official value of the investment in the eyes of the IRS will remain at $100,000. As such, this investor will pay taxes on a worthless investment that the IRS continues to officially value at $100,000.
Especially for alternative assets, self-directed IRA owners must ensure regular appraisals of their values. Otherwise, inaccurate asset valuations may lead to very unpleasant financial repercussions.
Complicated Asset Valuations for Alternative Assets
Traditional IRA investments that focus more on exchange-traded assets such as bonds and stocks enjoy the benefit of daily valuations. The end-of-day closing prices of such assets are considered to be their official values.
What are Exchange-Traded Assets? These refer to assets listed on exchanges like the New York Stock Exchange or Nasdaq.
If an investor has 500 shares of Facebook in a Traditional IRA portfolio with a last traded price of $150 per share, the value of this investment is $75,000. One thing that makes it easier for IRA investors is that brokers can automatically update the values of their regular clients’ investments in exchange-traded assets like Facebook shares.
However, calculating the value of alternative investments is more complicated. This is because, as mentioned earlier in the article, alternative assets like businesses and real estate properties aren’t frequently traded.
If an investor owns shares of a business that’s not listed on major stock exchanges like the Nasdaq and NYSE, he or she will only know its true value upon selling those shares.
But, if there’s no intention to sell the business, how can this investor know how much the investment is worth? Also, how can this investor justify the investment value reported to the IRS?
The answer: An official appraisal report from a professional appraiser.
Important Appraisal Rules for Alternative Investments
Pay for Professional Appraisers Using the IRA
Investors must make sure that payments to professional appraisers for the valuation of alternative investments come from the IRA. The IRS prohibits paying for appraisal reports from an investor’s personal funds.
The IRS can compel investors who pay for appraisal reports using their personal funds to remove the assets concerned from their IRAs. These investors will have to pay taxes on Traditional IRA distributions and, possibly, early withdrawal penalties.
Another important rule to follow for alternative investment valuations and reporting them to the IRS is timely submission. After the professional appraiser completes the alternative asset valuation, the investor must pass it on to the IRA broker, who then submits it to the IRS.
IRA brokers usually require submission of appraisal reports by end of the year at the latest. But, it’s better to be safe than sorry, which is why investors should always check their IRA broker’s submission deadline.
IRA brokers can compel their IRA clients who fail to submit appraisal reports on time to withdraw the assets concerned from their IRAs. Worse, they may also get into hot water with the IRS if they submit their alternative investments’ appraisals late.
While inaccurate asset valuations can be potentially costly, it’s something that investors can easily avoid. It’s always a good idea to consult with an advisor when it comes to the complex aspects of managing IRAs, especially alternative asset valuation.
Do you have alternative assets in your IRA portfolio and, if so, are you properly valuing them and reporting their values to the IRS? Let us know in the comments section below.
- 7 Real Estate IRA Rules To Remember | Inside Your IRA
- Choosing Between A Conventional IRA and A Self-Directed IRA When Investing For Retirement | Inside Your IRA
- 13 Reasons Why You Should Get A Financial Advisor | Inside Your IRA