We’re always distressed to see something like this occur. One of the many great benefits of using Self-Directed IRAs is the substantial creditor and bankruptcy protection granted to them under federal law – specifically 11 USC Section 522(d)(12).
But a recent ruling in a bankruptcy case has demonstrated that there are limits to this bankruptcy protection. In this case, a debtor was trying to assert that assets in his real estate IRA was properly protected from creditors under that law. At stake was an IRA worth $252,112.67, as of October 27th, 2008. The creditors objected, however – and won their case. Here’s why:
The debtor, Barry Kellerman and his wife Dana owned an LLC called Panther Mountain Land Development, as well as an IRA. Mr. Kellerman was a co-debtor on a number of Panther Mountain’s debts. The Kellermans directed their IRA administrator to have the IRA and Panther Mountain enter into a partnership agreement to develop four acres of land. The IRA was to contribute non-cash contributions of $122,830.56 worth of land and another $40,523.93 in cash. The LLC was to match these contributions in cash.
In the end, the land itself was titled to the IRA and LLC in partnership, and each held an undivided 50 percent interest in the property. As a result of this transaction other lands held by Panther Mountain received sewer access, increasing their value.
So far, so good.
But then the LLC couldn’t pay its bills. Like a lot of real estate investors that year, the Kellermans, and then Panther Mountain, LLC itself, were driven into bankruptcy. And the LLC’s documents listed the IRA as well as the LLC’s creditors as unsecured creditors.
Some alert lawyers on the creditor’s part pointed out that the IRA that owned the LLC had engaged in a prohibited transaction with it. The LLC is a disqualified person. Under the law, an IRA that engages in a transaction with an unqualified person ceases to be an IRA as of January 1st of that year – in this case, before the bankruptcy filing. And if it’s no longer an IRA, it no longer qualifies for the tax advantages of an IRA, and it no longer qualifies for the asset protection benefits, either.
While the Kellermans raised a number of defenses, none of them would overcome the fact that they owned Panther Mountain, and that their IRA had made a loan to an entity they controlled.
The court also ruled that the Kellermans, by using the IRA to control land that could provide sewer access to their other tracts of land held outside the IRA, had improperly used the IRA to increase their personal assets.
The lesson: Don’t get too cute with arrangements in Self-Directed IRAs. The prohibited transaction rules are clear: You cannot use your IRA as a source of capital for entities you or members of your family (spouses, descendants and antecedents) control. This is true whether the capital comes in the form of a loan or as a contribution.
As a result of their actions, the Kellermans not only lost the asset protection benefits of the IRA as well as the benefit of future tax deferral; they also likely got a nasty bill from the IRS, since they would have to pay income tax and penalties on the entire amount distributed from the IRA.
The asset protection benefits and tax advantages of the real estate IRA are compelling enough. It doesn’t make sense to get too greedy and endanger these valuable benefits by entangling your IRA assets with your personal assets in this way. The KISS principle applies: Keep it simple, make sound investment decisions to begin with, and guard against possible conflicts between your IRA and your personal interests that could potentially draw you into prohibited transactions, expose your retirement savings to creditors, and potentially put everything you have at risk.
Headquartered in beautiful Asheville, North Carolina, with offices in lovely Charlotte as well, American IRA, LLC is a nationwide leader in providing administrative services for owners of real estate IRAs and other Self-Directed IRAs. If you are interested in owning real estate or other non-traditional assets within your IRA or other retirement account, contact us today via our website, www.americanira.com, or call us at 866-7500-IRA(472). We look forward to hearing from you.