Why Capital Losses Don’t Apply to IRAs
QUESTION: In one of the Individual Retirement Accounts that I set up before the 1986 tax law changes, I invested in stock and warrants that have since become worthless. Since I have managed to accumulate only losses, I would like to close out the account. However, the IRS says because I did not pay any income taxes on the money I used to open the account, I have no basis against which to claim a loss. Is this true? Is there any way I can claim these losses against my personal income? Should I just hold on to the account and hope I can generate enough gains to offset the loss?--J. M.
ANSWER: Your situation, our experts say, demonstrates why IRAs should be put in the most secure investments possible. Why? Because the capital loss deductions which apply to other investments are not available for IRAs.
The reason is that you opened the account with money you had not yet paid income taxes on, and, if the account generated any earnings, those funds had not yet been taxed. So, unlike other investments that are generally made with after-tax dollars, your IRA provides no tax basis against which to claim a loss. Further, and for the same reasons, the IRS does not allow you to deduct the losses against any personal income.
Now, should you try to build up that account again to offset the loss? Only you can decide whether you want to stick with what has proven so far to be a disastrous investment strategy. But here’s the tax perspective: The assets in IRAs are tax-deferred until the money is withdrawn, so if you build up the account again, you will be taxed on any withdrawals you make from it.
It’s not a matter of generating gains to offset losses for tax purposes but a question of whether you stand a chance of earning back your initial nest egg. You will be taxed on whatever you withdraw from the account. If you withdraw nothing, you have no tax obligation; if you miraculously build the account up to, say, $100,000, you will be taxed on your withdrawals when you make them.
IRS Regulations Say Record Loan and Deed
Q: In a recent column you discussed a parent’s lending money to a child and taking a second trust deed back on the child’s house in order for the child to declare the interest payments as a tax deduction. In your answer, you implied that recording the loan at the county or other appropriate government agency was optional. However, it is my understanding that recording the loan and deed is mandatory. Am I correct?--G.W.
A: Technically, yes. According to Internal Revenue Service regulations, recording the loan and deed is required in those states where document recording is permitted. California is one such state. So, if you want to be in strict compliance with all IRS regulations, you should get the deed recorded, if you can.
Why should you have to go to all this trouble? The IRS doesn’t want taxpayers claiming deductions to which they are not entitled. If you have gotten a loan from someone that is not secured by a trust deed on your house, the interest on that loan is considered personal interest, not mortgage interest, and is not fully deductible.
In 1990, just 10% of personal interest is deductible, and the deduction is eliminated entirely thereafter. However, mortgage interest on second trust deeds of up to $100,000 is fully deductible, providing that the loan does not bring the total debt on the house to above its fair market value.
By requiring you to record the loan and deed, the IRS is making taxpayers declare from the outset that the loan is secured by a home mortgage and therefore fully deductible. Without this requirement, a taxpayer involved in an audit theoretically could backdate a trust deed to support his deduction of the loan interest. Such a move is virtually impossible--and certainly illegal--if the document must be recorded.
Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest.
