The IRS has proposed expanded information reporting for IRAs that hold certain hard-to-value assets, such as non-publicly traded securities and real estate. The proposed reporting change signals an increased effort by the IRS to identify IRAs that invest in certain types of assets, most likely to focus audit efforts on underreported income and prohibited transactions associated with them.
In a recently released draft of the 2014 Instructions for Forms 1099-R and 5498, the IRS has proposed adding two new boxes to Form 5498, IRA Contribution Information. These instructions would require IRA trustees and custodians to report in Box 15a the fair market value (FMV) of certain hard-to-value assets and identify in Box 15b the type of asset by category. The following assets would be subject to the additional reporting requirement.
- Stock or other ownership interest in a corporation that is not readily tradable on an established US or foreign securities market
- Short or long-term debt obligation that is not traded on an established securities market
- Ownership interest in a limited company of similar entity that is not traded on an established securities market
- Real estate
- Ownership interest in a partnership, trust, or similar entity that is not traded on an established securities market
- Option contracts or similar products that are not offered for trade on an established US or foreign options exchange
- Other assets that do not have a readily available FMV
The IRS has also proposed the use of a new code K for reporting distributions of assets other than cash, including the above listed assets, on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
The proposed FMV reporting change would not apply to IRA assets such as stocks, bonds, or mutual funds that are publicly traded, or to traditional credit union IRA investments such as IRA share accounts and IRA share certificates. The FMV of these IRA assets would continue to be reported in Box 5 on Form 5498 under the existing reporting scheme. Likewise, cash distributions from IRAs would continue to be reported on Form 1099-R using the applicable distribution code.
While an IRA is not permitted to invest in collectibles or insurance contracts, alternative IRA investments such as real estate, private equity and debt offerings, limited partnerships, and limited liability companies are permitted. Many self-directed IRA investors hold these types of alternative investments, but they add complexity to IRA administration, and may run afoul of the prohibited transaction rules in cases where the IRA owner engages in self-dealing.
The IRS is also concerned that with the difficulty in valuing these investments, the correct tax may not be applied to these transactions, resulting in an underreporting of income. Their concerns are heightened by a slew of promoters touting the use of self-directed IRAs to avoid taxes, often through the use of fraudulent or sham transactions. Self-directed IRAs are also rife for abuse, with reports that IRA owners have been targeted by fraudulent investment schemes, including the Ponzi scheme run by Bernard Madoff. Such incidents are rare, but they have the IRS taking a closer look at self-directed IRAs with hard-to-value investments.
Most credit unions offer traditional IRA investments, such as IRA share savings accounts and IRA share certificates, or partner with a financial services firm to offer alternative investments, such as stocks, bonds, and mutual funds. There are a number of boutique banks and trust companies that specialize in offering self-directed IRAs for real estate and other alternative investments, but some credit unions also offer self-directed IRAs that allow investments in real estate and limited partnerships.
If your credit union offers these types of self-directed IRA investments, you should carefully monitor the proposed reporting changes so that you are prepared to comply with them if enacted. Although a draft of the 2014 Form 5498 has not yet been released, adding two additional boxes to the form will likely change the form layout and require all IRA trustees and custodians to make system changes. Trustees and custodians would need to modify their systems to track IRA investments by category, report the FMV and category code in the appropriate boxes on Form 5498, and report code K in Box 7 on Form 1099-R for distributions of assets other than cash.
The IRS has requested comments on the proposed information reporting changes. The changes, if adopted, would be effective for tax year 2014, with reporting in early 2015.