It’s finally here: My top ten list of frequently asked self-directed IRA questions! Whether you’re just getting started or you’ve been investing with a self-directed account for decades, make sure you know the answers to these ten questions. In most instances, I’ve linked to more comprehensive articles and videos on the subject. And of course, you can always crack open the best-selling book on the subject for even more information and detail: The Self-Directed IRA Handbook.
1. What is a self-directed IRA?
A self-directed IRA is an IRA (Roth, Traditional, SEP, Inherited IRA, SIMPLE) where the custodian of the account allows the IRA to invest into any investment allowed by law. These investments typically include: Real estate, promissory notes, precious metals, and private company stock. The typical reaction I hear from investors is, “Why haven’t I ever heard of self-directed IRAs before, and why can I only invest my current retirement plan into mutual funds or stocks?” The reason is that large financial institutions that administer most U.S. retirement accounts don’t find it administratively feasible to hold real estate or non-publicly traded assets in retirement plans.
2. Can I rollover or transfer my existing retirement
account to a self-directed IRA?
Well, it depends. Here’s my chart that breaks down every possible scenario:
|I have a 401(k) account with a former employer.||Yes, you can rollover to a self directed IRA. If it is a Traditional 401(k), it will be a self-directed IRA. If it is a Roth 401(k), it will be a self-directed Roth IRA.|
|I have a 403(b) account with a former employer.||Yes, you can roll-over to a Traditional self-directed IRA.|
|I have a Traditional IRA with a bank or brokerage.||Yes, you can transfer to a self-directed IRA.|
|I have a Roth IRA with a bank or brokerage.||Yes, you can transfer to a self-directed Roth IRA.|
|I inherited an IRA and keep the account with a brokerage or bank as an inherited IRA.||Yes, you can transfer to a self-directed inherited IRA.|
|I don’t have any retirement accounts but want to establish a new self-directed IRA.||Yes, you can establish a new Traditional or Roth self-directed IRA, and can make new contributions according to the contribution limits and rules found in IRS Publication 590.|
|I have a 401(k) or other company plan with a current employer.||No, in most instances your current employer’s plan will restrict you from rolling funds out of that plan. However, some plans do allow for an in-service withdrawal if you are at retirement age.|
3. What can a self-directed IRA invest in?
Under current law, a retirement account is only restricted from investing in the following:
And, any investment that constitutes a prohibited transaction pursuant to ERISA and/or IRC 4975 (e.g. purchase of any investment from a disqualified person such as a close family member to the retirement account owner).
The most popular self-directed retirement account investments include:
- Rental real estate;
- Secured loans to others for real estate (trust deed lending);
- Private small business stock or LLC interest; and
- Precious metals, such as gold or silver.
These investments are all allowed by law and can be great assets for investors with experience in these areas.
4. What restrictions are there on using a self-directed IRA?
When self-directing your retirement account, you must be aware of the prohibited transaction rules found in IRC 4975. These rules don’t restrict what your account can invest in, but rather, whom your IRA may transact with. In short, the prohibited transaction rules restrict your retirement account from engaging in a transaction with someone who is a disqualified person to your account. A disqualified person to a retirement account includes: The account owner, their spouse, children, parents, and certain business partners. So, for example, your retirement account could not buy a rental property that is owned by your father since a purchase of the property would be a transaction with someone who is disqualified to the retirement account (e.g. father). On the other hand, your retirement account could buy a rental property from your cousin, friend, sister, or a random third-party, as these parties are not disqualified persons under the rules.
Here’s a diagram outlining who is disqualified to your IRA:
Prohibited transactions should be avoided as the consequence is distribution of the entire account involved.
5. Can my self-directed IRA invest in my
personal business, company, or deal?
No, it would violate the prohibited transaction rules if your IRA transacted with you personally (or with a company you own). In addition, your IRA cannot transact with or benefit anyone who is a disqualified person (e.g. IRA owner, spouse, children, parents, spouses of children, etc.)
