Live Happily Ever After With A Properly Structured Roth IRA Conversion

For a variety of reasons, self-directed individual retirement account (“IRA”) holders transfer assets to a self-directed Roth IRA. Converting a self-directed IRA asset or assets can be extremely beneficial if the IRA holds an asset that is expected to appreciate readily in the future such as pre-IPO stocks. Converting a self-directed IRA asset or assets to a self-directed Roth IRA typically involves opening a new self-directed Roth account, instructing the IRA’s custodian to transfer assets (or doing a 60-day rollover), and paying taxes on the pre-tax amount converted. The process allows for “in-kind” transfers of assets like corporate stocks or real estate often requiring a fair market valuation, and is taxed as ordinary income in the year of conversion. There are a number of traps associated with converting a self-directed IRA to a self-directed Roth IRA such as improperly valuing an illiquid asset or triggering the so-called 5-year rule. This article discusses the tax considerations associated with converting a self-directed IRA to a self-directed Roth IRA.

What is a Self Directed IRA

The appeal of investing retirement funds outside of the typical investments has driven a surge in the use of self-directed IRA investment structures. Investments within self-directed IRAs frequently include real estate, closely held business entities, private loans, and can include any other investment that is not specifically prohibited by federal law. Since 1974, the IRS has permitted individuals to totally “self-direct” investments made within their self-directed IRAs that are also authorized by federal law and are held by a trustee or custodian that permits investments in a broader range of assets than is permitted by traditional IRAs. See Levine v. Entrust Grp., Inc., 2012 WL 6087399 (N.D. Dec. 6, 2012). Self-directed IRAs allow individuals and small companies to invest in asset classes that are often deemed illiquid. These include but are not limited to tax lien certificates, real estate, livestock, domestic and foreign private companies. Hence, self-directed IRAs allow individuals who prefer to leverage their personal expertise in their investment to do so.

Although a self-directed IRA allows individuals to invest in numerous illiquid assets, investments in some assets are prohibited. These include, but may not be limited to, collectibles, including artwork, stamps, jewelry, antiques, and rugs. Investments in life insurance are also prohibited. In addition, an individual cannot use an IRA to invest in real estate that he or she will personally use. See IRC Section 408.

Most individuals who fund self-directed IRAs do not realize that funding such a structure may trigger tax obligations and filing requirements. Anyone considering funding a self-directed IRA must understand the term unrelated business taxable income (“UBTI”). If the self-directed IRA earns UBTI, the IRA may need to file a Form 990-T and pay annual taxes. To calculate UBTI, the income from the business activity that is not passive in nature must be identified. Next, any business expenses must be identified. In addition, if the self-directed IRA utilizes non-recourse debt to acquire property, the self-directed IRA may be subject to Unrelated Debt Financing Tax (“UBFI”). Below, please find two illustrations which demonstrate how the aforementioned taxes and filing requirements apply to self-directed IRAs.

The Taxation of UBTI

An IRA is considered a tax-exempt entity, meaning that it generally does not pay taxes on interest, dividends, or capital gains within the account. As a tax-exempt organization, an IRA is subject to the tax-exempt rules stated in the Internal Revenue Code. Since 1950, exempt organizations have been taxed on unrelated business taxable income, which is defined as gross income (less directly connected expenses) derived from an unrelated trade or business. See IRC Section 512(a). If the property producing such income is acquired with borrowed funds, however, the debt-financed property rules of Internal Revenue Code Section 514 treat all or part of the income as unrelated business taxable income with the result that it is subject to tax.

An exempt organization is taxed on unrelated business taxable income which is defined as gross income (less directly connected expenses) derived from an unrelated trade or business. An unrelated trade or business is defined as: (a) any trade or business; (b) that is regularly carried on; and (c) is not substantially related, aside from the need of the organization for funds, to the organization’s exempt purpose.

In most instances, investment activities of exempt organizations would be regularly carried on and not substantially related to the organization’s exempt purpose, thus meeting the second and third prongs of the definition of an unrelated trade or business. It is less clear whether the conduct of investment activities constitutes a trade or business. The regulations of the Internal Revenue Code provide that, in general, the term “trade or business” has the same meaning it has in Section 162 of the Internal Revenue Code and generally includes any activity carried on for the production of income from the sale of goods or the performance of services. The Supreme Court held in Higgins v. Commissioner, 312, 217 (1941) that an individual’s management of his own investments was not a trade or business even though the individual’s activities were extensive enough to require an office and a staff. Congress ultimately overruled Higgins and enacted Section 212 of the Internal Revenue Code. Section 212 of the Internal Revenue Code allows individuals to deduct “ordinary and necessary” expenses for producing income, managing income-producing property, or handling tax-related matters.

