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.
If you have a self-directed IRA with non-publicly traded assets like real estate, private stock, or an LLC interest, you’ve definitely been asked for an annual fair market valuation for the assets in your account. Why does your IRA custodian ask for this every year? Because they have to.
An IRA must report its fair market value to the IRS annually. Fair market value is reported to the IRS by your IRA custodian via IRS Form 5498. For standard IRAs holding stocks or mutual funds, those account values are automatically determined as they simply take the stock or fund price as of the close of the market on December 31st each year, and they use these amounts to set the year-end account fair market value. For self-directed accounts, such fair market values are not readily available and it becomes the IRA account owner’s responsibility to obtain their self-directed investment values so that their custodian can properly report the account’s fair market value. The value of an account is important for a few reasons. First, the IRS requires it to be updated annually. Second, it is used to set required minimum distributions (“RMDs”) for those account holders over the age of 70 ½ with traditional IRAs. Lastly, the account value is used when converting an entire account, or a particular investment or portion of the account, from a traditional IRA to a Roth IRA.
WHAT IS FAIR MARKET VALUE
Fair market value of an investment has been broadly defined by the Court as:
“The price at which property would change hands between a hypothetical willing buyer and a hypothetical willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts.” U.S. v. Cartwright, 411 US 546 (1973).
Now here’s the hard part: Even though the IRS requires IRAs to update their fair market value on an annual basis, the Government Accountability Office noted in their recent report that:
“Current IRS guidance includes NO [emphasis added] guidance or advice to custodians or IRA owners regarding how to determine the FMV [fair market value]”. United States Government Accountability Office, GAO-17-02, Retirement Security Improved Guidance Could Help Account Owners Understand the Risks of Investing in Unconventional Assets. (Dec. 2016).
The absence of guidance, however, has not relieved IRA owners or their custodians from obtaining and reporting this information. While there is no specific fair market valuation guidance for IRAs, there are commonly accepted methods of reporting value used by professionals and companies within the self-directed IRA industry. Most of these methods have been adopted from law and regulations governing employer retirement plans or estates.
METHODS TO BE USED BY ASSET TYPE
The table below outlines preferred valuation methods that are commonly used in the industry for the most common self-directed IRA assets. As you will note, when the valuation is needed for a taxable event, such as a distribution or Roth conversion, greater detail and supporting information will be required as the valuation will result in tax being due.*
|Asset||Non-Taxable (Annual FMV)||Taxable (RMD, distribution or conversion)|
|Real Estate||Comparative Market Analysis (CMA) from a real estate professional is preferred. Some IRA custodians accept property tax assessor values or Zillow reports in non-taxable situations.||Real estate appraisal is preferred. Some IRA custodians accept a broker’s price opinion.|
|Promissory Note||Value of a note can be reported by calculating the principal due plus any accrued and unpaid interest. This is the valuation method used for calculating the value of a note for estate tax purposes.||Same as non-taxable, principal amount due plus accrued and un-paid interest. For notes in default, a third-party opinion as to value is typically required in order for the note to be written-down below face value.|
|Precious Metals||For bullion, use the spot value of the metal in question times the ounces owned. Spot value is widely reported on a daily basis on financial sites.|
For acceptable coins, use market data for the coin in question via the Grey Sheets available at www.bullionvalues.com.
|Same as non-taxable.|
|LLC, LP, or Private Company Interest||Obtain a third party-opinion of value of the LLC interest. The opinion should rely on IRS Revenue Ruling 59-60. For asset holding companies, the valuation should focus on the value of the assets. For operating companies, the valuation should focus on earnings.||Similar requirement, but the detail of the opinion should be more significant. For example, for an asset holding company where the IRAs interest is determined by the assets of the LLC. A CMA would be acceptable for calculating that assets value in the company in an annual valuation. However, an appraisal of the real estate to calculate in that asset would be required in a taxable situation.|
Since the valuation reporting policies of custodians vary, IRA owners should make sure that they understand their IRA custodian’s policies for valuations for the assets in question.
