Self-Directed IRAs, the DOL Fiduciary Rule, and Private Investment Denials

The so-called “DOL Fiduciary Rule” went into effect in June and has caused negative repercussions on self-directed retirement account investors who self-directed their IRA, 401(k), or pension into alternative investments. Many self-directed investors have been shut out from investing into private offerings – real estate funds, private placements, start-ups, private REITs, etc. – as investment sponsors or private companies raising funds fear that, by accepting the self-directed retirement account’s investment, they will be labeled a “fiduciary” and will need to adhere to fiduciary rules really meant for investment advisers.

What is a Fiduciary?

The Department of Labor (“DOL”) recently expanded the definition of who a “fiduciary” is to include any person or entity who renders “investment advice” for a fee or other compensation. The fee doesn’t need to be from the compensation itself, but just has to flow from the investment. Here’s the problem: If you run a private fund, start-up, or a real estate partnership, and you take investment dollars from a retirement account, then the DOL definition may include you as a fiduciary since your investment documents will likely contain information that would be considered “investment advice.” And, since you will indirectly receiving compensation as a part of management of the fund or start-up, then you are indirectly receiving a fee for providing investment advice and may consequently be deemed a fiduciary.

Fiduciary Rule Repercussions

Most investment sponsors dread being labelled a fiduciary as they are placed with very high legal standards including as the duty of prudence, the duty of loyalty, and they have to avoid self-dealing prohibited transactions that may arise if they are receiving any compensation that isn’t found to be “reasonable”. In short, application of the fiduciary rule makes them re-align the company’s or management’s interests to be in the best interest of the invested retirement account. While this sounds like a good deal for the retirement account investor – and it is – it puts the interests of management at odds with the retirement account, and creates significant liability to management if they accept retirement plan dollars when they are a fiduciary.

The fiduciary rule was primarily intended to apply to an adviser advising a client so that the investment adviser recommended investments in the best interest of the client, not just the highest paying commission for the adviser. Although that makes sense, the new definition is so broad that it also could apply to the company raising funds from a self-directed IRA or 401(k), and force those companies to reject investment dollars from self-directed IRAs and 401(k)s.

Exceptions

There are two exceptions to the Fiduciary Rule that will allow a self-directed retirement account to invest into a private investment offering: Independent Fiduciaries and Best Interest Contract Exemption.

Independent Fiduciary

If the self-directed retirement account investor has an independent fiduciary, then that fiduciary is responsible for their investment advice and the offering company won’t be deemed a fiduciary. An independent fiduciary would include a registered investment adviser or a broker-dealer. Consequently, if a self-directed IRA investor had an investment adviser who reviewed the investment, then the offering company would likely not be deemed a fiduciary for this investment. I’ve seen numerous companies starting to require this for all retirement account investments. For those clients who already use an investment adviser, this is easier to comply with. But, most self-directed investors do not use an adviser, and as a result would need to spend money to engage one for the purposes of reviewing the investment just so they could qualify to invest.

Best Interest Contract Exemption (BICE)

The second exemption is the best interest contract exemption, otherwise known as “BICE.” BICE provides that a person is exempt from the fiduciary rule, but has lengthy requirements that really won’t work for an investment sponsor or someone raising private capital from an IRA. Based on the requirements, it will really only work for advisers or insurance companies offering financial products.

What to Do Moving Forward?

Many private investment offerings are not restricting self-directed accounts yet. They are either agreeing that they are fiduciaries and are taking that into account their company’s operations or they are taking the legal position that the fiduciary rule doesn’t apply to them, which may be correct as the law is new and still unclear. However, if you end up being restricted from investing your self-directed IRA or 401(k) into a private investment because the offering company is worried about the fiduciary rule, you may choose to rely on the Independent Fiduciary exemption and could engage an investment adviser – if you don’t already have one – to review this investment and serve as the fiduciary for the investment.

Pitching Your Business or Deal with Kevin Harrington from Shark Tank

pitching-your-dealI had the pleasure of interviewing Kevin Harrington on our Refresh Your Wealth podcast last week. Kevin was an original shark on the hit TV Show Shark Tank and appeared on 160 episodes. He is also the founder of the infomercial, a pioneer of As Seen On TV, and a co-founder of Entrepreneur’s Organization (EO). He also took a $500M company public on the NYSE. In short, he’s the perfect person to ask on how to pitch your business, product, or investment. In the podcast you can hear Kevin provide his Top 9 tips for pitching your deal, business, or product. I’ve noted the Top 9 list below and you can check out the podcast here.

  1. Get Their Attention. Start strong and don’t get too far into the details.
  2. Show Problem. Why is your deal, product, or business needed?
  3. Show Solution. What is your solution to the need?
  4. Why are You Unique to Solve. What makes you so special? Why are you the person or company to solve this problem?
  5. Magical Transformation. Show me how this works. Wow me with how cool this is.
  6. Have Testimonials. Have testimonials of people who’ve experienced your company, product or service.
  7. Irresistible Offer. Make an irresistible offer. In the case of courting an investor, make me feel good about getting my money back first. Provide a term that I get paid back my cash investment first before you take any profit. For a product or service, give me a call to action.
  8. Use of Proceeds. If I’m investing money, tell me how the money is going to be used. Is it buying a property, inventory, funding R&D, or paying your salary? That makes big difference.
  9. Create an Invest or Buy Now Incentive. I may be interested but why should I do this now while you have my attention. Close the deal and give me comfort that this will be okay (money back guarantee, warranty, personal guarantee).