Certain types of income, commonly referred to as “passive income,” are excluded from UBTI. See IRC Section 512(b). These include dividends, interest, payments with respect to securities loans, amounts received or accrued as consideration for entering into agreements to make loans, annuities, royalties, rents from real property and personal property leased with the real property if the rent attributable to the personal property is 50 percent or less of the total and the rent does not depend on income or profits derived from the leased property, and capital gains and losses. See IRC Section 512(b)(5). In addition to passive income, royalties are excluded in computing the unrelated business taxable of a tax-exempt entity. A “royalty” has been defined as any payment received in consideration for the use of a valuable intangible property right, whether or not payment is based on the use made of the intangible property. However, payments for services provided in connection with the granting of these types of rights are not royalties and are generally taxable as unrelated business income.

The UBTI for self-directed IRAs are taxed at progressive trust tax rates, which can reach up to 37% for income over $16,000 (as of 2026). If an IRA generates over $1,000 in annual gross income from unrelated business income, it can be subject to UTBI tax at a rate of 37%. As discussed above, deductions are permitted for expenses that are “directly connected” with the carrying on of the unrelated trade or business, and net operating losses are allowed to be carried forward and backward (with certain limitations). Losses from one unrelated business activity are not able to offset gains in another; profit and losses are determined per activity.

Below, please see Illustration 1 which provides an example as to how UBTI can be assessed against a self-directed IRA holder.

Illustration 1.

Jill invested $500,000 from her IRA into an LLC custom jewelry company. The investment gave Jill a 25 percent interest in an LLC. The LLC had three other owners, not related to Jill, and none of the other investors were co-owners with her in any other business entities. Jill was not involved in the LLC’s day-to-day operations and did not otherwise personally benefit from the investment.  The LLC recorded a significant profit on its annual Form 1065, U.S. Partnership Income Tax Return. In turn, each investor, including Jill’s self-directed IRA was issued yearly Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., which showed ordinary income. The Internal Revenue Code imposes a tax on income earned by a tax-exempt organization in a trade or business that is unrelated to the organization’s exempt purpose. This type of tax liability is known as UBTI and it became a large tax liability for Jill.

It should be understood that most IRA investments do not trigger current tax consequences, not because all income an IRA earns grows tax free, but because the types of income that an IRA typically earns are exempt from UBTI tax rules. For example, IRAs that invest in publicly traded securities (e.g., stocks, bonds, and mutual funds) do not owe current tax because gains from the sale of C corporation stock dividends, and interest income are exempt from UBTI. For this reason, most IRA investors are unaware that an IRA can require a tax return (Form 990-T Exempt Organization Business Income Tax Return) and pay taxes. Income from a business that is regularly carried on (whether directly or indirectly) can result in UBTI and filing requirements.

In this case, since the LLC Jill invested into conducted a regularly conducted business, the self-directed IRA had a tax consequence. To make matters worse, in Jill’s case, the self-directed IRA was taxed at trust rates. This resulted in Jill’s self-directed IRA realizing a far greater tax liability compared to an individual who is taxed at ordinary marginal tax rates. Jill may be shocked to discover that her self-directed IRA is subject to taxes on the LLC’s yearly profits, but also that the tax rate on income over $16,000 is a whopping 37 percent. To add insult to injury, there was an additional net investment income tax of 3.8 percent assessed on the trust income over $16,000.

The Taxation of UDFI

The exclusion for passive income is not available for income derived from debt-financed property. Section 514(a)(1) of the Internal Revenue Code requires an exempt organization to include UBTI a percentage of income derived from “debt-financed property” equal to the “average acquisition indebtedness” for the taxable year over the average amount of the adjusted basis for the taxable year. A like percentage of deduction is allowed in computing UBTI. See IRC Section 514(a)(2). The straight-line method of depreciation must be used. See IRC Section 514(c)(3). Debt-financed property is defined in Section 514(b)(1) as any property held to produce income with respect to which there is an acquisition indebtedness at any time during the taxable year or, if the property is disposed of during the taxable year, at any time during the 12-month period ending on the disposition. The statute contains several exceptions to the definition of debt-financed property, which have the collective effect of limiting its application to investment income. Specifically, the following are excepted from the definition of debt-financed property: (a) any property substantially all of the use of which is substantially related to the organization’s exempt purpose; (b) any property the income from which is included in UBTI without regard to the debt-financed property rules, except that gain from the sale or disposition of such property is not excluded under Section 512(b)(5); (c) any property to the extent income is excluded under Section 512(b)(7) relating to government research, Section 512(h)(9) relating to college, university, and hospital research, and Section 512(b)(9) relating to fundamental research the results of which are made freely available to the public; (d) any property used in any trade or business described in Section 513(a)(1) relating to work performed by volunteers, Section 513(a)(2) relating to convenience of members, etc., and Section 513(a)(3) relating to selling of merchandise received as gifts; and (e) neighborhood land acquired with the intent of using it for exempt purposes within 10 years.

