There are 28 trillion dollars in retirement plans in the United States. Do you know that these funds can be invested into your business? Yes, it’s true, IRAs and 401(k)s can be used to invest in start-ups, private companies, real estate, and small businesses. Unfortunately, most entrepreneurs and retirement account owners didn’t even know that retirement accounts can invest in private companies but you’ve been able to do it for over 30 years.
Think of who owns these funds: It’s everyday Americans, it’s your cousin, friend, running partner, neighbor…it’s you. In fact, for many Americans, their retirement account is their largest concentration of invest-able funds. Yet, you’ve never asked anyone to invest in your business with their retirement account. Why not? How much do you think they have in their IRA or old employer 401(k)? How attached do you think they are to those investments? These are the questions that have unlocked hundreds of millions of dollars to be invested in private companies and start-ups.
How Many People Are Doing This?
Recent industry surveys revealed that there are one million retirement accounts that are self-directed into private companies, real estate, venture capital, private equity, hedge funds, start-ups, and other so-called “alternative” investments (e.g. Bitcoin and cryptocurrencies). It is a sliver of the overall retirement account market, but it’s growing in popularity.
So, how does it work? How can these funds be properly invested into your business? If you ask your CPA or lawyer, the typical response is, “It’s possible, but very complicated, so we don’t recommend it.” In other words, they’ve heard of it, but they don’t know how it works, and they don’t want to look bad guessing. If you ask a financial adviser, particularly your own, they’ll talk about how it’s such a bad idea while thinking about how much fees they’ll lose when you stop buying mutual funds, annuities, and stocks that they make commissions or other fees from. Well, not all financial advisers, but unfortunately too many do.
Now, there are some legal and tax issues that need to be complied with, but that’s what good lawyers and accounts are for, right? And yes, there is greater risk in private company or start-up investments so self-directed IRA investors need to conduct adequate due diligence and they shouldn’t invest all of their account into one private company investment. So how does it work?
What is a Self-Directed IRA?
In order to invest into a private company, start-up, or small business, the retirement account holder must have a self-directed IRA? So, what is a self-directed IRA? A self-directed IRA is a retirement account that can be invested into any investment allowed by law. If your account is with a typical IRA or 401(k) company, such as Fidelity, Vanguard, TD Ameritrade, Merrill Lynch, Charles Schwab, then you can only invest in investments allowed under their platform, and these companies deem private company investments as “administratively unfeasible” to hold so they won’t allow your IRA or 401(k) to invest in them (some make exceptions for ultra-high net-worth clients, $50M plus accounts). As a result, the first step when investing in a private company with retirement account funds is to rollover or transfer the funds, without tax consequence, to a self-directed custodian who will allow your IRA, Roth IRA, SEP IRA, HSA, or Solo 401(k) to be invested into a private company. My company, Directed IRA & Directed Trust Company, handles self-directed IRAs and our clients have invested millions in private companies.
Legal Tip: If an investor’s retirement account is with their current employer’s retirement plan (e.g. 401(k)), they won’t be able to change their custodian until they leave that employer or until they reach retirement age (59.5 years old or 55 under some plans). So, for now, they’re 401(k) is usually limited to buying mutual funds they don’t understand and don’t want.
Sell Corporation Stock or LLC Units to Self-Directed IRAs
Are you seeking capital for your business in exchange for stock or other equity? If so, you should consider offering shares or units in your company to retirement account owners. You don’t need to wait until your company is publicly traded to sell ownership to retirement accounts. Here are a few well-known companies who had individuals with self-directed IRAs invest in them before they were publicly traded: Facebook, Staples, Sealy, PayPal, Domino’s, and Yelp, just to name a few.
You can also raise capital for real estate purchases or equipment whereby a promissory note is offered to the IRA investor who acts as lender, and the funds are usually secured by the real estate or equipment being purchased. There are many investment variations available, but the most common is an equity investment purchasing shares or units where the IRA becomes a shareholder or note investment whereby the IRA becomes a lender. Keep in mind, you need to comply with state and federal securities laws when raising money from any investor.