I’ve listened to plenty of clients explain their deal and/or business and found this list to be very insightful and practical. Enjoy!

You can find this interview as well as hundreds of other episodes on iTunes under Refresh Your Wealth or at refreshyourwealth.com. Pleas subscribe and tune in weekly for new episodes.

 

UBIT Tax and Self-Directed IRAs: Three Key Tips Every Investor Should Know

Photo of two people at a desk using their mobile and tablet devices with the text "UBIT Tax and Self-Directed IRAs: Three Key Tips Every Investor Should Know."Unrelated Business Income Tax (“UBIT”) is often misunderstood by self-directed IRA investors and their professional advisors. In essence, UBIT is a tax that is due to an IRA when it receives “business income” as opposed to “investment income”. When we think of IRAs and retirement accounts, we think of them as receiving income without having to pay tax when the income is made. For example, when your IRA sells stock for a profit and that profit goes back to your IRA you don’t pay any tax on the gain. Similarly, when you sell real estate owned by your IRA for a profit and that profit goes back to your IRA, you don’t pay any tax on the gain. The reason for this is because the gain from the sale of an investment asset is deemed investment income and as a result it is exempt for UBIT tax.

Tip 1: “When Does UBIT Apply?”

UBIT applies when your IRA receives “unrelated business income”. However, if your IRA receives investment income, then that income is exempt from UBIT tax. Investment income that is exempt from UBIT includes the following.

Investment Income Exempt from UBIT:

  • Real Estate Rental Income, IRC 512(b)(3) – The rent of real estate is investment income and is exempt from UBIT
  • Interest Income, IRC 512(b)(1) – Interest and points made from the lending of money is investment income and is exempt from UBIT.
  • Capital Gain Income, IRC 512(b)(5) – The sale, exchange, or disposition of assets is investment income and is exempt from UBIT.
  • Dividend Income, IRC 512(b)(1) – Dividend income from a c-corp where the company paid corporate tax is investment income and exempt from UBIT.
  • Royalty Income, IRC 512(b)(2) – Royalty income derived from intangible property rights such as intellectual property and from oil/gas and mineral leasing activities is investment income and is exempt from UBIT.

There are two common areas where self-directed IRA investors run into UBIT issues and are outside of the exemptions outlined above. The first occurs when an IRA invests and buys LLC ownership in an operating business (e.g. sells goods or services) that is structured as a pass-thru entity for taxes (e.g. partnership) and that that does not pay corporate taxes. The income from the LLC flows to its owners and would be ordinary income. If the company has net taxable income it will flow down to the IRA as ordinary income on the k-1 and this will cause tax to the IRA as this will be business income and it does not fit into one of the investment income exemptions.

The second problematic area is when IRAs engage in real estate investment that do not result in investment income. For example, real estate development or a number of significant short-term real estate flips by an IRA will cause the assets of the IRA to be considered as inventory as opposed to investment assets and this will cause UBIT tax to the IRA.

Tip 2: UBIT Applies When You Have Debt Leveraging an IRA Investment

UBIT also applies to an IRA when it leverages its purchasing power with debt. If an IRA uses debt to buy an investment, then the income attributable to the debt is subject to UBIT. This income is referred to as unrelated debt financed income (UDFI) and it causes UBIT. The most common situation occurs when an IRA buys real estate with a non-recourse loan. For example, lets say an IRA buys a rental property for $100,000 and that $40,000 came from the IRA and $60,000 came form a non-recourse loan. The property is thus 60% leveraged and as a result, 60% of the income is not a result of the IRAs investment but the result of the debt invested. Because of this debt, that is not retirement plan money, the IRS requires tax to be paid on 60% of the income. So, if there is $10K of rental income on the property then $6K would be UDFI and would be subject to UBIT taxes.

For a more detailed outline on UDFI, please refer to my free one-hour webinar here.

Tip 3: UBIT Tax is Reported and Paid by the IRA via a Form 990-T Tax Return

Unrelated business income tax (UBIT) for an IRA is reported and paid via IRS Form 990-T. IRS Form 990-T is due for IRAs on April 15th of each year. IRA owner’s can file and obtain an automatic 3-month extension with the IRS by filing an extension request before the regular deadline.

If UBIT Tax is due, it is paid from the IRA and the IRA owner would send the prepared Form 990-T to their IRA custodian for their signature and for direction of payment to the IRS for any tax due as part of the 990-T Return.

For a more detailed outline of UBIT, please refer to Chapter 15 of The Self Directed IRA Handbook.