Acquisition indebtedness is defined as the unpaid amount of (a) indebtedness incurred by the organization in acquiring or improving debt-financed property; (b) indebtedness incurred before the acquisition or improvement of the debt-financed property if such indebtedness would not have been incurred but for such acquisition or improvement; and (c) indebtedness incurred after the acquisition or improvement of the debt-financed property if such indebtedness incurred after the acquisition or improvement of the debt-financed property if such indebtedness would not have been incurred but for such acquisition or improvement and, the incurrence of such indebtedness was reasonably foreseeable at the time of such acquisition or improvement. See IRC Section 514(c).

The statute excludes from the definition of acquisition indebtedness a number of transactions that relate to non-investment transactions common to exempt organizations. These include: (a) a 10-year exception if mortgaged property is acquired by bequest or devise and certain conditions are met; (b) liens for taxes and assessments that attach before the payment date; (c) extension, renewal, or refinancing of an obligation evidencing a pre-existing indebtedness; (d) indebtedness inherent in performing an organization’s exempt purpose such as indebtedness incurred by a credit union accepting deposits from its members; (e) charitable gift annuities; and (f) certain federal financing for low-and-moderate-income persons. The statute also excludes from the definition of acquisition indebtedness securities loans and real property acquired by pensions trusts and schools, colleges, and universities.

If none of the statutory exceptions is applicable, then, to determine whether there is acquisition indebtedness, one must first determine whether there is indebtedness and then determine the indebtedness is traceable to the acquisition or improvement of income-producing property.

Below, please see Illustration 2 which provides an example as to how UDFI can be assessed against a self-directed IRA plan holder.

Illustration 2.

Mark had $1.5 million in his 401(k). Mark decided to invest the $1.5 million in a self-directed IRA. Mark’s goal for his self-directed IRA was to invest in residential real estate through an LLC. Mark found a real estate investment group that frequently organized partnerships and promised “passive” investment (no direct involvement by Mark). The real estate partnership collected capital contributions from 20 investors and used the cash plus debt to purchase an apartment building. The apartment building was held as a rental property, with net income distributed to the investors, including Mark’s self-directed IRA LLC.

As stated above, it is possible for a self-directed IRA to invest in a broad range of investments. Thus, real estate partnerships are acceptable self-directed IRA investments is technically correct. However, this does not answer the question of whether there are more difficult legal or tax issues. For example, “rent from real property” is normally exempt from UBTI, and thus currently not taxable when earned by a self-directed IRA or self-directed IRA LLC. However, income from debt-financed property (whether held directly or indirectly by the self-directed IRA or self-directed IRA LLC) is partially taxable under the  rules because the income generated from the investment is not earned by investment of the self-directed IRA capital, but rather by financing.

In this case, the yearly income that is allocated to Mark’s self-directed LLC is partially subject to tax under the UBFI rules. Income received from debt-financed property may be subject to the  UBFI rules. Because the property placed in the self-directed IRA was financed and subject to the UBTI rules, the self-directed IRA was required to file Form 990-T, annually. This was the case whether or not UBFI taxes were required to be paid. Failure to pay the UBFI taxes and file Form 990-T could subject Mark’s self-directed IRA to significant penalties and interest.

Overview of the Applicable Prohibited Transaction Rules

A key term governing self-directed IRAs is “prohibited transactions.” If a self-directed IRA engages in a “prohibited transaction,” the “self-directed” IRA will lose its tax exempt status. Because of the importance of the “prohibited transaction” concept, individuals need to identify a prohibited transaction. Internal Revenue Code Section 408(a) provides the technical statutory definition of a “prohibited transaction” with respect to self-directed IRAs. For this purpose, a “prohibited transaction” is determined under the rules of Section 4975 of the Internal Revenue Code. The sanction for a prohibited transaction is the disqualification of the tax exempt status of the IRA account. In the event of a prohibited transaction, for income tax recognition purposes, the IRS will treat all the assets of the IRA as being distributed to its owner as of the first day of the year in which the transaction occurs. In many cases, the IRS will assess an additional 10 percent tax for premature distribution. In addition, the IRS could assess an additional 20 percent tax under Internal Revenue Code Section 6662. (The Internal Revenue Code imposes an additional tax of 20 percent on the portion of an underpayment attributed to: 1) negligence of federal tax law and 2) a substantial understatement of income tax).

In order for a prohibited transaction to occur, there must be a transaction involving a “disqualified person” with respect to the “plan.” A “disqualified person” includes: 1) a fiduciary; 2) a person providing services to the plan; 3) an employer any of whose employees are covered by the plan; 4) an owner, direct or indirect of 50 percent or more of: i) the combined voting power of all classes of stock entitled to vote or the total value of the shares of all classes of a corporation; ii) the beneficial interest of a trust or unincorporated enterprise which is an employer or an employee organization; 5) a member of the family including spouse, ancestor, lineal descendant and any spouse of a lineal descent; 6) a corporation, partnership, or trust or estate of which is 50 percent or more of the combined voting power of all classes entitled to vote of the total value of the shares of all classes of stock of such corporation; 7) the beneficial interest of such trust or estate or owned directly or indirectly or held by persons; 8) an officer, director, a 10 percent or more shareholder or a highly compensated employee. See IRC Section 4975(e).

