The Self-Directed IRA (SDIRA) is an individual retirement account that allows you to save for retirement in a tax-efficient manner. The most defining characteristic of the Self-Directed IRA is that investors can use their retirement funds to invest in traditional assets (stocks, bonds, ETFs, etc.) as well as alternative assets (real estate, private business, precious metals, etc.). Here, we provide a Self-Directed IRA FAQ list to help shed light on this type of retirement plan.
Solo 401(k) vs Self-Directed IRA LLC
Q: If I am self-employed, is there any reason I would not want to adopt a solo 401(k) Plan vs. a Self-Directed IRA LLC?
A: If you are self-employed or a small business owner with no full-time employees other than the owners, the Solo 401(k) Plan offers the same benefits of a self directed IRA LLC plus many more tax and retirement advantages.
Tax-Free IRA Distribution
Q: Will it be possible to take an IRA distribution and put it directly into a charitable trust, tax free?
A: In general, the charitable IRA provision benefited a lot of taxpayers more than they would have saved by taking money from an IRA, paying income taxes on it and writing a check to charity. However, if one were under the age of 70 and wished to use IRA funds to make a charitable contribution, the individual would first have to take an IRA distribution and then make a charitable contribution. In other words, the individual would have to take the distribution into income and then would receive a charitable deduction for the amount of the contribution.
Take the example of a $20,000 gift. Someone who doesn’t itemize deductions normally would receive no tax break for the gift. But the qualified charitable distribution would allow the taxpayer to exclude the $20,000 from income. Assuming one is in the 25% tax bracket that would save $5,000.
Types of Self-Directed IRAs
Q: Are all Self-Directed IRAs the Same?
A: A Self-Directed IRA is a type of IRA structure that allows the IRA holder (you) to have more control over your retirement funds. There are essentially three types of Self-Directed IRAs:
- Those offered by financial institutions: With this type of Self-Directed IRA, the IRA holder is generally able to only make IRA investments offered by the financial institution which typically only includes financial relates investments, such as stock, mutual funds, and ETFs. Even though these types of IRA accounts are called “Self-Directed IRA” accounts that are very limited in their investment scope and do not allow IRA investors to make any non-traditional investments, such as real estate.
- Those controlled by custodians: Unlike a typical financial institution, most IRA custodians generate fees simply by opening and maintaining accounts and do not offer any financial investment products or platforms. The funds are generally held with the IRA custodian who, at the IRA holder’s direction, invests the funds accordingly.
- Checkbook control: The IRA holder has total control over IRA funds and does not need to get investments approved by the custodian of the account. Instead, all decisions truly belong to the account holder. When the account holder finds an investment that they want to make, they can simply write a check or wire the funds straight from their Self-Directed IRA LLC bank account to make the investment.
Self-Directed IRA LLC Custodian
Q: Do I need to use a special custodian in order to create a Self-Directed IRA LLC?
A: An individual retirement account is a trust or custodial account set up in the United States for the exclusive benefit of you or your beneficiaries. The account is created by a written document. The document must show that the account meets certain requirements. Specifically, the trustee or custodian must be a bank, a federally insured credit union, a savings and loan association, or an entity approved by the IRS to act as trustee or custodian. Hence, when opening a self-directed IRA, a custodian must be used in order to house the IRA account. However, in the case of a self-directed IRA LLC, after the IRA account has been established, the IRA funds are then invested into a LLC account, which can be opened at any local bank.
Self-Directed IRA LLC & Checkbook Control
Q: Is there a difference between a Self-Directed IRA LLC and a “checkbook control” IRA? I hear these terms being referenced but not sure if they are different structures.
A: This is a really good question that comes up often. There is no difference between a Self-Directed IRA LLC and the “checkbook control” IRA. Both terms refer to a type of structure that involves the establishment of a special purpose limited liability company (“LLC”) that is wholly owned by the IRA and managed by the IRA holder or any third-party. This structure offers the IRA holder more control and investment freedom over his/her IRA assets.
Q: If I make a real estate or other investment with my Self-Directed IRA LLC, are they protected against fraud?
