The Self-Directed IRA – The Basics all Estate Planners Should Know

  

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By: Warren Baker
Amicus Law Group, PC
warren@amicuslawgroup.com

Investing retirement funds into "alternative" investments, such as privately-held businesses, real estate, private loans, tax liens, etc. can be liberating for many entrepreneurial types and/or "I hate the stock market" people, but it is fraught with complexity, gray areas, and tax landmines.  If you have a client that proclaims “I am going to buy real estate with my IRA!” (or something similar), it will be important for you as their advisor to understand some basic issues.

To start with, what is a "self-directed" IRA? The vast majority of people that have a retirement plan, whether it's in the form of an IRA, 401(k), 403(b), etc. have their money invested in "traditional" types of investment, e.g. stocks, bonds, mutual funds. However, the general rules governing an IRA allow for any type of investment except for investments into "collectibles" (e.g. rare coins, antique cars, wine, etc.) and "life insurance contracts." That sounds great in theory, but in order to actually invest retirement money into "alternative" types of investments your client will need to find a custodian that will allow this type of investment. This realization leads many people to an Internet search engine.

Typing "self-directed IRA" into Google will bring a bevy of results. Many of the top results will be sponsored links from companies that would like to assist you in setting up one of these structures. You will also find many articles and commentaries on the topic. However, the information online, as with many complicated tax topics, will result in a wide variety of information, ranging from very helpful to blatantly wrong. In addition, it's likely that your client will immediately have questions, such as: "what does checkbook control mean?", "what is a 'custodian' and what role do they play?", and "how do I make this happen?"

There are two basic methods for investing retirement funds into alternative assets and both require your client to first "roll" current retirement assets into a new IRA held by a specialized type of custodian. This will likely raise the first major hurdle: is your client even eligible to move their retirement funds from their current location? This is a question that your client will need to ask their current custodian, but in general, most IRAs and 401(k)s from a previous employer are able to be rolled tax-free into a new IRA. Once your client determines that they are allowed to move their retirement account, your client will need to decide the exact method they will use to purchase the alternative assets.

Let's assume for a moment that your client’s goal is to invest into a piece of residential rental real estate. Your client can either:

(1) request that the new custodian purchase the property directly on behalf of the IRA; or

(2) direct the custodian to first invest the IRA into a Limited Liability Company ("LLC") that is thereafter 100% owned by the IRA and purchase the property using the LL (note: your client will act as the Manager of this LLC).

The latter option gives your client the flexibility to purchase the property using a check from the LLC's checking account, which depending on the custodian's ability to move quickly, will be quicker than option number one. For tax purposes, because the LLC is a "flow-through" tax entity, investments made using either method are normally tax deferred (but see more on this below), just like investing into stocks, bonds, mutual funds, etc. using an IRA. The method of setting up an IRA-owned LLC structure is normally facilitated by a third-party company or law firm - hence the ads on Google.

Once your client has set up their self-directed IRA structure, it is vital for them (and you) to be well-informed regarding the federal and state rules and regulations prior to investing. Under federal law, if your client uses the structure in a way that creates a "prohibited transaction," the IRA will lose its tax-favored treatment and the entire value of the IRA (not just the amount involved in the specific transaction) will be taxable to your client in one year. In addition, if the prohibited transaction is discovered (e.g. by an IRS audit) several years after it occurred, your client could face huge penalties and interest charges. The most common way for a prohibited transaction to occur is an interaction between the IRA (or IRA-owned LLC) and a "disqualified person" - which includes the account holder of the IRA, his or her spouse, many of his or her family members, and certain businesses and business partners associated with him or her. Also, if a disqualified person personally benefits from the IRA's (or IRA-owned LLC's) investments, a prohibited transaction will occur. The classic violation of this rule occurs when the IRA account holder tries to use the property owned by the IRA (or IRA-owned LLC).

In addition to prohibited transaction concerns, it is possible for the IRA (or IRA-owned LLC) to invest in a manner that creates immediate tax consequences to the IRA itself. As mentioned above, an IRA's investment income is normally tax-deferred until a later date when the IRA account holder removes the money from the IRA. However, if an IRA invests using debt-financing (i.e. a mortgage) or earns income from an active business, the IRA's income is not tax-exempt and the IRA will have to file a tax return and pay a tax. This situation significantly complicates the filing requirements imposed on the IRA (or IRA-owned LLC).

Finally, if all of the above was not enough, you and your client must also be properly educated on the following issues prior to investing out of a self-directed IRA:

(1) State-specific issues that can apply to alternative types of IRA investments (e.g. possible state, county, and city filing requirements);

(2) Dealing with expenses that arise from alternative types of investments (e.g. real estate maintenance costs, property taxes, etc.);

(3) Proper record keeping in order to prove, if necessary, that none of the above prohibited transaction or tax issues arose;

(4) How to deal with on-going IRA contributions and eventual IRA distributions; and

(5) Understanding the ramifications of owning a self-directed IRA at your death (e.g. beneficiary designations, estate tax valuation issues (non-liquid assets), on-going management of the IRA-owned LLC, etc.)

Despite all of the complexities and tax issues that the account holder of a self-directed IRA will need to address (often times with the help of their advisors), many clients find these structures to be helpful in achieving their long-term goals of retirement plan diversification and growth

Editor Notes:

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