Here’s a true story I heard recently from a Phoenix colleague. A client wanted to invest her IRA in real estate, so she opened a self-directed IRA, which required forming an LLC in the process. (This is becoming more common in today’s investing environment.) The client later decided to remodel the property, and hired a handyman to perform the work.
The client ran into a problem—because the property was in the LLC, the transaction was commercial, not residential. Unfortunately, the city does not issue permits on commercial transactions to unlicensed contractors. Instead of contacting her attorney to review options, the client came up with what she thought was an ideal solution. She transferred the property out of the LLC to herself, obtained the residential permits through her handyman, had him do the repairs, and then deeded the property back into the IRA/LLC when the repairs were complete. Simple and smart. Well, maybe not.
Unfortunately, when she transferred the property from the LLC to herself, it was a taxable distribution from the IRA, taxed as ordinary income plus a 10% early withdrawal penalty. Then when she transferred the property back into the LLC/IRA, because the property had a mortgage, the transfer was considered debt relief for her and added $150,000 to the gain. In total, her well-intentioned but uninformed steps led to over $100,000 in extra taxes and penalties. Had she consulted with her attorney first, she would have learned the consequences for her perceived ideal solution and probably decided it was better to pay a few extra dollars to hire a licensed contractor.
Issues like this illustrate precisely why we offer our clients membership in our Client Care Program, which provides free phone and email access to our firm among several other benefits. This access makes it much easier to seek professional advice when it might be needed and potentially save unnecessary costs and headaches.