6. What is a checkbook-control IRA or IRA/LLC?
Many self-directed retirement account owners, particularly those buying real estate, use an IRA/LLC (aka “checkbook-control IRA”) as the vehicle to hold their retirement account assets. An IRA/LLC is a special type of LLC, which consists of an IRA (or other retirement account) investing its cash into a newly created LLC. The IRA/LLC is managed by the IRA owner, and the IRA owner then directs the LLC investments and the LLC to take title to the assets, pay the expenses to the investment, and receive the income from the investment. There are many restrictions against the IRA owner being the manager (such as not receiving compensation or personal benefit) and many laws to consider, so please ensure you consult an attorney before establishing an IRA/LLC. For more details on the IRA/LLC structure, including cases and structuring options, please refer to my blog post, “New Case Answers Important Questions about IRA/LLCs.”
Here’s a simple diagram that outlines how the IRA/LLC (checkbook-control IRA) operates:
7. Can my IRA invest cash and can I get a
loan to buy real estate with my IRA?
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. A non-recourse loan is made by the lender against the asset, and in the event of default the sole recourse of the lender is to foreclose and take back the asset. The lender cannot pursue the IRA or the IRA owner for any deficiency. Second, your IRA may be subject to a tax known as unrelated debt financed income tax (UDFI/UBIT).
8. Are there any tax traps? What about UBIT/UBTI?
The tax 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 exempt from UBIT includes the following.
- Real Estate Rental Income (IRC 512(b)(3)) – Rent from real estate is investment income, and is exempt from UBIT.
- Interest Income (IRC 512(b)(1)) – Interest and points made from the money lending 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.
So, make sure your IRA receives investment income as opposed to “business income”.
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 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. If your IRA has UBIT income, it must file it’s own tax return using IRS Form 990-T. The second instance occurs when the IRA invests into real estate activities whereby the IRA is deemed to be in the business of real estate as opposed to investing in real estate (e.g. real estate development, construction, significant short-term real estate flips).
9. What is unrelated debt financed income (UDFI)?
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, let’s say an IRA buys a rental property for $100,000, and that $40,000 came from the IRA and $60,000 came from 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, which is not retirement plan money, the IRS requires tax to be paid on 60% of the income. So, if there is $10K of net 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.
10. Should I use a solo 401(k) instead of a self-directed IRA?
A solo 401(k) is a great self-directed account option, and can be used instead of an IRA for persons who are self-employed with no other employees (other than business owners and spouses). If you are not self-employed, then the solo K will not work in your situation.
A solo 401(k) is generally a better option for someone who is self-employed and still trying to maximize contributions, as the solo 401(k) has much higher contribution amounts ($54,000 annually versus $5,500 annually for an IRA). On the other hand, a self-directed IRA is a better option for someone who has already saved for retirement and who has enough funds in their retirement accounts which can be rolled over and invested via a self-directed IRA as the self-directed IRA is easier and cheaper to establish.
Another major consideration in deciding between a solo 401(k) and a self-directed IRA is whether there will be debt on real estate investments. If there is debt and the account owner is self-employed, they are much better off choosing a solo 401(k) over an IRA as solo 401(k)s are exempt from UDFI tax on leveraged real estate.
Here’s what the solo 401(k) look like and how the money flows:
Choosing between a self-directed IRA and a solo 401(k) is a critical decision when you start self-directing your retirement. Make sure you consider all of the differences before you establish your new account. Check out my blog article and video outlining the differences between self-directed IRAs and solo 401(k)s.
The recent case of Niemann v. Commissioner involves a successful real estate investor who unknowingly used his self-directed IRA owned LLC (aka, checkbook control IRA) in a way that caused a prohibited transaction under IRC § 4975. While the Tax Court’s holding and decision focused on other tax matters, the Court did outline the history of the case and the prohibited transactions that occurred and that disqualified Niemann’s IRA. Here are the pertinent facts regarding Niemann’s self directed IRA investments.
- Neimann formed Real Estate Rabbit, LLC with his IRA as the sole member and himself as manager.
- Neimann used Real Estate Rabbit, LLC for numerous real estate investments including buying homes at auction and slipping them for a profit. Real Estate Rabbit, LLC also bought mineral rights investments and held notes.