Our firm routinely assists clients with obtaining third-party opinions of value and can assist IRA owners who need to produce a report or third party opinion as to an LLC or other investment interest held by an IRA.
* Please note that there are clearly differences of opinions on these matters, and since there is no specific legal guidance for IRA valuations, please keep in mind that the table above is based on my own industry experience and opinions. Seek a licensed professional in all instances for your specific situation.
The IRS recently released updated the extension rules for 990-T tax returns that are required for certain self-directed IRAs. Form 990-T is a tax return that must be filed by an IRA when it receives what is known as unrelated business taxable income (“UBTI”). For a description on UBTI and 990-T returns in general, see my prior article here.
The new rules allow an IRA to receive a automatic 6 month extension of time to file by filing IRS Form 8868. Previously, IRAs required to file a 990-T, were only allowed an automatic 3 month extension. The new extension procedures were released in January 2017 and apply to 2016 990-T returns. To claim the extension, the IRA must take the following steps.
- Obtain a Tax ID/EIN for the IRA. Generally, IRAs do not have their own Tax ID/EIN and they should not obtain one, except when a 990-T return needs to be filed. The Tax ID/EIN can be obtained at IRS.gov.
- Complete and File the Extension Request Using IRS Form 8868. The automatic 6-month extension for the filing of a 990-T is obtained by filing IRS Form 8868.
- File the Extension by April 15th. The regular filing deadline for form 990-T is the 15th day of the fourth month following the tax year (e.g. April 15th each year). Make sure the extension is filed by April 15th and keep a copy as you’ll need to send a copy with the extended return. Keep in mind, the extension to file is not an extension to pay so if you end up owing UBIT and if your IRA hasn’t made any tax deposits you may have a small amount of penalty and interest due when you later file and pay.
If your self-directed IRA investments are running into UBIT, make sure you’re reporting and paying any applicable UBIT via form 990-T to the IRS. Failure to do so can result in penalties, interest, and potentially loss of the IRA’s tax preferred status. If you’re not ready to file by April 15th, make sure you file the automatic extension request to give yourself 6 more months to file.
The Government Accountability Office (“GAO”) concluded over a year of research and investigation on self-directed IRA’s and 401(k)’s with a report to Congress called Retirement Security: Improved Guidance Could Help Account Owners Understand the Risks of Investing in Unconventional Assets.
Self-directed IRA’s and 401(k)’s are accounts that may be invested into “unconventional” assets. The most common “self-directed” assets are real estate, LLC’s, start-ups, venture capital, private funds, and precious metals. The self-directed IRA industry has tripled over the past ten years and the demand and interest from retirement account holders continues to grow.
The GAO was tasked to research self-directed IRA’s by Senator Ron Wyden (D-OR) who serves as the ranking member of the Senate Finance Committee.
The GAO identified 27 custodians who handle self-directed IRA’s holding “unconventional” assets such as real estate, LLC’s, private company stock, and precious metals. Seventeen of these companies participated and responded to surveys and requests for information. These 17 companies reported holding 500,000 retirement accounts and $50 Billion in assets in unconventional investments.
I was interviewed by the GAO for this report and they also used my book, The Self-Directed IRA Handbook, while conducting research on the laws and taxes affecting self-directed IRA and 401(k) investors.
The GAO’s report concluded that IRS guidance is lacking in three specific areas:
- Prohibited Transactions: The GAO concluded that self-directed account holders who invest in unconventional assets are at greater risk of engaging in prohibited transactions and that the IRS should engage in additional outreach and education with regards to unconventional assets to ensure compliance. The prohibited transactions rules are found in IRC § 4975 and essentially restrict the account owner, and certain family members, from transacting personally with their own IRA. For example, it would be a prohibited transaction for an IRA owner to sell private stock they personally own to their own IRA. It is also a prohibited transaction to have use or benefit of your IRA’s assets. For example, if your IRA owned real estate, it would be a prohibited transaction to have personal use or occupancy of the property.