Need to Know #1: Prohibited Transactions
There are two key rules to understand when other people invest their retirement account into your business. First, the tax code restricts an IRA or 401(k) from transacting with the account owner personally or with certain family (e.g. parents, spouse, kids, etc.). This restriction is known as the prohibited transaction rule. See IRC 4975 and IRS Pub 590A. Consequently, if you own a business personally you can’t have your own IRA or your parents IRA invest into your company to buy your stock or LLC units. However, more distant family members such as siblings, cousins, aunts and uncles could move their retirement account funds to a self-directed IRA to invest in your company. And certainly, unrelated third-parties would not be restricted by the prohibited transaction rules from investing in your company. What if you are only one of the founders or partners of a business, and you want to invest your IRA or your spouse’s IRA into the company? This is possible if your ownership and control is below 50%, but this question is very complicated and nuanced, so you’ll want to discuss it with your attorney or CPA who is familiar with this area of the tax law.
If a prohibited transaction occurs, the self-directed IRA is entirely distributed. That’s a pretty harsh consequence and one that makes compliance with this rule critical.
Need to Know #2: UBIT Tax
The second rule to understand is a tax known as Unrelated Business Income Tax (“UBIT”, “UBTI”). UBIT is a tax that can apply to an IRA when it receives “business” income. IRAs and 401(k)s don’t pay tax on the income or gains that go back to the account so long as they receive “investment” income. Investment income would include rental income, capital gain income, dividend income from a c-corp, interest income, and royalty income. If you’ve owned mutual funds or stocks with your retirement account, the income from these investments always falls into one of these “investment” income categories. However, when you go outside of these standardized forms of investment, you can be outside of “investment” income and you just might be receiving “business” income that is subject to the dreaded “unrelated business income tax.” This tax rate is at 37% at about $12,000 of taxable income annually. That’s a hefty rate, so you want to make sure you avoid it or otherwise understand and anticipate it when making investment decisions. The most common situation where a self-directed IRA will become subject to UBIT is when the IRA invests into an operational business selling goods or services who does not pay corporate income tax. For example, let’s say my new business retails goods on-line, and is organized as an LLC and taxed as a partnership. This is a very common form of private business and taxation, but one that will cause UBIT tax for net profits received by self-directed IRA. If, on the other hand, the same new business was a c-corporation and paid corporate tax (that’s what c-corps do), then the profits to the self-directed IRA would be dividend income, a form of investment income, and UBIT would not apply. Consequently, self-directed IRAs should presume that UBIT will apply when they invest into an operational business that is an LLC, but should presume that UBIT will not apply when they invest into an operational business that is a c-corporation.
Legal Tip: IRAs can own c-corporation stock, LLC units, LP interest, but they cannot own s-corporation stock because IRAs and 401(k)s do NOT qualify as s-corporation shareholders.
Now, if you’re an LLC raising capital from other people’s IRAs or 401(k)s, you should have a section in your offering documents that notifies people of potential UBIT tax on their investment. UBIT tax is paid by the retirement account annually on the net profits the account receives so it doesn’t cost the company raising the funds any additional money or tax. It costs the retirement account investor since UBIT is paid by the retirement account. Despite the hefty tax, many IRAs and 401(k)s will still invest when UBIT is present as they may be willing to pay the tax on a well-performing investment or their investment strategy. Alternatively, many self-directed IRAs may be investing with an intent to sell their ownership in the LLC as the mechanism to receive their planned return on investment. When selling their LLC ownership, the gain in the LLC units would be capital gain income and would not be subject to UBIT.
If the investment from the self-directed IRA was via a note or other debt instrument, then the profits to the IRA are simply interest income and that income is always investment income and is not subject to UBIT tax. Many companies raise capital from IRAs for real estate purchases or for equipment purchases. These loans from an IRA or IRA(s) are often secured by the real estate or equipment being purchased and the IRA ends up earning interest income like a private lender.
