Self-directed IRAs open up investment opportunities, but carry risks. A wrong move can result in current taxation of IRA income, immediate taxation of all assets in the IRA, and a variety of penalties.
Although the stakes are high, a self-directed IRA might be just the thing for the IRA owner with the time, energy and patience to take control. In assessing the options, the key is to nail down what needs to be done and who will do it.
What Custodians Do
A custodian holds IRA assets in trust for the IRA owner under a custodial agreement. Typically, it is the custodian’s job to identify a range of suitable investment options, manage the investments, and perform compliance due diligence.
They also make sure IRS rules are followed for contributions, distributions, and reporting. They file Form 5498 IRA Contribution Information for each IRA account under their custody, and report the fair market value of IRA assets. They submit Form 1099-R Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., each year that an IRA withdrawal occurs and identify the total distributions from the account during the calendar year.
Many custodians limit investment options to publicly traded funds, stocks or bonds. These are the conventional assets that form the vast bulk of IRA investments.
These kinds of assets are fairly easy to administer. Income consists of yearly dividends and interest, the fair market value is the market price, and reporting is straightforward.
In general, the division of authority and obligations are clear. The IRA owner chooses from among a range of investment options, and the custodian does the rest.
Some custodians allow their customers to invest in “unconventional” assets. Popular unconventional assets include real estate, private equity and hedge funds. The list also includes promissory notes, equipment leases, energy investments, precious metals, agriculture-based assets, foreign-based assets, virtual currency, and tax liens. Some allow holding closely held businesses.
Caution: IRAs are prohibited from owning life insurance contracts and collectibles. Collectibles for this purpose would include art, rugs, antiques, metal, gems, stamps, coins or alcoholic beverages. Note that the IRS does not keep a list of permissible investments.
IRA owners seeking unconventional assets are typically motivated to:
- avoid the stock market;
- diversify their retirement portfolio;
- invest in a kind of asset they know and understand; or
- invest in a company that is not publicly traded.
Custodians that allow unconventional assets do so by offering self-directed IRAs. These types of IRAs shift more of the day to day investment burden to the IRA owner. Typically, it may be the owner’s responsibility to:
- identify and locate potential assets;
- assess investment suitability and risks;
- assess prohibited transaction risks;
- collect, review, and prepare all purchase documents for the custodian to execute;
- direct, manage and monitor the investments;
- hire necessary professional advisors such as attorneys, accountants, tax advisors or planners;
- decide whether to retain assets;
- direct custodian to make required minimum distributions; and
- assume the risk of noncompliance and the loss of their investment’s tax favored status.
Self-directed IRAs still require the owner to act through the custodian. Although many of the investment and compliance burdens are shifted to the owner, custodians may have to be more involved in managing the assets. For example, a custodian that allows the IRA to own rental real estate has to pay all expenses from IRA funds, and add income to the IRA. Of course, this extra work generates extra fees.
Checkbook IRA LLCs
Checkbook IRA LLCs allow the IRA owner to make investments directly without going through the custodian. The IRA owner sets up an LLC, and directs the IRA custodian to invest in it. The owner is named a nonsalaried manager of the LLC. The owner opens a business checking account linked to IRA funds. The owner can then act quickly to buy assets without having to wait for a custodian.
Typically, checkbook control IRAs are marketed for investors who already have personal knowledge or expertise in a narrow investment area. For example, real estate professionals might have a deep understanding of the opportunities and risks of investing in their local property markets. They do not need a custodian to second guess them.
Saving Custodial Fees
Checkbook control also allows IRA owners to save some custodial fees by doing some of the investment management themselves. For example, an owner whose IRA LLC holds rental property can as manager of the LLC issue checks to pay bills. These might include bills for property taxes, insurance premiums, utilities, repairs and maintenance.
For the owner to be so involved in managing the asset, it is crucial that the owner understand the effect of the rules regarding:
- prohibited transactions,
- unrelated business income, and
- the tax rules on IRA contributions and distributions.
The prohibited transaction rules limit what an owner can do with IRA assets without risking penalties and current taxation of the entire IRA. The purpose of these rules is to prevent the retirement account own from benefiting from the IRA other than as a retirement asset.
Prohibited transactions between a plan and a disqualified person include:
- sale, exchange or lease of property;
- lending money or extending credit;
- furnishing goods, services or facilities;
- transfer or use of plan income or assets;
- act by a disqualified person who is a fiduciary with respect to plan income or assets; and
- receipt of consideration by disqualified person who is a fiduciary.