A “prohibited transaction” with respect to a self-directed IRA includes:

1) sale or exchange, or leasing, or any property between a plan and a disqualified person;

2) lending of money or other extension of credit between a plan and a disqualified person;

3) furnishing of goods, services, or facilities between a plan and a disqualified person;

4) transfer to, or use by or for the benefit of, a disqualified person the income or assets of a plan.

5) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own interests or his own account; or

6) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.

The basic rule of a “prohibited transaction” is that a self-directed IRA holder cannot do the following:

1. The IRA owner cannot enter into a transaction between the IRA and his or her spouse, a lineal ascendant (parents) or descending lineage (children), or the spouses of descendants;

2. The IRA holder cannot make personal use of the IRA’s property;

3. The IRA holder cannot personally guarantee a loan from his or her IRA nor use the IRA as collateral for a personal loan;

4. The IRA holder cannot work for or take income from an IRA investment;

5. An entity, such as a partnership, that is at least 50% owned by any combination of disqualified persons cannot transact with the self-directed IRA;

6. A 10% owner, director or other highly paid employee of such an entity cannot transact with the self-directed IRA.

When properly operated and all of the above discussed rules are carefully followed, a self-directed IRA offers the IRA owner tax deferred growth. This is a significant tax advantage. However, there are times when assets placed in a self-directed IRA have significant growth potential and it may make sense to transfer the asset to a self-directed Roth IRA in order to avoid taxation on that growth. The next subsections of this article discuss the important considerations when transferring an asset from a self-directed IRA to a self-directed Roth IRA.

What is a Self-Directed Roth IRA?

Roth IRAs are individual retirement accounts that an individual contributes into with after-tax dollars. With a Roth IRA, an individual can withdraw contributions from the Roth IRA with no additional tax or penalties. After an individual reaches age 59 ½, the participant can withdraw earnings from the Roth IRA with no tax on the IRA’s gains and earnings as long as the account was held by the participant for at least five years. The Roth IRA five year rule mandates that at least five years from January 1 of the year of the first contribution must pass from the first contribution before a Roth IRA holder can withdraw earnings and assets tax and penalty free. Thus, if an individual converted an asset from a self-directed IRA to a Roth IRA, a separate 5-year clock starts to run for each conversion in order to tax and a 10 percent penalty on the withdrawal. In addition, if an owner of a self-directed IRA is under 59 1/2, removing an asset from the IRA is subject to income tax and incurs a 10 percent penalty, unless an exemption applies. The IRS considers contributions to a Roth IRA to be withdrawn first, then conversions, and earnings last. A self-directed Roth IRA is subject to the same filing requirements and “prohibited transaction” rules discussed above that apply to self-directed IRA.

Self-Directed IRA to Self-Directed Roth IRA Asset-to Asset Conversion

If a self-directed IRA account holder expects an asset in his or her self-directed IRA to appreciate significantly in the future, transferring the asset to a self-directed Roth IRA may permit that asset’s growth to become tax-free. Below are the steps to convert an asset of a self-directed IRA to a self-directed Roth IRA.

1. A self-directed IRA account holder cannot move an asset to a self-directed Roth IRA without liquidating the asset for income tax purposes. A self-directed IRA asset-to-asset conversion is when the account owner moves investments such as real estate, business equity, or cryptocurrency directly from a self-directed IRA to a Roth self-directed IRA without selling the asset. This is a taxable event that requires a fair market value appraisal to determine the income tax consequence of the asset transfer.

2. The asset being transferred from a self-directed IRA to a self-directed Roth IRA is taxed during the year of the transfer. Transferring a self-directed IRA to a self-directed Roth IRA is a taxable conversion. This transfer is a taxable event to the self-directed IRA holder. The self-directed IRA will owe income taxes on the pre-taxed funds and earnings converted to the self-directed Roth IRA. In certain cases, a fair market valuation must be obtained for specialized assets (real estate and certain securities) before the self-directed IRA is converted to a Roth IRA.

3. The self-directed IRA holder must obtain the fair market value of the transferred asset by a certified appraiser.

4. If a self-directed Roth does not exist, a self-directed Roth IRA must be established with a custodian.

5. The self-directed IRA owner must provide instructions to the self-directed IRA custodian to move the asset from the self-directed IRA to the self-directed IRA Roth.

6. The self-directed IRA holder will pay income tax on the value of the asset transferred from the self-directed IRA to the self-directed Roth IRA.