So, here’s a brief summary of what we’ve learned. First, there’s $28 trillion in retirement plans in the U.S. These retirement accounts can be used to invest into your start-up or private company. You need to comply with the prohibited transaction rules and you can’t invest your own account or certain family member’s account into your business as that would invalidate the IRA. But everyone else’s IRA can invest into your company. And lastly, depending on how the company is structured (LLC or C-Corp), and how the investment is designed (equity or debt/loan), there may be UBIT tax on the profits from the investment. Remember, UBIT tax usually arises for IRAs in operating businesses structured as LLCs where the company doesn’t pay a corporate tax on their net profits. This income is pushed down to the owners and in the case of an IRA this can cause UBIT tax liability.
Here’s the bottom line, retirement account funds can be a significant source of funding and investment for your business, so it’s worth some time and effort to learn how these funds can most efficiently be utilized. While there are some rules unique to retirement accounts they can easily be understood and planned for.
IRAs are the most overlooked opportunity in real estate. Let me explain.
First, there are over 9 Trillion Dollars in IRA accounts in the U.S. This number is staggering and makes IRAs one of the largest sections of investable cash in the world. Source, Investment Company Institute & Federal Reserve Board. But what does this have to do with real estate? Well, contrary to popular belief, IRAs have always been able to invest in and own real estate. They can own single family rentals, or flip properties, or own LLCs that own multi-family or commercial real estate. They can also invest as a private lender on real estate.
At this point in the IRA and real estate conversion. I’m usually asked, why have I never heard of this before? Well, the major providers of IRAs have generally found real estate to be “administratively unfeasible” as it takes more work to handle and administer than a publicly traded stock or REIT does. In other words, the brokerage and insurance firms who administer most IRAs restrict their IRAs to…well…the stuff they sell like publicly traded stock, mutual funds, and annuities. You’ve always been able to own real estate in an IRA but there have been few IRA custodians who allow it and as a result it isn’t as widely known as it should be. This have been changing over the past decades as awareness has spread.
IRAs can own single-family rental properties. IRAs can own properties being flipped for profit. IRAs can invest in small private LLCs that own commercial properties or multi-family properties with other individuals or IRAs. IRAs can own options on real estate. And IRAs can lend money secured to other real estate investors as a private investor or hard money lender. You can’t, however, buy real estate for personal use or for use by certain disqualified family members. The assets owned by your IRA must be held for investment purposes.
In sum, any real estate owned for investment purposes can be owned by an IRA. The law has very few restrictions on assets owned by a retirement account. In fact, the only investment assets restricted for IRAs is life insurance, collectible items (e.g. art, antique car), and s-corporation stock. IRC 408(m);IRC 408(a)(3);IRC § 1361 (b)(1)(B). So all investment real estate is fair game for IRAs.
To own real estate with an IRA, you must establish what is called a self-directed IRA and transfer the funds from your current IRA provider (or prior employer 401(k)) to the “self-directed IRA” provider. There are many companies who offer these types of accounts, like my own company, Directed IRA and Directed Trust Company.
What is a Self-Directed IRA?
A self-directed IRA is an IRA that can invest into any investment allowed by law. Real estate is the most common investment for self-directed IRAs but they can also be invested into start-ups, private equity funds, venture capital funds, precious metals, and even crypto-currency. Let’s focus on real estate though.
There are a few critical issues to consider when buying real estate with an IRA.
The IRA Owns the Property, Not You Personally
Let’s go over a real estate rental or property you plan to flip with the IRA. The purchase contract to buy the real estate must be in the name of the IRA and the deed to the property will be in the name of the IRA. The IRA funds, including the earnest money deposit, will come from the IRA account. Keep in mind, the IRA account owner is not buying the property so the contract should not be in their personal name nor should the IRA owner’s personal funds be used. IRAs are held in the name of the custodian of an IRA. So, for example, if your IRA is with my company, Directed IRA & Directed Trust Company, the titling of your IRA would be Directed Trust Company FBO John Doe IRA. That is the name of the buyer on the contract and is the name on title to the property.
Improvement costs and expenses for the IRA owned property must be paid by your IRA and not personally by the IRA owner. Conversely, when there is rental income on the property or when the property sells for a gain then that income goes back into the IRA. Now, one of the huge perks of investing with an IRA is that there is no tax when the IRA makes money. That works with buying and selling stock for gain as well as buying and selling real estate for gain. Consequently, the rental income and the income when you sell the property is not taxable. If this is a Traditional IRA, then the money comes out tax-deferred at retirement and you pay tax as you draw it out. But if it is a Roth IRA, then money comes out tax-free at retirement…so put your best real estate deals in your Roth IRA. But remember, even the Traditional IRA grows tax-deferred with all income accumulating and growing until retirement.
