Given the recent market volatility, advisers have questioned whether you can deduct losses incurred within an IRA. The answer is no. Losses as well as gains are never recognized within an IRA.
That was always the case, but that didn't stop an attorney from testing this in a recent tax court case. He lost. It cost him more than $15,000 in taxes plus a $3,000 accuracy-related penalty. (Ronald C. Fish v. Commissioner, (2015) TC Memo 2015-176 Sept. 10, 2015)
The only way you can deduct a loss in an IRA is when all the funds from all IRAs are withdrawn, and there must be basis. For an IRA, basis means nondeductible (after-tax) funds, which most traditional IRAs don't have that much of.
Read more:
Who keeps track of IRA basis?
To claim a loss, all funds from all IRAs, including SEP and SIMPLE IRAs must be withdrawn, and the amount withdrawn must be less than the basis, otherwise there is no loss. Even then, a loss only may be deductible. It can only be deducted by itemizing deductions on Schedule A (Form 1040), and even then, only maybe. The loss must be claimed as a miscellaneous itemized deduction subject to the 2% adjusted gross income limitation. Even then, the loss deduction is still not guaranteed. If the alternative minimum tax applies (AMT), the deduction is lost. Even without the AMT, high income clients could lose up to 80% of the loss (along with several other itemized deductions) to the overall 3% phase-out of itemized deductions.
The ability to claim a loss is more likely with a Roth IRA, since Roth IRAs generally contain more basis. Roth IRAs contain mostly after-tax funds.
If a Roth IRA owner has a loss on a Roth IRA investment, they can recognize the loss on their income tax return, but only when all the amounts in all their Roth IRAs have been distributed and the total distributions are less than their unrecovered basis. For a Roth IRA, basis is the total amount of tax year contributions and converted funds in all Roth IRAs.
[More: Who’s keeping track of IRA basis?]
The rules for recognizing a loss apply separately to traditional and Roth IRAs. For a person to claim a Roth IRA loss on their income tax return, all of the funds in all their Roth IRAs (but not traditional IRAs) must be distributed.
Even then, it might not be worth it to withdraw all of a client's Roth IRAs to claim a loss that may not even be deductible.
THE TAX COURT CASE
Ronald Fish was a semi-retired patent attorney living in California. He had a traditional IRA during 2009 and used it to buy and sell various securities, including shares of two master limited partnerships that were involved in the oil and gas pipeline and storage industry. Mr. Fish received a Schedule K-1 from each of the partnerships. Both reported an ordinary business loss for 2009 and both stated that the partner was an "IRA/SEP/KEOGH." Right there, that should tell you that this is a non-reportable loss, since it was within an IRA.
Mr. Fish reported the losses on the Schedule E of his 2009 Form 1040. The IRS disallowed the deduction for the losses. Mr. Fish brought the case to tax court challenging the IRS's disallowance of the claimed deduction for the losses. He represented himself. You know the rest of the story.
At tax court, Mr. Fish argued that an IRA should be treated as a pass-through entity which would mean all items of income, deductions and credits would be treated as belonging to him and reportable on his individual tax return. He tried to claim that his IRA was really the same as a pass-through grantor trust. Based on that logic, his IRA gains too, if he had them, would be taxable, but they are not.
Mr. Fish lost his case. The tax court held that Mr. Fish could not deduct the losses. The court said that an IRA is a tax-exempt entity, not a pass-through entity.
The court reminded Mr. Fish that while he might disagree with the rule that a taxpayer may recognize a loss from IRA investments only when all amounts from all IRAs have been distributed and the total distributions are less than any unrecovered basis, the court did not have the power to change the rule for him.
The court said that they must decide cases on the basis of the law actually enacted by Congress, not on the basis of a taxpayer's policy arguments as to how he believed the law should have been written.
The court also held that Mr. Fish was liable for the 20% accuracy-related penalty. In assessing this penalty, it noted: “A seasoned attorney would not have taken the position petitioner took on his return.”
Attorney Mr. Fish learned the hard way that when it comes to claiming losses, you are not your IRA. While it may be possible to claim a loss on an IRA investment, the rules are very limited and specific.
Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott's Elite IRA Advisor Group. He can be reached at irahelp.com.