The Importance of Proper Valuation

An asset being transferred from a self-directed IRA to a self-directed Roth IRA must be valued at its fair market value on the date of transfer. Treasury Regulation Sections 20.2031-1(b) and Treasury Regulation Section 25.2512-1 define the fair market value standard as “the price at which the property would change hands between a hypothetical willing buyer and a hypothetical willing seller, neither being under compulsion to buy or sell, and both having reasonable knowledge of the relevant facts.”

1. State law generally determines the property rights being transferred.

2. Federal tax law determines how those rights will be taxed.

3. General standard presumes hypothetical and willing seller and buyer. Actual buyer and seller are irrelevant to valuation analysis. See Est. of Bonner v. United States, 84 F. 3d 196 (5th Cir. 1996); LeFrak v. Commissioner, 66 T.C.M. (CCH) 1297, 1299 (1993). Nonetheless, the collateral consequences of the hypothetical ownership transfer are to be taken into consideration, such as the effect of a controlling or minority ownership interest.

4. No compulsion to buy or sell: not an emergency need to buy or desperation “fire sale.”

5. All relevant facts are to be considered, including those directly related to the asset to be valued, the market in which the asset is available (e.g., private sale, publicly traded, retail, or wholesale), and the general economic condition (e.g., depression, recession, modest growth, or boom times).

Although the goal in valuation for IRA tax purposes is an objective determination of the value of the self-directed IRA’s assets as of the date of the conversion, the hypothetical willing buyer/seller standard necessarily results in a subjective analysis, methodology and expert opinion play a major role. If a valuation of an asset transferred from a self-directed IRA to a self-directed Roth IRA exceeds its fair market value, the self-directed IRA holder will pay more in taxes than he or she reasonably should. On the other hand, an understatement of an asset transferred from a self-directed IRA to a self-directed Roth IRA can trigger additional tax, interest, and valuation related penalties. Section 6662 of the Internal Revenue Code provides a 20 percent penalty for the underpayment of the federal tax of $5,000 or more when the underpayment is attributable to valuation understatements. If a gross-valuation understatement occurs, the Section 6662 penalty can increase to 40 percent.

In order to avoid the overpayment of taxes or penalties for the underpayment of taxes, self-directed IRA holders that transfer assets to a self-directed Roth IRA should be a competent and professional appraiser to value the asset or assets being transferred. If the self-directed IRA owner wants the valuation of an asset to be given credence (by the IRS, the Tax Court, etc.), it is imperative that the self-directed IRA owner retain a qualified appraiser. The appraiser should maintain membership in at least one of the following professional organizations.

1. American Society of Appraisers- an independent multi-disciplinary appraiser organization whose goal is to maintain and elevate the standards of the appraisal professional.

Institute of Business Appraisers, Inc- a testing and certifying organization for appraisers in the valuation of smaller closely held businesses.

American Institute of Public Accountants- established standards which generally apply to all services provided by CPAs, including valuation engagements.

Although membership in a professional appraisal organization may be indicative of a qualified appraiser, it is not the only determining factor. The following questions should be asked of any potential appraiser:

1. How many appraisals were challenged by the IRS.

2. How many appraisals have resulted in settlements with the IRS.

3. How many litigation appearances has the appraiser and the appraiser’s form made and with what results.

Finally, in certain valuation cases, an appraiser should be well aware of the following topics discussed below in detail.

1. Lack of Marketability and Minority Interest Discounts (closely held business interests).

2. Discounting to Present Value (promissory notes).

3. Fractional Interest Discounts (real property).

Valuation Discounts

We will begin this portion of our article with a discussion on “valuation discounts.”
For purposes of an IRA, a “valuation discount” is not really a discount in the sense that the IRS holder is receiving a bargain at the expense of the IRS. Rather, the valuation discount is an appropriate factor in determining the fair market value of an asset held by an IRA. A valuation discount can be thought of as one or more factors that a hypothetical willing buyer would consider in determining a fair price to pay for an asset that is taxed in an IRA conversion. That is, if certain factors exist that would affect the hypothetical buyer’s use and enjoyment of such an asset, the hypothetical buyer would demand some sort of discount to compensate him or her for purchasing such an asset. A valuation discount can be contrasted with valuation “premium.” That is, if one or more factors exist that would enhance a hypothetical buyer’s use and enjoyment of an asset, the hypothetical seller would demand an increased purchase price. An example of such a premium is a control premium for a majority interest in a business entity. Theoretically, the fair market value of a controlling interest in a business is greater than the net asset value of the business represented by the shares of stock. This is so because, an individual with a controlling interest in a business may direct the day-to-day affairs of the business.

Lack of Marketability & Minority Interest Discounts

Although a discussion of valuation methodologies of closely held business interests is beyond the scope of this article, it is important to briefly address the two most important discounts with respect to the valuation of closely held business interests – Minority Interest Discounts and Lack of Marketability Discounts. This is so because often there is no significant dispute as to the underlying value per share of the business interest to be valued. Rather, the controversy focuses upon the applicability and size of relevant discounts.

