Let’s squelch any misconceptions now: It was the government itself—not a cabal of maverick tax lawyers—that created self-directed IRAs for your benefit. Consequently, self-directed IRAs are not magnets for IRS scrutiny.
The concept for self-directed IRAs is as old as the 1974 ERISA law that created IRAs and 401(k)s. At that time, Congress ruled that employees—not employers—should determine where to invest individual tax-deferred retirement monies. In other words, the government wants you to take personal responsibility for your own retirement account.
Spurred by the aging baby boomer population and a schizophrenic stock market, investors are now choosing to take a more hands-on approach to controlling their retirement money. The result is a rapidly growing self-directed IRA industry. Both beginning and experienced investors are discovering the advantages of personally directing their IRA investments into a near-limitless variety of traditional and nontraditional arenas, including real estate, tax liens, personal loans, etc.
1) Learn the two prohibited investments
With a self-directed IRA, your investment opportunities are remarkably wide open and, according to the tax code, there are only two investments closed to you:
- Collectibles (purchasing art, antiques, rugs, coins, stamps, wine, cars, etc.)
- Life Insurance Benefits (purchasing life insurance benefits from a policy holder)
Other than these two exceptions, you can grow your retirement account by investing in just about anything you feel would return a healthy profit—whether it be rental properties, tax liens, private stock placements, or even royalties from movie productions.
2) Understand conflicts of interest
When you take personal control of your IRA transactions, you, in effect, become the fiduciary or trustee of your account—so you must conscientiously avoid any conflict of interest. Every investment you make should be for the exclusive benefit of your retirement account and not for the immediate benefit of you or another disqualified person. The IRS and Department of Labor have defined disqualified persons and prohibited transactions in the Internal Revenue Code (IRC § 4975) and its ERISA counterpart. Below is a list of the main prohibited parties:
- The IRA owner; his or her ancestor; his or her lineal descendents (i.e., parents, grandparents, children or grandchildren)
- The spouse of the IRA owner
- Financial advisors and other fiduciaries
- Any entity owned 50% or more by a disqualified party (such as a business half-owned or more by the IRA holder’s daughter)
Some examples of prohibited transactions include:
- Renting IRA-owned property to lineal family members or a spouse
- Lending IRA cash at a below-market rate to a friend
- Paying yourself from income derived from an IRA investment
- Personally guaranteeing a loan to an IRA asset
Your familiarity with these caveats—combined with some judicious use of common sense should help keep your self-directed IRA investments running smoothly.
Tip: Additionally, be sure to stay away from investing your IRA money into an S corporation. S corporations only allow individuals (not entities) and certain permitted trusts to be investors. So if your IRA (an entity) is the investor, the S Corp would lose its status and its tax rate would change to a potentially less favorable one.
3) Evaluate UBIT and UDFI
Self-directed retirement accounts are not taxed for most of the investments people pursue with them, including rental income, interest from loans, dividends from corporate stock, etc. However, there are certain types of investments that, while acceptable for a self-directed IRA to make, ARE subject to being taxed at what are commonly referred to as "trust rates." You’ll want to be conscious of any transactions that might trigger unrelated business income taxes (UBIT) or produce unrelated debt financed income (UDFI). This is one area where it may take more than common sense to navigate the tax code. If you suspect you may be about to make a transaction that could generate UBIT or UDFI, it is advisable to work with a tax professional.
The government requires that all businesses in the U.S. pay taxes. If any business sells some or all of its products or services without paying taxes, it would have an unfair advantage over its competitors. For this reason, UBIT could be triggered if your IRA owns all or part of a business that earns its income through the sale of a product or service. Flipping real estate and developing land for resale are examples of investments that are, more often than not, considered "businesses"—which makes profits generated by such activities fair game for taxation.
Tip: Rental income is not subject to UBIT; however, if your investment was made using your IRA money plus debt financing or leverage, portions of the income/profits you generate would be subject to UDFI. This tax would apply only to the percentage of profit realized through borrowed capital, not through your own retirement funds.
4) Consult with your advisor
Always check with your financial advisor should you have any questions about your self-directed IRA transaction. Take advantage, too, of the free consultations offered by many financial services companies that structure self-directed IRAs. By keeping these few prohibitions in mind, you should be able to enjoy the convenience of self-directed IRAs and the many benefits that come with them. And the IRS should be pleased that you’re making good use of the “power-to-the-people” retirement program the