When you take a distribution from your IRA, whether to put the funds in a taxable account or to convert it to a Roth IRA, you have the option of taking the distribution “in kind” or in cash.
In cash means that you sell the holding in the account or simply take distribution of cash that already exists in the account. This is the most common method of taking distributions, and it is definitely the simplest way to go about receiving and dealing with a distribution. Cash is cash, it has only one value – therefore the tax owed on the distribution, whether a complete distribution or a conversion to a Roth account.
On the other hand, if you choose to use the “in kind” option, you might just save some tax on the overall transaction. The reason this is true is due to the fact that the amount reported on your 1099-R for the distribution is the Fair Market Value (FMV) of the distribution.
Quite often, when you have holdings in your IRA that have very limited liquidity or marketability, the actual value on any given date could be discounted quite a bit from the eventual or Net Asset Value (NAV) of the holding.
For example, if you held shares in a limited partnership (LP) that makes investments in leveraged real estate, meaning that the real estate holdings are encumbered by mortgage loans, the value of the overall holding will first be reduced by the outstanding non-recourse (mortgage) loans against the assets. Secondly, if the property is limited in its marketability (and what property isn’t these days?) there could be a reduction in the FMV for liquidity and marketability.
Let’s say that the LP owned several properties that amounted solely to vacant real estate that is to be eventually sold to developers. The property was purchased several years ago with the idea that developers would quickly be willing to purchase and develop the tracts, as the area was growing quickly. Then the property values dropped off drastically and development in the area dried up completely.
When you originally purchased the shares in the LP, you invested $100,000, and your shares are encumbered by an additional loan of $100,000 – so the original NAV of your holdings is $200,000. Now that the property values have dropped off by 40%, your holdings effectively have a value of $120,000. When a qualified appraiser reviews and values the property in the LP, the Fair Market Value (FMV) is set at exactly 60% of the original NAV. In addition, the loan balance against your shares is now down to $90,000.
If you decide to convert your holdings of this LP to your Roth IRA in kind, here’s how the FMV would be calculated for tax purposes: your FMV of the overall holdings of $120,000 (60% of the NAV) minus the encumbrance loan of $90,000, for a total value of $30,000. So this is the amount that is reported on the 1099-R for the value of your holdings being converted.
Then (hopefully), after a year or so, fortune once again smiles on your LP, and developers come a’callin’. Now they’re willing to pay full value plus a premium of 30% on the original values of the properties – for a total of $260,000 value on your shares. So effectively you have a property that cost you a total of $100,000 initially, is now worth $170,000 (your $260,000 minus the $90,000 loan), and you only had to pay tax on $30,000 of the value – the rest is tax free!
Granted, this is an extreme set of circumstances that uses the tax laws to your advantage, but it represents an example that, with some adjustments, could be a real world happening. If you happen to be investing in esoteric-type investments that might have wildy-fluctuating FMVs over time, this could be a good strategy to look into. Just make sure you have a trusted advisor on your side who is familiar with this sort of activity – you don’t want to mess this one up, as the tax and penalty downsides can be substantial.An IRA Owner's Manual or if you'd prefer the Kindle version (and let's face it, ALL the cool kids do!), you can find that at this Kindle version link.