Minority Interest Discounts

A minority interest discount is defined by the American Society of Appraisers as “a discount for lack of control applicable to a minority interest.” It entails an ownership interest in less than 50 percent of the voting interest in an enterprise. The rationale for recognizing the existence of a minority interest discount relies upon a number of factors, including the inability of a minority to realize his or her pro rata share of the entity’s net assets through liquidation, lack of control (e.g., over corporate policy, the payment of dividends, executive compensation, etc.), and other factors. Minority discounts reflect the fact that a minority shareholder lacks control over a company’s board, operating, dividend policy and liquidation decisions, so that a buyer would generally pay less when acquiring such a less advantageous position in the corporation. The essential question that must be answered in the process of supporting the existence and the qualification of a minority interest discount is what rights and benefits does the minority interest holder possess? The rights and benefits that a minority interest possess may be ascertained by identifying the elements of control, if any, held by the minority owner.

Lack of Marketability Discounts

The lack of marketability discount is based on the principle that, because the shares are not actively traded or otherwise readily marketable, an adjustment should be made per share value.

Promissory Note Valuation

A number of self-directed IRA holders hold promissory notes such as mortgages in an IRA. A promissory note in a self-directed IRA is generally valued at its outstanding principal balance plus any accrued, unpaid interest. If the note is in default or has a below-market interest rate, there may be a discount for lack of marketability.

Fractional Interest Discounts

An owner of a fractional interest in property holds an undivided interest in the entire property. Fractional interest discounts reflect the reality that a willing buyer would expect some measure of price reduction for owning less than the whole property. The value of an undivided interest in property is not equivalent to the proportionate part of the value of the entire interest. Rather, the value of a fractional interest should be less than the value of the proportionate part of the whole. To support such a discount with respect to real property, however, an appraisal by a qualified appraiser is necessary. However, a fractional interest discount can be established without a showing of comparable sales.

In Whitehead Estate v. Commissioner., T.C. Memo 1974-53, the taxpayer produced uncontroverted evidence as to the legal costs involved in a partition suit, the surveying cost involved in partitioning, and the depressing effect on the market of an undivided interest. The court found that such evidence justified a downward adjustment in the value of the property. The following factors, which generally affect marketability and control of real estate, are used by appraisers to support a fractional interest discount.

Banks generally will not lend money to the owner of a fractional interest in real property without the consent of the co-owners.

2. The historic difficulty of selling an undivided fractional interest in real property.

3. The necessity of resorting to partition and the related costs to liquidate an individual’s undivided interest.

A partition action normally involves substantial legal costs, appraisal fees, and delay.

5. The holder of a fractional interest in real estate lacks because he or she cannot unilaterally decide how to manage it.

6. The facts and circumstances might involve a land parcel the partitioning of which could be difficult or impossible owing to topographical matters- access to roads, water, other amenities, zoning problems, etc.

7. The forced sharing of control that concurrent ownership arrangements require.

8. The requirement that any hypothetical buyer must enter into a cotenancy relationship with one or more holders of a fractional interest.

9. The marketing time, cost, and real estate commission involved in selling property in the particular market.

Valuation of Businesses

Valuing a business interest (LLCs, private stock, partnerships) held in a self-directed IRA using methods like analyzing earnings multiples (EBITDA), comparing to similar sold businesses, or assessing asset values. The most common methods of valuing businesses are as follows:

1. Multiple of Earnings/SDE/EBITA: The most common method to value a business is to multiply the company’s earnings SDE i.e., Seller’s Discretionary Earnings for small businesses, EBITDA for larger ones (EBITA stands for Earnings Before Interest, Taxes, and Amortization. It is a financial metric used to measure a company’s profitability and core operational efficiency by excluding financing costs, tax obligations, and non-cash amortization expenses).

2. Market Approach: Consists of comparing the business to similar companies recently sold, often using a multiple of annual revenue of sales.

3. Asset-Based Approach: This approach calculates the total value of all the company’s assets (equipment and inventory) and subtracting liabilities to determine the net asset value.

4. Discounted Cash Value: This method involves projecting future cash flows and reducing them to their present value using a specific discount rate.

5. Capitalized Earnings: This method dividends projected future net income by a capitalization rate (expected rate of return).

In the case of stock or securities of a corporation the value of which, by reason of their not being listed on an exchange and by reason of the absence of sales thereof, cannot be determined with reference to bid and asked prices or with references to sales prices, the value thereof shall be determined by taking into consideration, in addition to all other factors, the value of stocks or securities of corporations engaged in the same or a similar line of business which are listed on an exchange. See IRC Section 2021(b).