- Neimann personally engaged in real estate investments in his own name and in the name of an LLC he personally owned called Magic, LLC. Neimann intended for Magic, LLC to be a multi-member LLC to be owned by himself, his personal LLC, and his IRA/LLC. This LLC was not properly established nor was it properly operated. He learned about it from a seminar and engaged a non-lawyer (“vendor”) to set up the LLC.
- Neimann transferred properties from his Real Estate Rabbit, LLC (his IRA/LLC) to himself personally and to his personally owned LLC. These transfers caused a prohibited transaction and resulted in the entire distribution of Neimann’s self directed IRA.
It is quite clear from the case and from the Court’s analysis that Neimann was not intending to unfairly avoid tax nor was he attempting to improperly engage in a prohibited transactions. In fact, his real estate transactions were very successful. And if you were a successful real estate investor looking to illegally avoid taxes, you wouldn’t transfer properties from your IRA owned LLC (that pays no taxes on gains) to yourself personally (where you do pay taxes on the gains). If you were a tax cheat, you’d do the opposite and would transfer properties with gains from yourself personally to your IRA. It is quite clear instead, that Neimann was unaware of the rules and as a result he moved his real estate investments around between his LLCs and his personal name as he would with any property he owned. These transfers were made without regard to IRA rules which require IRA investments to be held separately from personal assets and which restrict transactions between the IRA (and IRA/LLC) and the IRA owner personally.
Neimann conceded with the Court and the IRS that he engaged in a prohibited transaction when his IRA owned LLC (Real Estate Rabbit, LLC) transferred property to himself personally and to his personally owned LLC.
LEARN THE RULES AND SEEK OUT QUALIFIED LICENSED PROFESSIONALS
This case illustrates a critical point that self-directed IRA investors must first become acquainted with the self-directed IRA rules before they enter into real estate, LLC, or other transactions with their IRA. Neimann was a successful investor and a former engineer but he either received poor advice or he sought no professional legal or tax advice in the process.
Learning how to self-direct your IRA is like learning a new board game. At first, it takes some time to learn what you can and cannot do but once you understand the rules for the investments you intend to make it becomes second nature and you can proceed without having to consult the “rulebook” or a lawyer, or CPA, or other licensed advisor. So, if you’re new to self directing your IRA, make sure you’ve received competent advice from licensed professionals. Don’t rely on something you’ve heard at a seminar or by someone trying to sell you an investment. Instead, seek a specific consult with a licensed attorney or CPA who is competent in the rules effecting your self-directed IRA.
What is a Self Directed IRA?
A self directed IRA is an IRA (Roth, Traditional, SEP, Inherited IRA, SIMPLE) where the custodian of the account allows the IRA to invest into any investment allowed by law. These investments typically include; real estate, promissory notes, precious metals, and private company stock. The typical reaction I hear from investors is: “Why haven’t I ever heard of self directed IRAs before, and why can I only invest my current retirement plan into mutual funds or stocks?” The reason is that the large financial institutions that administer most U.S. retirement accounts don’t find it administratively feasible to hold real estate or non-publicly traded assets in retirement plans.
What Can a Self Directed IRA Invest Into?
Under current law, a retirement account is only restricted from investing in the following:
– Collectibles such as art, stamps, coins, alcoholic beverages, or antiques IRC 408(m);
– Life insurance IRC 408(a)(3);
– S-corporation stock, IRS Letter Ruling 199929029, April 27, 1999, IRC § 1361 (b)(1)(B);
– And, any investment that constitutes a prohibited transaction pursuant to ERISA and/or IRC 4975 (e.g. purchase of any investment from a disqualified person such as a close family member to the retirement account owner).
The most popular self directed retirement account investments include; rental real estate, secured loans to others for real estate, small business stock or LLC interest, and precious metals such as gold or silver. These investments are all allowed by law and can be great assets for investors with experience in these areas.
When self-directing your retirement account you must be aware of the prohibited transaction rules found in IRC 4975. These rules don’t restrict what your account can invest in, but rather, whom your IRA may transact with. In short, the prohibited transaction rules restrict your retirement account from engaging in a transaction with someone who is a disqualified person to your account. A disqualified person to a retirement account includes the account owner, their spouse, children, parents, and certain business partners. So, for example, your retirement account could not buy a rental property that is owned by your father since a purchase of the property would be a transaction with someone who is disqualified to the retirement account (e.g. father). On the other hand, your retirement account could buy a rental property from your cousin, friend, sister, or a random third-party, as these parties are not disqualified persons under the rules.
