Here is Why Understanding the Self-Directed IRA Rules May be as Important as Picking the Right Investment for Your retirement

May 17th, 2018

It has been almost fifty years since IRAs have been established and still the majority of retirement account holders are not aware of the self-directed IRA rules which allow IRA holders to buy real estate and other alternative assets with an IRA.

By using a self-directed IRA, which is essentially an IRA held at a custodian that allows for alternative asset investments, an IRA holder is able to make traditional as well as alternative asset investments, such as real estate, notes, tax liens, gold, cryptocurrencies, private businesses, and much more.  In fact, the Internal Revenue Code does not describe what a self-directed IRA can invest in, only what it cannot invest in. Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain types of transactions.  In general, as long as the self-directed IRA does not purchase life insurance, collectibles, or engage in a prohibited transaction outlined in Code Section 4975, then the investment can be made.

The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest.  In other words, one cannot use their IRA funds to invest in any transaction directly or indirectly involving themselves or any lineal descendant, such as a parent, child, spouse, daughter/son-in-aw, as well as any entity affiliated with such persons.

In addition to understanding the application of the self-directed IRA prohibited transaction rules,  any IRA investor seeking to use a loan associated with real estate or invest in an active business operated through a passthrough entity must be conscious of the unrelated business taxable income (UBTI) rules.

In general, most passive investments that your Self-Directed IRA might invest in are exempt from UBTI. Some examples of exempt type of income include: interest from loans, dividends, annuities, royalties, most rentals from real estate, and gains/losses from the sale of real estate.  However, the following types of income could subject a Self-Directed IRA to the UBTI tax:

  • Income from the operations of an active trade or business through a passthrough entity, such as an LLC.
  • Using a nonrecourse loan to purchase a property (there is an exception for a 401(k) plan)
  • Using margin on a stock purchase

Almost a million retirement account investors have used self-directed IRAs to invest in what they know and understand, such as real estate.  However, before deciding to use a self-directed IRA to make an investment, it is wise to get a handle on the self-directed IRA rules, especially the prohibited transaction rules and the application of the UBTI tax.

 

Adam Bergman is the founder of the IRA Financial Group & IRA Financial Trust Company.  For more information on this topic please call 800-472-0646.