Treasury Regulations Section 20.2031-3 and 20.2031-2(f) and (h) contain special requirements for the valuation of interests in business. All relevant factors must be considered, including:

A. A fair appraisal of all the tangibles and intangible assets of the business including goodwill;

B. The demonstrated earning capacity of the business;

C. To the extent applicable, other relevant factors, including:

1. The company’s net worth;

2. Its prospective earning power;

Its dividend-paying capacity;

4. The economic outlook in the company’s industry;

5. The company’s position in its industry;

6. Its management;

7. The degree of control of the business represented by the block of the ownership interest to be valued;

8. The values of securities of companies engaged in the same or similar lines of business that are listed on a stock exchange;

9. Nonoperating assets, including proceeds of life insurance policies payable to or for the benefit of the company (to the extent not already taken into account in determining net worth, earning capacity, and dividend-paying ability); and

10. The impact on the value of the value of the IRA’s interest in the business of an option or contract to purchase the interest owned by the IRA.

The IRS has issued a number of Revenue Provisions for the valuation of nonpublicily traded stock and closely held corporations. Below is a list of Revenue Rulings that may assist in valuing corporate stocks in the context of a transfer of a self-directed IRA to a self-directed Roth IRA.

1. Revenue Ruling 59-60, 1959-1 C.B. 237, contains the basic guidelines for valuing closely held stocks.

Revenue Ruling 65-193, 1965-1 C.B. 370, modifies Revenue Ruling 59-60 somewhat in the context of intangible assets of a business.

3. Revenue Ruling 77-287, 1977-2 C.B. 319 amplifies Revenue Ruling 59-60 by providing guidelines for discounts to be applied to publicly traded stock the transfer of which is restricted under federal securities laws.

Valuing Pre-IPO Shares

Sometimes a self-directed IRA will hold pre-IPO (Initial Public Offering) stocks which may dramatically increase in value in the near future. The transfer of a pre-IPO raises a number of complicated issues that are beyond the scope of this article. In general, valuing pre-IPO stocks includes estimating a private company’s worth before public trading typically using the recent funding round prices, or discounted cash flow analysis. Key methods include comparing metrics (EV/Revenue) to similar public companies, assessing private secondary market sales, and reviewing growth prospects. Valuation of pre-IPO stock in an IRA is done using independent, fair market value assessment, typically, based on the last funding round price, 409A valuations, or secondary market transactions.

Discounting Valuation of Ownership Interests

Perhaps the most common way to discount the valuation of a business in a self-directed IRA could be the way ownership interest is held: e.g., minority interest versus controlling interest; general partner interest versus limited partner interest; common stock versus preferred stock; freely traded publicly traded stock versus restricted stock. The ownership interest in the business being transferred by the self-directed IRA to a self-directed Roth IRA may result in a “discount” in the valuation of the value of the business interest for income tax purposes. The term “discount” in this context is merely a shorthand expression of the difference between the valuation conclusion using two different valuation methods. For example, if a self-directed IRA’s interest in a pre-IPO stock is valued based on its liquidation value at $10,000,000 and at $6,000,000 using a discounted cash flow method valuation, the “discount” resulting from using the latter method would be 40 percent (($10,000,000 – $6,000,000 = $4,000,000 / $10,000,000 = 40%)). In appraisal parlance, the term “discount” most often is used in referring to components of the overall valuation analysis, such as a marketability discount, which is an expression of the difference in value when one stock is readily traded, such as for publicly traded stock, and another is closely held. Similarly, minority discount is an expression of the difference between the value of a controlling interest and a minority interest in the entity.

Cryptocurrency Valuation

For self-directed IRA purposes, cryptocurrency is valued at its fair market value. In certain cases, determining the fair market value of cryptocurrency can be extremely complicated and is beyond the scope of this article. As a general rule, cryptocurrency for purposes of valuation in a self-directed IRA transaction, includes such common valuation methods as: 1) Selling for Fiat (USD): the valuation of the cryptocurrency asset is determined on the difference between the sale price and the IRA’s basis in the asset; 2) Crypto-to-Crypto Trading: the valuation is determined by exchanging one crypto for another; and 3) Mining and Rewards: the valuation of cryptocurrency obtained through mining raises a number a valuation challenges.

Cryptocurrency mining involves using computing power to validate blockchains and earn cryptocurrency. Cryptocurrency mining through a self-directed IRA is typically viewed by the IRS as a taxable activity subject to UBTI. The IRS considers cryptocurrency mining a “trade or business” rather than passive activity. This should come as no surprise because cryptocurrency mining operations typically require significant involvement of the investor. The individual or entity involved in cryptocurrency mining must make significant investments in hardware and monitor electricity usage and costs, which are critical to profitability. Individuals and entities involved in cryptocurrency mining operations are often actively involved in the day-to-day operations of the mining activity. By being a material participant in the day-to-day operations of cryptomining, the individual or entity involved in the mining is considered to be in an active trade or business. It is easy to understand as to why the IRS treats cryptocurrency mining activity done through a self-directed IRA as being subject to UBTI. But what about situations where cryptocurrency mining is done on a very small scale through a self-directed IRA, is it possible to treat the cryptocurrency mining as passive rather than as a trade or business and not be subject to UBTI?