- UBTI (Unrelated Business Taxable Income): The GAO’s research and investigation concluded that many self-directed IRA and 401(k) investors are unaware of the unrelated business taxable income (“UBTI”) that can apply to some “unconventional” investments owned by an IRA. UBTI tax applies to IRA’s when they receive “business” income as opposed to “investment” income. IRA’s are designed to receive investment income such as rental income, interest income, dividend income, or capital gain income. However, if an IRA receives “business” income or “ordinary” income, that causes UBTI and the IRA ends up being responsible for tax on its income. In this instance, the IRA files a 990-T tax return and is responsible for tax on the income earned. Most self-directed IRA investments do not cause UBTI, but many self-directed investors unwittingly run into this tax. The GAO found in its report that there isn’t any guidance regarding UBTI in the IRS publications on IRA’s, Publications 590-A and 590-B. The GAO warned that without caution or specific guidance in these publications or through other efforts by the IRS, that self-directed account owners may unwittingly invest their account into assets that cause UBTI tax.
- Fair Market Valuations: The GAO’s report found that there is zero advice to custodians of IRA’s or to IRA owners regarding how to determine the fair market value (“FMV”) for unconventional assets held in a retirement account. Each year, the custodian of a self-directed IRA must report the FMV of the account to the IRS via form 5498. For publicly traded assets such as stocks or mutual funds, valuation is relatively simple as the valuations is the price of the stock or fund as of close of the market price on December 31 each year. For assets such as real estate or private company stock, such value is not as readily available and account holders and companies use varying methods for reporting FMV annually to the IRS. The GAO recommended that the IRS develop guidance or regulations on how unconventional assets should be valued and reported to the IRS. In their response to the report, the IRS stated that they will recommend that Treasury address fair market valuations in their upcoming retirement plan regulations for 2016-2017
The GAO report was an excellent analysis and summary of the common issues facing self-directed IRA and 401(k) owners investing in unconventional assets. As an attorney representing self-directed account holders for over ten years, I wholeheartedly agree with the three issues the GAO cited in their report and believe that further guidance from the IRS would increase awareness for not only account holders but also for their professional tax, legal, and financial advisers.
The RISE Act proposed by Senator Ron Wyden of Oregon would significantly impact self-directed IRAs. I previously wrote about the bill here and provided a detailed analysis. In summary, the bill would require that all self-directed IRA investment purchases be valued by a third-party appraiser and reported on the IRA owner’s personal tax return. In addition, the Act would change the disqualified person rule for companies from 50% to 10%. The Act also greatly effects Roth IRAs and would eliminate Roth conversions and would cap Roth IRA accounts at $5M.
Here are few quick updates that are very important to the bill.
- Senator Orrin Hatch of Utah (R) has introduced the Retirement Enhancement and Savings Act of 2016. This bill is farther long in the process and addresses retirement account issues but is entirely un-related to Senator Wyden’s proposed RISE Act the impacts self-directed IRAs. I’ve had a few clients worried as they’ve ran across this bill as it is currently working its way through the Senate.
- Senator Wyden’s RISE Act is in proposed form and is out for comment until December 7, 2016. You can reply with comments to Retirement_Savings@finance.senate.gov. I will post my Comment in a subsequent blog article.
- While the bill is sponsored by Democrat Senator in a Republican controlled Senate, it is still vitally important that the Senate Finance Committee understand the roadblocks and burdens that the bills IRA provisions will cause to hundreds of thousands of Americans who are investing for retirement with their self-directed IRA.
- If your Senator is a member of the Senate Finance Committee, I would highly recommend sending focused and professional comments to your Senator regarding provisions that will hinder your ability to save and invest for retirement. The current members of the Senate Finance Committee can be found here.
Additionally, if you have comments or feedback relative to the proposed bill, please feel free to that to me at email@example.com.