The rationale behind the prohibited transaction rules is that the federal government doesn’t want tax advantaged accounts conducting transactions between parties who are close enough to the account owner that there could be a transaction designed to avoid or un-fairly minimize tax by altering the true fair market value/price of the investment. The consequence of a prohibited transaction is disqualification of the retirement account as of January 1 of the year the prohibited transaction occurred. In a typical self directed IRA investment, your IRA cusotidan holds your investment in their company name for your IRAs benefit (e.g. property is owned as ABC Trust Company FBO John Smith IRA) and receives the income and pays the expenses for the investment at the account owner’s direction and instruction.
What is an IRA/LLC?
Many self-directed retirement account owners, particularly those buying real estate, use an IRA/LLC as the vehicle to hold their retirement account assets. An IRA/LLC is a special type of LLC, which consists of an IRA (or other retirement account) investing its cash into a newly created LLC. The IRA/LLC is managed by the IRA owner and the IRA owner then directs the LLC investments and the LLC takes title to the assets, pays the expenses to the investment, and receives the income from the investment. There are many restrictions to the IRA owner being manager (such as not receiving compensation or personal benefit) and many laws to consider so please ensure you consult an attorney before establishing an IRA/LLC. For more details on the IRA/LLC structure, the cases, and the structuring options, please refer to my prior blog post here.
By: Mat Sorensen, Attorney and Author of The Self Directed IRA Handbook.
This article is an excerpt from The Self Directed IRA Handbook: An Authoritative Guide For Self Directed Retirement Plan Investors and Their Advisors.
When IRA-owned property is held for rent, the management of the rental property must be structured such that rental income is received by the IRA and expenses are paid by the IRA. The IRA owner and other disqualified persons (e.g. IRA owner, spouse, etc.) cannot personally be the “middle man” by paying expenses personally or by collecting the rent in their personal account and then forwarding the funds to the IRA. There are essentially three different methods whereby the IRA may be structured to properly collect rent and pay expenses.
3 METHODS TO MANAGE THE PROPERTY
|1. Manage directly through the IRA. Money goes to the IRA custodian and expenses are paid by the custodian at the direction of the IRA owner.|
|2. Property Manager. The IRA hires a property manager who manages the property and receives the income and pays property expenses. Cash flow is returned to the IRA.|
|3. IRA/LLC. Under the IRA/LLC, the IRA owner is the manager of the IRA/LLC and receives income and pays expenses from an IRA/LLC checking account. The IRA/LLC structure is very common in IRA owned real estate investments.|
First, the IRA may be receiving the income directly and paying the expenses. This method involves a lease between the IRA and the tenant directly. Under this method, the tenant pays rental income to the IRA (e.g. ABC Trust Company FBO Sally Jones IRA) and sends the actual payment to the IRA custodian and the custodian then deposits that income into the respective IRA. If expenses are due, the IRA owner will need to direct the custodian to pay them by completing a written form (e.g. payment authorization letter) and instructing the IRA custodian as to the expenses to be paid from the IRA. There is usually a fee each time an instruction letter is issued to a self directed IRA custodian. This method can be tedious and can be fee intensive and as a result is not the most common way of managing a rental property held by an IRA.
Second, the IRA hires a property manager who receives the rental income to the property and pays the expenses to the property. The property manager cannot be a disqualified person to the IRA owner and the property manager will typically take a percent of the rental income collected as payment for their services. Under this method the IRA enters into an agreement with the property manager and the property manager then enters into leases with respective tenants. The IRA receives rental income minus property expenses and fees charged by the property manager.
Third, many IRA owners with rental property decide to use a structure known as an IRA/LLC. Under the IRA/LLC structure, the IRA invests into a newly created LLC and the IRA’s investment is then the ownership of the LLC. The IRA will invest an amount designated by the IRA owner into the LLC, and then funds are typically deposited into an LLC checking account at a bank selected by the IRA owner.