Avoid Prohibited Transactions
When self-directing your retirement account, you must be aware of the prohibited transaction rules found in IRC 4975. These rules restrict WHOM your account may transact with, not what kind of investment your account may own. 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). Similarly, you couldn’t buy a rental property from a third-party and then rent to your child as your child is a disqualified person. On the other hand, your retirement account could buy real estate from your cousin, friend, sister, or a third-party, as these parties are not disqualified persons under the rules.
A prohibited transaction can also arise if there is self-dealing where the IRA owner or disqualified family members are personally benefitting or making money from the IRAs investments. For example, if you are a real estate agent/broker and your IRA buys real estate you cannot receive the buyer’s agent commission as that would result in a financial benefit to you personally. You’d have to waive this fee and have the purchase price reduced or have someone else represent the IRA.
If an IRA engages in a prohibited transaction, the entire IRA account involved is deemed distributed and is no longer an IRA. Taxes and possible early withdrawal penalties apply under the normal distribution rules.
Use an IRA Owned LLC (aka, IRA/LLC or checkbook control IRA)
Many self-directed retirement account owners, particularly those buying real estate, use an IRA owned LLC as the vehicle to hold their retirement account assets. Under the IRA/LLC structure, the IRA typically owns the LLC 100% and the LLC in turn owns the real estate So, rather than buying real estate and owning it directly in the IRA custodian’s name, your IRA would invest and own an LLC and the LLC in turn would own the real estate.
The IRA/LLC is typically managed by the IRA owner. Under the structure, the IRA owns all of the membership/ownership units of the LLC but the IRA owner can serve as the manager of the LLC. Manager of an LLC is like the president of a corporation. The manager can sign for the LLC and can act on behalf of the LLC. As manager of the LLC, the IRA owner would establish an LLC bank checking account for the LLC and the IRA funds would be invested and deposited into that LLC business checking account. Because the IRA is funding all the investment dollars into the LLC, the IRA owns 100% of the LLC.
Now, the LLC is funded with the IRA cash and the IRA owner is the manager of the LLC. The IRA owner can decide how much cash to invest into the LLC from the IRA depending on the real estate they are planning to buy with the IRA/LLC. When offers to purchase real estate are made with an IRA/LLC, the LLC is the buyer on the real estate purchase contract and the earnest money deposit and final funds to close on the property would come from the LLC bank checking account. The IRA owner, as manager of the LLC, signs the real estate purchase contract and has control of the LLC bank checking account and can sign checks or send wires for the LLC account. Keep in mind, the LLC is owned 100% by the IRA and the LLC funds cannot be used for personal purposes and cannot be used to pay the IRA owner. If you ever want to take money from the IRA/LLC, you must send money from the LLC bank account back to the IRA (since the IRA owns the LLC) and you then take a distribution from the IRA.
And lastly, the IRA/LLC docs are unique and most contain IRA provisions in the LLC operating agreement and subscription sections. As a result, you should use a lawyer who is familiar with IRA/LLCs as many IRA custodians who allow for IRA/LLCs require an attorney or CPA to sign off on the docs. My law firm, KKOS Lawyers, has been drafting IRA/LLCs for over 12 years and charges a flat fee of $800 plus state filing fees. There are more complex IRA/LLC structures that involve multiple IRAs (e.g. spouses or other investors) and or combinations of IRAs and individuals and those structures are called Multi-Member IRA/LLCs and typically cost more to set-up.
How to Properly Get a Mortgage Loan With Your IRA?
Your IRA, or IRA/LLC, can get a mortgage loan when you buy real estate, but you need to know two things before you do.