A “disqualified person” can include the IRA owner, certain family members, and persons providing services to the plan. Examples of a prohibited transaction include:
- buying property for the owner’s personal use;
- selling the owner’s property to the IRA;
- taking a salary; and
- borrowing money or using the IRA as security for a loan.
Consequences of a Prohibited Transaction:
If the IRA owner engages in a prohibited transaction, the IRA is treated as distributing all of its assets to the owner at the FMV on the first day of the year in which the transaction occurred. The owner may also be subject to a 10 percent additional tax on early distributions unless an exception applies. Separate prohibited transaction penalties may apply to disqualified persons.
Prohibited transactions are more likely to arise with investments in promissory notes, private equity, and real estate because these investments can involve disqualified family members or other disqualified persons. Disqualified family members include parents, children, and spouses.
IRA investments in rental real estate, with its many transactions, can leave owners susceptible to a number of prohibited transactions, any one of which would result in the loss of the IRA’s tax-favored status. For example, an IRA owner cannot:
- live in any property owned by the IRA;
- rent to certain relatives;
- pay bills or deposit checks with their own account rather than through the IRA LLC account; or personally repair a rental home.
Unrelated Business Income Taxes
IRA earnings are typically reinvested with taxes deferred until distribution. However, two taxes may apply currently:
- Unrelated Business Taxable Income (UBTI); and
- Unrelated Debt-Financed Income (UDFI).
Unrelated business taxable income is gross income generated from an ongoing trade or business (less allowable deductions) that is not related to the tax-deferred purposes of the IRA. An IRA that earns $1,000 or more of gross income from an unrelated business must file Form 990-T with IRS and pay related taxes.
Caution: UBTI for a self-directed IRA is taxed at trust rates. In 2019, the maximum rate is 37 percent that fully kicks in at just $12,501.
Comment: Typically, IRA custodians require IRA owners to monitor their unconventional assets for taxable business income and Form 990-T filing requirements (including making quarterly estimated payments). Note that the custodian must make the filings and pay the tax from the IRA.
Unrelated debt-financed income is a form of UBTI. If an asset purchased by an IRA is debt-financed (e.g., a mortgage on a rental property), income produced by that asset could be subject to taxes.
Comment: Rental income is generally excluded from UBIT as are property sale proceeds (as long as the property is not held in the normal course of business). However, the portion of gross income attributable to a mortgage loan would generate taxable UDFI. Other income excluded from UBIT includes C corporation dividends, interest, and royalties.
Investing in Someone Else’s Business
An IRA can buy equity in a non-publicly traded business. The transaction should be an arm’s length purchase in a business operated by someone unrelated to the IRA owner.
Caution: A risk is that the IRA owner will be deemed to own the assets of the business. The Department of Labor has lengthy “look through” regulations regarding under what circumstances an equity investment by IRA in corporation or partnership will be treated as direct ownership of the business’s assets. Professional guidance is essential for this type of transaction.
Comment: Custodians that only provide for publicly traded assets nevertheless sometimes allow the IRA owner to buy non-publicly traded stock for the IRA. In that case, the custodian would issue a check to the corporation on behalf of the IRA and the owner would deliver the check. Because this is not considered a distribution, the rollover rules do not apply. Accordingly, it does not matter if the stock is delivered more than 60 days after the check is delivered.
Investing in the IRA Owner’s Business
Operating one’s own business through an IRA is fraught with potential prohibited transactions. It is hard to find anyone who recommends this course of action.
As for using the IRA for financing, the rule is that an IRA cannot extend credit or be used as collateral for any loan.
The safest way to use an IRA to support the owner’s business is to take taxable distributions on an as-needed basis. A good time to take fully taxable distributions is during a business’s start-up years. Businesses typically generate losses in their early years, or at least minimal income. This option is better for individuals who do not need to worry about early withdrawal 10 percent additional tax because they are at least age 59 ½, or come under some other exception.
There are plenty of custodians eager to sell self-directed IRAs. The best advice is to investigate thoroughly. A good custodian will make the risks and obligations clear up front. Independent advice from a CPA, investment advisor, or attorney steeped in these matters is essential.
In the end, however, it is up to the IRA owner to make it work.
By James Solheim, J.D.