IRA/LLC STRUCTURE FOR REAL ESTATE
The IRA owner then, as manager of the LLC, signs the contract for the LLC to purchase the real estate. The property should close in the LLC name with funds from the LLC bank account and the LLC then in turn rents the property, receives the income and pays the expenses all from the LLC checking account. The LLC is entirely owned by the IRA and all funds in the LLC checking account must eventually be returned to the IRA when the IRA owner desires to take a distribution.
Regardless of the method used to own and manage the IRA owned rental property, the property cannot be leased to a disqualified person. So, for example, the IRA cannot purchase a property and allow the IRA owner’s son to lease the property as that lease would be a transaction with a disqualified person which results in a prohibited transaction.
In addition to prohibited transactions that are involved in leasing the property to family members, the IRA owner should closely analyze any leasing arrangement to a company where the IRA owner or other disqualified persons are owners of the IRA or company. For example, any lease to a company that is owned 50% or more by the IRA owner or other disqualified persons would constitute a prohibited transaction. IRC § 4975(e)(2)G).
In summary, there are many different ways to manage a rental property owned by your IRA. Make sure you are implementing one of these methods and that you are managing the IRA’s income, expenses, and properties properly.
This article is an excerpt from Mat Sorensen’s book, The Self Directed IRA Handbook.
By: Mat Sorensen, attorney and author of The Self Directed IRA Handbook.
There are numerous laws, cases, and regulations to consider in analyzing whether your IRA can own an LLC (commonly referred to as an “IRA/LLC” or a “checkbook control IRA”). Despite the complexity of the law, your IRA can own 100% of the ownership interest of an LLC and you as the IRA owner may serve as the Manager of this LLC. This proposition was first supported by the case of Swanson v. Commissioner, 106 T.C. 76 in 1996 where the U.S. Tax Court held that it is not a prohibited transaction under IRC Section 4975 for a retirement plan to invest and own 100% of newly created corporation nor was it prohibited for the IRA owner to serve as an officer of that company where no salary or compensation was paid to the IRA owner. In summary, the U.S. Tax Court has supported the structure whereby a new created company is wholly owned by a retirement plan and managed by the retirement plan owner and that is the same rationale used in many IRA/LLC’s.
So what does the IRS think about IRA/LLC’s? The IRS issued IRS Field Service Advisory #200128011 in April of 2001 which indicated that the IRS will not contend that there is a prohibited transaction when there is a newly formed and capitalized company that is 100% owned by a retirement plan. Keep in mind that both of these cases deal with newly formed companies and do not apply to LLC’s or corporations (or other companies) which a retirement plan owner may have already established. Also, it is possible to partner your retirement plan with others into one IRA/LLC but you must carefully consult with professional who are experienced in this area as there are numerous prohibited transaction issues that may arise when you partner your IRA with others.
Serving as the Manager of the IRA/LLC allows the IRA account owner to enter into contracts on behalf of the IRA/LLC and to sign checks on behalf of the IRA/LLC. There are restrictions on the amount of work you may do (for example, if the IRA/LLC owned a property you may not work on the property) but you may oversee the administrative matters like the signing of contracts and checks. The prohibited transaction rules still apply to IRA/LLC’s in the same way they apply to your self-directed IRA so you still must pay careful attention to these rules and most consult with professionals who are competent in the laws that apply to retirement plans. Moreover, an IRA/LLC is different from your typical LLC and the IRA/LLC documents should include numerous provisions which protect your IRA from a prohibited transaction. This doesn’t mean that an IRA/LLC should costs thousands of dollars. In fact, our law firm sets IRA/LLC’s up for $750 plus the state filing fee if the IRA/LLC is owned by one IRA or $1,500 if owned by multiple IRA’s or partners. In the end, an IRA/LLC can be a powerful tool to gain more control of your IRA’s investments but you must do so with adherence to the rules and laws that apply to your IRA. Written by Mathew Sorensen, Attorney at Law and Partner at Kyler Kohler Ostermiller & Sorensen, LLP, a law firm assisting self directed retirement plan owners across the U.S. for over ten years from offices in Arizona, Utah and California. To learn more about our law firm, please visit our website at ww.kkoslawyers.com or call us at 435-586-9366.