Court Rules in Favor of Self-Directed IRA Real Estate Investor in Prohibited Transaction Case

Photo of a gavel in front of empty seats in a courtroom with the text "Court Rules in Favor of Self-Directed IRA Real Estate Investor in Prohibited Transaction Case."A recent Bankruptcy Court decision dealt with prohibited transaction claims against a self directed IRA owner who was using their IRA to flip real estate for profit. The claims were brought by a bankruptcy trustee who argued that the protected IRA was no longer an IRA because it engaged in a number of prohibited transactions. If the trustee is successful in disqualifying the retirement account because of a prohibited transaction, then the funds and assets held in such retirement account are no longer protected from creditors and may be used to pay debtors involved in the bankruptcy. While most prohibited transaction cases arise in Tax Court, I’m seeing more cases on prohibited transactions in Bankruptcy Court as trustees are becoming more aggressive and as self directed IRAs are becoming more popular.

The case in question is known as In re Cherwenka, Case 13-57592-MGD (Bankr. N. D. GA 2014). The case included two important prohibited transaction analysis that are helpful to IRA owners.

Court Rules No Prohibited Transaction When Managing IRA Investment Properties Without Compensation

The first significant ruling from the Court was that there was no prohibited transaction when the IRA owner completed the following tasks related to the IRA owned property.

  • Research and identified properties to buy
  • Appointed and approved work on the properties
  • Oversaw payments on the property for work from the self-directed IRA.

The Court reasoned that these actions do no constitute a “transaction” as defined in IRC § 4975 and as a result they cannot constitute a prohibited transaction. The Court further stated that, “…self-directed IRAs as qualified IRAs, necessarily implies that a disqualified person (the owner as fiduciary) will make investment decisions regarding the plan. The Court distinguished this case from In re Williams, 2011 WL 10653865 (Bankr E.D. Cal 2011) a similar case in which the self-directed IRA owner was managing properties owned by the IRA because in Williams the IRA was paying the self-directed IRA owner for the services. The court stated that it was the payment from the IRA to the IRA owner in Williams that caused the prohibited transaction and not the mere provision of managing the IRAs investment owned by the IRA.

Court Ruled That No Prohibited Transaction Occurred When IRA and Owner Invested Into Property Together

The second significant ruling from the Court was that there was no prohibited transaction when the IRA owner and the IRA co-invested into a property together. The property in question was owned 45% by the IRA and 55% by the IRA owner. The Court rejected the bankruptcy Trustee’s argument that such co-investment purchase resulted in a prohibited transaction and stated that the interests appeared to have been treated distinctly and that the HUD documents from the sale of the property show that the IRA and the IRA owner’s proceeds from the sale were treated separately and that they were apportioned properly. As a result, the Court concluded that no prohibited transaction occurred since there was no evidence of un-fair benefit between the IRA owner and his IRA. In its reasoning, the Court referenced DOL Opinion 2000-10A which addressed an IRA and the IRA owner co-investing into a partnership. In the Opinion the DOL states that, “a violation of section 4975 (c)(1)(D) or (E) will not occur merely because the fiduciary [IRA owner] drives some incidental benefit from the transaction involving IRA assets.” The Court referenced this opinion and stated that unless there is evidence of some un-fair benefit that no prohibited transaction occurred merely because of co-investment into the same property.

There are two key take-away’s for self-directed IRA investors from this case.

First, never take compensation or payment from the IRA for services rendered. It is clear that the Courts will find a prohibited transaction if you do and that you will no longer have an IRA.

Second, if you are buying property or others assets (e.g. LLC interests) between your IRA and yourself personally (or another disqualified person) those interests must be carefully calculated and treated such that there is no benefit going unfairly between the IRA and the disqualified person (e.g. IRA owner). In sum, get advice and plan carefully as there are many land-mines you could encounter when investing IRA funds with your own personal funds. Bottom line, it can be done but it can easily be done incorrectly.

Buying Real Estate With Your IRA and a Non-Recourse Loan

Image of a miniature house on stacks of cash with the text "Buying Real Estate with Your IRA and a Non-Recourse Loan."Your IRA can buy real estate using its own cash and a loan/mortgage to acquire the property. Whenever you leverage your IRA with debt, however, you must be aware of two things. First, the loan your IRA obtains must be a non-recourse loan. And second, your IRA may be subject to a tax known as unrelated debt financed income tax (UDFI/UBIT). This comprehensive webinar explains the non-recourse loan requirements, as well as the non-recourse loan options and goes into detail on how UDFI tax may be applied and how it is calculated. Below are the slides from the presentation as well as the recorded video presentation of the webinar. Note that page 27 in the pdf slides below was up-dated from the webinar as I made a calculation mistake on the debt owed. The final tax numbers were still correct though. Thanks to Roger St.Pierre, Sr. VP at First Western Federal Savings Bank for co-presenting the topic with me.

buying-real-estate-with-ira-and-non-recourse-loan

 

Comprehensive Webinar: Buying Real Estate with Your IRA and a Non-Recourse Loan Mat Sorensen from Mathew Sorensen on Vimeo.