In certain cases, it is possible to treat cryptocurrency mining as passive and not subject to UBTI.  Whether or not cryptocurrency mining can be treated as a passive activity that is not subject to UBTI will likely depend on the blockchain network in which the mining activity takes place. Two of the most prevalent decentralized networks are Bitcoin and Ethereum. Bitcoin mining secures the network and verifies transactions by having computers (“miners”) solve complex cryptographic puzzles using high-powered hardware or (“ASICs”). Miners compete to find a specific 64-digit hexadecimal number (hash). The winner adds a new block to the blockchain and receives newly created bitcoin. Bitcoin mining is highly competitive in that participants compete aggressively to find the cheapest sources of power to run their machines, use highly optimized hardware to gain an advantage, and make dynamic decisions about power, timing, and contracts to stay ahead.

Ethereum cannot be mined without a Proof-of-Work form due to its shift to Proof-of-Stake. To generate Ethereum, the person or organization must stake, not mine. However, an individual or organization can still mine other GPU-mintable coins (e.g., Ethereum Classic) using GPUs (Nvidia/AMD) or ASICs (e.g, Bitmain Antminer E9). Ethereum is a permissionless system. Any person or organization willing to stake (lock up) 32 Ethereum can participate in the network. Ethereum operates a marketplace where validators bid to execute transactions and receive “gas” from bidders for executing their workloads on the network. Ethereum validators compete aggressively with one another and use highly optimized hardware and strategies to reduce costs and earn the right to compute workloads.

It is easy to understand how Bitcoin and Ethereum mining can be treated as a trade or business rather than as a passive activity. Other blockchain networks operate under a model completely different from that of the two most prevalent decentralized networks of Bitcoin and Ethereum. Some blockchain networks grant a license and the intangible right to register on their network and receive reward compensation based on a return on risk capital and money payments to offset fixed charges. Payments on these blockchain networks may use an algorithm that emits tokens to a wallet based on time on the network. Some networks may eliminate the “commercial business” from cryptocurrency mining such as selecting hardware, negotiating equipment purchases, and selecting partners. Consequently, mining in certain decentralized networks could potentially be classified as a passive activity or revenue received from royalties. In cases where the acquisition of cryptocurrency was obtained through passive activity and it was not taxed as UBTI, the cryptocurrency must be taxed at its fair market when it is transferred from a self-directed IRA to a self-directed Roth IRA.

Regardless of the theory used to determine the fair market value of cryptocurrency between transferred from a self-directed IRA to a self-directed Roth IRA, the IRA holder will need the following information to determine the tax consequences of the transfer of the cryptocurrency from a self-directed IRA to a self-directed Roth IRA:

1. The date of acquisition of the cryptocurrency;

2. The cost basis of the cryptocurrency;

3. The fair market value of the cryptocurrency at the date of its transfer;

4. The date of disposition.

Conclusion

The foregoing discussion is intended to provide the reader with a basic understanding regarding the taxation of an asset from a self-directed IRA to a self-directed Roth IRA. It should be evident from this article that in order to properly transfer an asset from a self-directed IRA to a self-directed Roth IRA, it is crucial for an account holder to retain the services of a qualified tax attorney and appraiser. Because the quality of the appraiser’s report is significantly affected by the quality of the factual information the appraiser receives, the tax attorney involved in the IRA rollover must work closely with the appraiser in obtaining the information that will serve as the basis for the appraiser’s report. The tax attorney should not expect the appraiser to go off and do his or her work without significant input from the tax attorney and the IRA account holder. The tax attorney is often the IRA account holder’s adviser in the best position to have an overall understanding of the factual information supporting the valuation determination. The tax attorney must be prepared to convey it to the appraiser and to the IRS or the courts if a dispute arises. In general, the tax attorney needs to be the quarterback to make sure the appraisal process proceeds in an orderly and efficient manner. The tax attorney often has the closest relationship with the self-directed IRA account holder and other account holder advisors. This means that the appraiser typically will depend on the tax attorney for assistance in moving things along with the tax attorney for assistance in moving things along with the account holder.

Anthony Diosdi is a tax attorney at Diosdi & Liu, LLP. He has significant experience defending private clients before the IRS in difficult and complex tax disputes. Anthony counsels clients through examinations and liability disputes and, when necessary, takes disputed issues to court. Anthony has advised a significant number of individuals who hold self-directed IRAs that contain cryptocurrency, pre-IPO shares, unlisted shares, and late-stage private equity, domestic and foreign corporations.

Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.