I have a tax problem that I hope you can help me with. I am in my early 40s and about seven years ago I invested a substantial amount of my IRA into a real estate venture. I was told at this time that it was very safe and secure. Unfortunately, it didn’t turn out that way. For the last couple of years I’ve wanted to sell the investment, but I couldn’t. However, in March of this year I was able to finally sell the investment at a substantial loss. Of the $150,000 I invested I only got back about $30,000, which I have just left in the bank Recently, in a conversation with my friend he shocked me when he told me I would have to pay taxes on the money. I can’t believe he is right. I was figuring I would be able to write off my loss. My question to you is who is right and who is wrong? If in the unlikely event that my friend is right is there anything I can do to avoid the tax?
I hate to be the bearer of bad news but your friend is correct. In fact, not only do you have to pay taxes but in addition, you’re also subject to the early withdrawal penalty of 10 percent. Furthermore, I hate to say, but you also, are not entitled to deduct your losses.
In understanding the situation at hand, it’s important to remember the money was in an IRA. In a traditional IRA you do not have a cost basis in the investment because the money you invested was pre-taxed. Because of this, whatever comes out of a traditional IRA, whether you had a gain or loss on your investment, is subject to ordinary income tax. Consequently, when you sold the investment and took a distribution of the proceeds as opposed to reinvesting the money back into the IRA, that is considered a taxable event. Therefore, the $30,000 you received from the sale of the property is 100 percent subject to income tax.
The next issue is the 10 percent penalty. When you withdraw money from a traditional IRA before the age of 59½, unless you qualify for some of the exceptions, which I do not believe you do, then in addition to the tax, you must pay a 10 percent early withdrawal fee. Had you taken the proceeds from the sale of the property and reinvested that into an IRA within a 60-day period, there would have been no tax or penalty. However, since you did not do this, the money is treated as a normal distribution and thus, is subject to the tax and the penalty.
Unfortunately, you’re also not allowed to deduct the loss on your investment. Typically, if you have losses on the sale of an investment, those are deductible. However, the rules are different for an IRA. Once again, with a traditional IRA you have no basis. As a result, you cannot have a loss. With investments outside the IRA, a loss is where your basis exceeds your selling proceeds. With an IRA, since you have zero basis, you cannot have a loss.
I hate to keep piling it on, but something you must also consider is whether you should make an estimated payment or not. Because the proceeds are subject to tax, it may require you to make an estimated payment. Most people think our taxes are due on April 15th; however, that is not the case. Taxes are due on a quarterly basis throughout the year; it’s only the return that is due on April 15th. Therefore, you should review your tax situation to make sure that you don’t have to make an estimated payment. If you should make an estimated payment and you do not, you could be subject to interest and additional penalties.
I know sometimes our tax laws don’t make sense and they seem to be unfair. However, I’m always reminded of what my tax professor taught me when I went to the University of Michigan Law School and that is, taxes are not meant to be fair.
If you would like Rick to respond to your questions, please email Rick at email@example.com