First, the loan must be non-recourse to the IRA owner as the rules regarding IRAs do not allow the IRA owner to personally be responsible for the loan or to personally extend credit to the IRA. Under a non-recourse loan, the bank lends money to the IRA, or IRA/LLC, and gets a deed of trust or mortgage against the property securing the loan. In the event of default, the lender can foreclose and take the property back but cannot go after the IRA or the IRA owner for any deficiency in the loan. Because the lender’s ability to collect is limited to the property they loaned on, the banks who lend to IRAs require 30-40% down. There are several banks who specialize in these non-recourse loans to IRAs and an IRA owner is best served by using a bank or private lender who routinely provides these type of non-recourse loans.
Second, there is a tax called unrelated debt financed income tax (“UDFI”) that applies to an IRA when the IRA leverages its investment dollars with debt. Essentially, the IRS will tax the income from the debt invested while leaving the percent of the deal attributed to the IRAs cash investment not subject to tax. So, for example, let’s say your IRA bought a rental property for $100k with the IRA putting $40k cash down and getting a non-recourse loan for $60k. To the IRS, 40% of this deal is the IRA funds and 40% of the income is not subject to tax while the other 60% is non-IRA funds and that 60% is subject to tax. The tax on this 60% is UDFI tax. The tax rate on UDFI is the trust tax rates which maxes out at 34% on rental income. This is after expenses of course; which expenses include depreciation.
Upon the sale of the property, the IRS allows you to use the capital gains tax rate for the UDFI tax so you can move down from the 34% rate to the max long-term capital gains rate of 20%. Now technically, UDFI is a form of UBIT tax discussed below. But it applies in a very different way, when there is debt, so I explain it separately.
Many self-directed IRA investors will only buy real estate with cash in their IRA and won’t bother with a non-recourse loan and the UDFI tax burden while others view the UDFI tax as a cost of doing business and see debt as a tool to buy more property and thereby increase overall returns. Keep in mind, UDFI tax is only due on net rental income or net gain upon sale and this is after property expenses and depreciation expense.
Watch Out for Unrelated Business Income Tax (UBIT)?
There is a tax that can apply to an IRA’s income called unrelated business income tax (“UBIT”). Usually, when we think of IRAs, we aren’t expecting there to be taxes on the income and this is typically the case. However, there are a few situations where IRAs will have to pay tax on the income they make. These tax situations arise when the income being made is considered “business income” (aka, ordinary income) as opposed to investment income. Most real estate income is automatically exempt from UBIT. Exempt income from UBIT includes rental real estate income, capital gain income when you sell real estate, and interest income when you lend money on real estate. IRC 512. So let’s go over the common situations where UBIT tax is generally due.
First, there is the instance of debt mentioned above which causes UDFI. UDFI is a form of UBIT and applies to the profits attributable to the debt involved.
Second, if the IRA is doing real estate development activities, or is otherwise invested in real estate projects that create ordinary income it will need to pay UBIT tax on the profits. Real estate development income that is ordinary income in nature, as opposed to long-term capital gain, will cause UBIT for the IRA. It is possible to do real estate development with an IRA and hold the property for investment purposes. If a real estate development was done and the property held for investment, then the IRA would avoid UBIT tax. That being said, you should carefully consult with your tax lawyer or CPA on the details of your strategy and whether UBIT would apply.
The last situation where UBIT can apply is when you flip multiple properties with your IRA in a year. Since most fix and flip transactions are short-term in nature (under one-year hold time), IRA owners need to be careful not to do too many flips with their IRA in one year as the IRA can be deemed to be in the business of real estate. If the IRA is deemed to be in the business of real estate, then the income the IRA makes from the flips will be subject to UBIT. If the IRA is flipping one or two properties a year you don’t need to worry about the IRA being deemed in the business of real estate. However, if the IRA is flipping more a couple properties a year you should consult you tax lawyer or CPA on the exact details of your IRAs investments.
If your IRA is subject to UBIT, then the IRA files its own separate tax return called a 990-T and the IRA pays the tax due. This return is separate from the IRA owner’s personal tax return. The 990-T is the responsibility of the IRA owner and is not something that is generally prepared by your self-directed IRA custodian. You’ll need to engage a tax lawyer, CPA, or accountant to prepare and file the 990-T. Or you can complete it on your own, but it is a very technical return and there is little guidance on how it should be prepared for an IRA.
