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By John “Jack” F. Kiley, CPA, CISP
Managing Partner / MidAtlantic IRA, LLC
Now that we are into the New Year, savvy investors holding real estate in traditional IRAs are assessing whether now is a good time to convert those IRAs to Roth IRAs. The main reason investors consider converting is to place those retirement plans in a better tax position. Keep in mind that earnings on Roth IRA investments grow tax free as opposed to just growing tax deferred as in the case of Traditional IRAs. When you convert to a Roth IRA, you pay tax in the current year on the fair market value of the property at the time of the conversion. Two of the other benefits of Roth IRAs are that you do not have to begin taking distributions at age 70 ½ and you can continue to contribute up to the maximum annual allowable amount as long as you have earned income (for a more in depth discussion, please refer to the article ‘Does Converting to a Roth IRA Make Sense for You?’).

With real estate an additional consideration comes into play when thinking about converting. Because real estate is not a liquid asset and the real estate market tends to be inefficient (unlike stocks there is not always a ready market to buy or sell real estate), your property may be undervalued. Here lies the opportunity. Suppose you own a property that you feel is worth $200k in your traditional IRA, but given the current economic environment, the ‘market’ values the property at $150k.  If you convert at the current market value ($150k), you will lock in the difference ($50k gain) as tax free. Stated differently, you will never pay tax on the $50k difference.
Another advantage to looking at this now is that you have more than a year to settle up on the tax because the tax return for this year is not due until April 15 of NEXT year. If you converted the property above valued at $150k, the tax would be $50k (assuming a 33% tax bracket). If you converted in February, you would have fourteen months to pay the tax.

Of course one of the biggest worries is, “what if my analysis of the market is wrong?” You wouldn’t want to pay tax needlessly. Here the IRS provides us with a mechanism to unwind the transaction. We are able to recharacterize the newly formed Roth IRA back to a traditional IRA as if the transaction never occurred. Further, we have an astonishingly long time to do this. The recharacterization does not have to be complete until October 15 of the year following the year of the conversion (the date of the final extended due date for individuals). So in continuing with our example, let’s say that by June in the year following the conversion the value in our property has not bounced back. In fact, lets say now the property is only values at $100k. We simply notify the custodian to recharacterize the property and we will no longer owe the tax.  (For further discussion on recharacterizations see our article “Roth Recharactorizations, Hindsight can be 20/20.”)

When properly planned, converting to a Roth IRA can produce a significant tax savings with little downside risk. The time of conversion to the time when you have to pay the tax could be as long as fifteen months (if you convert in January of year 1, tax must be paid by April 15 of year 2). If the investment’s value has not performed to your expectations, you  could have as much as 21 months from the time you converted to decide this is not what you wanted to do (if you converted Jan of year 1, must recharacterize by Oct 15 of year 2). With a time line this long and proper planning, converting to Roth should not yield an unexpected tax bill.
With proper planning Roth conversions can be a powerful and accurate tax planning tool.