The IRS requires anyone investing through an IRA to maintain an up-to-date portfolio valuation every year. For conventional IRAs that focus on market assets like stocks and bonds, the valuation process is simple enough. But doing these calculations for self-directed IRAs can be more complicated.
The IRS requires these valuations because it is in their interest to track future tax estimates and to prevent tax avoidance through asset undervaluation. For example, say Taxpayer A owns a piece of real estate in a Traditional IRA and the property value increases from $100,000 to $300,000. Without an appraisal, he or she would continue to report an asset value of $100,000. If Taxpayer A were to roll over a Traditional IRA account to a Roth IRA, where gains are tax-free, he or she would effectively receive an extra $200,000 of untaxed income upon sale of the property. Clearly, this is something the IRS wants to avoid.
No matter which kind of IRA you invest in, annual valuations are an important part of IRA investing and should be handled properly to avoid potentially costly tax issues with the IRS.
Here are a few things to keep in mind when you are doing your valuation this year:
There are special valuation rules for alternative assets
Traditional IRA investors usually focus on publicly traded assets like stocks and bonds, which have a market price that is updated daily. As a result, investors can easily figure out the value of their investments – for example, if you have 300 shares of Apple stock and Apple closes the day at $100 a share, than you know your stock portfolio is worth $30,000. Brokers usually make this calculation automatically for regular IRA customers so they always know the value of their account.
But valuation calculations are considerably more complicated for alternative asset investors. Unlike stocks and bonds, these assets, like real estate or business partnerships, are not bought and sold every day. For example, if you own part of a privately-held business, you will only know exactly how much that business is worth when you sell it. In order to report a valuation on these hard-to-value assets to the IRS every year, you have to hire an appraiser.
There is a specific appraisal process to follow
There are a few important things to note on the appraisal process for alternative investments. First, it is crucial that you pay for this appraisal out of the funds in your IRA, not out of your own pocket since IRS rules prevent payment of IRA expenses using personal funds. If you do pay out of pocket, the IRS could force you to take the asset in question out of your IRA, leading to taxes and, potentially, an early withdrawal penalty.
Timing is also important. Once the appraiser finishes the valuation, you must send the report to your IRA broker for submission to the IRS. Brokers typically require that you do this by the end of the year, but you should check with your individual broker. If you miss their deadline, the broker could force you to take the asset out of your IRA, or you could also run into tax problems with the IRS.
An improper valuation carries heavy consequences
The IRS could charge you a costly accuracy penalty if you don’t report your valuations regularly. In addition to the regular income taxes that will be owed, the accuracy penalty entails an extra 20% of the pricing shortfall. In the example above, where Taxpayer A underreported a piece of property’s value by $200,000, he or she would owe $40,000 for the penalty plus the income taxes that should have originally been paid on the IRA rollover.
While asset appreciation can lead to a steep tax bill if you do not report regularly, significant depreciation of your assets could also get you in trouble. For example, there was an investor who owned shares of a real estate partnership in his self-directed IRA. The partnership went bankrupt and the shares dropped from a value of $77,000 to zero. The investor told his broker to adjust for the lost value but never performed an official appraisal. When he closed the IRA, the partnership shares were still listed at a $77,000 valuation. The IRS maintained that he had $77,000 of taxable income from the IRA, despite the fact that the shares he took out were worthless. He had to pay thousands of dollars worth of unnecessary taxes that could have been avoided with an appraisal.
Don’t let incorrect asset valuations set back your retirement plan. Ask your advisor to help you plan ahead.