Promissory Notes Distributed by Self-Directed IRA Were Not Worthless

Published Categorized as Federal Income Tax, Retirement Accounts, Tax
Promissory Notes Distributed By Self-directed Ira Were Not Worthless, Houston Tax Attorney

Self-directed IRAs are usually profitable.  But there are times when they lose money.  In Berks v. Commissioner, Docket No. 26883-11S, the U.S. Tax Court addressed a situation where the IRAs held promissory notes that may have been worthless.

Facts & Procedural History

The Berks rolled over money from pre-existing IRAs to self-directed IRAs, with the intention of making loans to real estate-related partnerships.

The partnerships issued promissory notes to the self-directed IRAs.  The promissory notes accrued interest, but the interest would only be paid only if and when the underlying real estate was sold.

All of the partnerships and the promissory notes became worthless.

The self-directed IRA custodian requested information to establish that the promissory notes had become worthless, the Berks relied on their financial advisor to respond to the custodian, and the financial advisor did not provide sufficient information to the custodian.

The custodian did close the IRA accounts as directed and distributed the promissory notes to the Berks.  The custodian also issued Forms 1099-R to the Berks to report taxable distributions.

The IRS concluded that the amounts reported on the Forms 1099-R was to be included in the taxpayer’s income, as the taxpayers provided no evidence that the promissory notes had become worthless.

Evidence Establishing Worthlessness

The taxpayers presented testimony from their financial advisor at trial to establish that the promissory notes were worthless.

The court found that the testimony was vague and not supported by any corroborating documentation. As a result, the court agreed with the IRS and concluded that the taxpayers had not met their burden to show that the promissory notes were worthless.

The taxpayers had to recognize the amounts in income as taxable distributions.

But All May Not Be Lost

The court opinion does not specify whether the taxpayers were able to deduct the loss for the promissory notes on their individual income tax returns. Presumably the taxpayers–who now held the notes individually outside of the IRAs–could gather the evidence to establish that the notes were worthless and take this tax deduction.  The loss might be sufficient to offset the income the taxpayers received.

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