IRS & Real Estate

Self-Direction and Asset Protection: Real Estate IRAs/401(k)s Lay Beyond the Reach of Creditors

By: Mark E. Hodges, Esq., from NWREporter December 2005

This timeless adage applies with particular force during our income-producing years and may ultimately determine the standard of living we realize at retirement age. Prudence admonishes us to save as much as we can of today’s earnings for tomorrow’s benefit, while, at the same time, investing those dollars wisely. Accordingly, to the extent we earnestly develop a retirement plan and persistently execute the plan, our future welfare should be marked with abundance. On the other hand, if we fail to plan, or do so haphazardly, our lifestyles may prove quite lean during the sunset years.

Let’s explore this “reap what you sow” principle in a hypothetical illustration. Earnest Licht participated in the company profit sharing plan and regularly made 401(k) contributions during his tenure at Galactic Enterprises, Inc. His employer-sponsored plan, however, limited the investment choices to stocks, bonds and mutual funds. Nonetheless, when he left the company, Earnest had accrued over $100,000.00 in his retirement account.

A friend told Earnest about self-directed retirement plans and the ability he would enjoy to freely choose his retirement account investments. So, he rolled his former company plan assets over to a “Truly Self-Directed IRA” with Entrust as his Custodian. This strategy expanded Earnest’s investment choices to include real estate, limited liability companies, partnerships, private placements, discounted notes, lending, factoring and a whole host of alternative opportunities.

Darrell Licht, Earnest’s father, had not bothered with a retirement plan. He re-married well, fortunately, as his new wife had over $100,000.00 in savings. Both Earnest and Darrell intended to partner-up on some local real estate investments.

Father and son made an offer to buy a $200,000.00 duplex in town, Earnest using his IRA monies and Darrell using his wife’s personal funds. They each put $100,000.00 down at closing. Entrust took title to an undivided 50% interest in the duplex, as Custodian for the benefit of Earnest’s IRA. Darrell and his wife took title to the remaining 50% interest, personally.

The duplex generated $10,000.00 per year positive cash flow; $5,000.00 each. Earnest’s IRA enjoyed tax-favored status, so realized no current tax liability. Darrell was able to take the normal investment real estate deductions to reduce or eliminate his tax liability on the annual income.

The real estate market was heating up in their area. The investor team anticipated doubling their money within the next three to five years. Should they each realize a $100,000.00 profit, however, the investors would experience completely divergent outcomes. The IRA’S gain would be tax-deferred until Earnest started taking distributions at retirement age. The entire equity would continue to build Earnest’s future retirement reserve. Darrell, unless he initiated an IRC §1031 Exchange, would recognize the full gain in the year of the sale and lose between 15% and 25% to federal income taxes. (If they sold the duplex in less than one year from the date of acquisition, Darrell would be taxed at the short-term capital gain rate of up to 35%.)

Unfortunately, calamity struck before the proverbial ship came in. Unbeknownst to Earnest and Darrell, the electrical system in the duplex was faulty. One morning, a toaster full of Pop-Tarts blew-out the electrical panel in Unit A and caused a ferocious fire. A caustic chain reaction engulfed Unit B in flames and took the lives of three tenants. The ensuing wrongful death lawsuits resulted in judgments totaling almost $10,000,000.00! (Fortunately, the duplex was insured, so insurance proceeds were used to restore the improvements at their replacement cost.)

Here’s where Earnest’s diligence really paid off. Asset protection for Retirement Plans derives from a variety of sources. ERISA protects assets held in Qualified Plans (generally, Employer-Sponsored Plans) from legal process, provided the Plan Document contains the prescribed “anti-alienation” provisions. In addition, the Bankruptcy Code excludes the Qualified Plan assets from a Bankrupt’s estate. ERISA does not protect assets held in IRAs from creditor claims, however. But, several States have statutes that exempt retirement plan assets, including those held in IRAs, from legal process. In my home state of Washington, for example, a statute exempts any “employee benefit plan” (defined to include IRAs, Roth IRAs, Qualified Plans, etc.) from “execution, attachment, garnishment, or seizure by or under any legal process whatever.” (RCW 6.15.020.)

Even in Bankruptcy, thanks to recent court cases and changes in the Bankruptcy Code, assets held in Retirement Plans, including IRAs, are effectively shielded from creditor claims. The recent decision of the U.S. Supreme Court in Rousey v. Jacoway (April, 2005) ruled that the IRAs held by Debtors in Bankruptcy, under the facts of that case, were exempt from the reach of their creditors. That decision may have limited application, however. The better news, for IRA Holders, is that the Bankruptcy Code itself has been amended (effective October 17, 2005) to exempt all IRA’S from the reach of creditors when an IRA Holder becomes a Debtor in Bankruptcy.

Because Earnest’s 50% interest in the duplex was held inside the IRA, both Earnest and the duplex are insulated from legal process initiated to collect on the judgments. How? By virtue of the State Statute and US Bankruptcy Code protections, an impenetrable barrier repels a judgment creditor trying to reach inside the Plan and grab assets to satisfy the judgment. The Retirement Plan Trust (e.g.- IRA) owned the duplex, so Earnest was not personally implicated in the duplex-related enterprise; both the benefits and liabilities were exclusively within the province of the IRA. In other words, the claimants had to sue the IRA Custodian, as Trustee, not Earnest, to obtain a judgment in the first place. So, only his IRA assets, not his personal assets, were potentially exposed to the claims. However, following the entry of a judgment against the IRA, a roadblock bars the creditor from executing against the duplex because it is an asset of the IRA and exempt from legal process. Earnest’s retirement plan assets lay beyond the reach of creditors.

Darrell did not fare as well as Earnest. His duplex investment was made with personal funds; Darrell and his wife held title personally. The judgment creditors had a field day going after Darrell’s 50% interest in the duplex, then proceeded to execute against their remaining personal assets. Darrell filed Bankruptcy, but still ended up with only the ’88 Buick and the gold cufflinks Grandma had given him.

The diligent Retirement Planner is wise to hold real estate and other assets inside his/her IRA or 401(k) Plan. Not only does this strategy lead to profit, but it serves to preserve the assets so amassed over a lifetime of investing. Abundance is the reward during retirement years.

The hasty will fail to plan or do so on a “Hail, Mary and hope for the best” approach. We see that Darrell lived up to his namesake by losing everything for lack of diligence. Be an Earnest, not a Darrell Licht.

© 2005 Mark E. Hodges

Mark Hodges has over 20 years experience as a Real Estate and §1031 Exchange Lawyer. He serves as President of Entrust Northwest, LLC, a local Administrator/Facilitator of “Truly Self-Directed Retirement Plans.” You may contact Mr. Hodges directly @ (425) 867-9800 or markh@entrustnw.com.

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