These rules can seem a little foreign and overwhelming at first. But I like to say that learning how to self-direct your IRA is like learning a new board game. It’s not that the board game rules are complicated. Rather, it is something you need to learn first before playing and moving pieces. When we play a new board game, we first read the rule book, or we play with someone who already knows the game. So, like playing a board game, read up on the subject and consider my book, The Self-Directed IRA Handbook, or play the game with others who knows the rules (e.g., a lawyer, CPA, advisor, or other investor). After you’ve properly self-directed your IRA into real estate once, you’ll have the rules down and it’s the same game each time thereafter…at least until Congress changes the rules of the game. And if they do, I’ll update my rulebook.
In a recent U.S. Tax Court case, the Court ruled against an IRA owner and deemed his IRA distributed and taxable as the IRA owner failed to properly execute his intended self-directed IRA real estate investment. Dabney v. Commissioner, T.C. Memo 2014-108.
The IRA owner had an IRA at Charles Schwab and intended to use the IRA to acquire real estate in Brian Head, UT. Upon conducting research Mr. Dabney learned that an IRA could own real estate. However, instead of rolling or transferring his IRA funds to a self directed IRA custodian who would allow his IRA to own real estate, Mr. Dabney took a distribution of the IRA and directed Schwab to wire the funds to closing for the purchase of the property. Additionally, he instructed title and eventually received a deed in the name of his Schwab IRA.
The problem was that rather than invest his IRA into real estate he instead distributed his IRA and use the distributed fund to buy real estate outside of his IRA. Charles Schwab issued Mr. Dabney a 1099-R for that distribution and Mr. Dabney contested the 1099-R and the taxes owed as a result arguing that the funds were used to buy a property owned by his Schwab IRA. Mr. Dabney argued that Charles Schwab made a mistake. However, the Court ruled against him because his funds were distributed out of his Charles Schwab IRA and because his IRA funds and the real estate were not held by a self-directed IRA custodian that allowed for IRAs to own real estate. The Court stated that an IRA can certainly hold real estate but that Charles Schwab’s policies did not allow for Mr. Dabney’s IRA to own real estate and since his custodian would not hold the real estate as an asset of his IRA that it was deemed distributed.
The lesson to be learned from the Dabney case is that in order to properly execute a self-directed IRA investment into an asset such as real estate, the IRA owner needs to roll over or transfer their IRA funds first to a self-directed IRA custodian who allows the IRA to own real estate and then that self-directed IRA will actually take title and ownership to the IRA asset directly. While these rules seem simple, I’d estimate that I speak to at least one or two IRA owners a year who took a distribution from an IRA and used those funds to buy real estate (or some other alternative asset) thinking that the real estate would still be owned by their IRA and that the funds would not be distributed and subject to tax. The confusion usually arises with the non-self directed custodian who misunderstands what the the account owner is trying to do (invest the IRA, not distribute it). Keep in mind, that in order to own real estate with a self-directed IRA, you must have a self-directed IRA custodian.
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Tom W. Anderson
The "Self Directed IRA Handbook" by attorney Mat Sorensen is the most comprehensive book ever written about one of the best investment and retirement savings tools ever created: the Self-Directed IRA. Mat has performed the impossible by effectively delivering complex information in an easily understandable manner for the layperson, while providing the necessary legal basis to suit the professional. Mat's book is a "must read" for investors, attorneys, CPAs, and other professionals and other interested individuals wanting to learn about all there is to know about Self-Directed IRAs.
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"Mat's books is a great reference guide for self-directed IRA investing – Best I’ve seen in 30 years of being in the business."
CEO / Polycomp Trust Company
"The Self Directed IRA Handbook by attorney Mat Sorensen is the most comprehensive book ever written about one of the best investment and retirement savings tools ever created: the Self-Directed IRA."
Founder and Retired CEO, PENSCO Trust Company
Mat’s book is the most practical and comprehensive self directed IRA guide in our industry. Reading this handbook should be the first step for any alternative asset investor, investment sponsor, or trusted advisor that seeks to become informed about how to maximize the value of IRAs.