A: In general, retirement funds are only protected against fraud or theft if they are deposited in an FDIC insured account. FDIC insurance covers all deposit accounts, including checking and savings accounts, money market deposit accounts and certificates of deposit. The standard insurance amount is $250,000 per depositor, per insured bank, for each account ownership category. If one makes a real estate investment or loans to a third-party and those funds are taken out of the FDIC insured account and invested, those funds are no longer granted FDIC insured protection and would not be protected against fraud.
IRA Financial Group is committed to helping our clients make safe and financial rewarding investments with their self-directed IRA accounts. While self-directed IRAs can be a safe way to invest retirement funds, investors should be mindful of potential fraudulent schemes.
FDIC Insured Funds
Q: With a Self-Directed IRA LLC, are my IRA funds FDIC insured?
A: When establishing a Self-Directed IRA LLC with “checkbook control”, the retirement funds must be deposited first with an IRA custodian/administrator before they are sent to the LLC. The IRA custodian, which is an FDIC insured bank, would be the financial institution where the funds are deposited before they are wired to the IRA LLC. FDIC insurance covers all deposit accounts, including checking and savings accounts, money market deposit accounts and certificates of deposit. The standard insurance amount is $250,000 per depositor, per insured bank, for each account ownership category.
IRS Stance on the Self-Directed IRA LLC
Q: Is a Self-Directed IRA LLC IRS Approved?
A: Yes. The Self Directed IRA LLC structure was affirmed in the Tax Court case Swanson v. Commissioner, 106 T.C. 76 (1996), and further confirmed by the IRS in Field Service Advisory (FSA) 200128011 (April 6, 2001).
Traditional Financial Institutions & The SDIRA
Q: Why hasn’t my CPA/Attorney/Financial Advisor heard of a Self Directed IRA LLC?
A: It is not entirely uncommon for a tax or financial advisor to have not heard of Self-Directed IRA LLCs given the fact that the traditional financial institutions have concealed their benefits due to their focus on selling the more profitable equities, bonds, and mutual funds.
Self-Directed IRA LLC Investments
Q: What investment can I make with a Self Directed IRA LLC?
A: A Self-Directed IRA LLC offers one the ability to use his or her retirement funds to make almost any type of investment on their own without requiring the consent of any custodian or person. In fact. the IRS only describes the type of investments that are prohibited, which are very few. The following are some of the more common of types of investments that can be made with your Self-Directed IRA LLC:
- Residential or commercial real estate
- Raw land
- Foreclosure property
- Mortgage pools
- Private loans
- Tax liens
- Private businesses
- Limited Liability Companies
- Limited Liability Partnerships
- Private placements
- Stocks, bonds, mutual funds
- Most currencies
Popularity of the Self-Directed IRA
Q: Why isn’t the Self-Directed IRA LLC more popular?
A: Alternative investments such as real estate have always been permitted in IRAs, but few people seemed to know about this option- until the last several years. This is because large financial institutions have little incentive to recommend something other than stocks, bonds or mutual funds which bring in extremely profitable commission and fees for them. Between now and 2020, alternative assets are expected to grow to $13.6tn in our base case scenario and to $15.3tn in our high case scenario. Self-Directed IRA alternative assets are valued at approx $200 billion
Self-Directed IRA LLC for Real Estate
Q: Can I use the Self Directed IRA LLC to invest in real estate?
A: Yes. The IRS has always permitted real estate to be held inside IRA retirement accounts. Investments with a Real Estate IRA are fully permissible under the Employee Retirement Income Security Act of 1974 (ERISA). Real estate is one of the most popular self-directed IRA investments. IRS rules permit you to engage in almost any type of real estate investment, aside generally from any investment involving a disqualified person. In addition, the IRS states the following on their website: “…..IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option.”
Q: What is a Disqualified Person?
A: The term “Disqualified Person” includes virtually anyone having a direct or indirect relationship to the plan other than as a participant or beneficiary. Under Internal Revenue Code Section 4975, the principal categories of Disqualified Persons are:
- The IRA participant (holder)
- The IRA participant’s spouse
- The IRA’s participant’s ancestors and lineal descendants (mother/father/daughter/son)
- Spouses of the IRA participant’s lineal descendants (son/daughter’s spouse)
- Fiduciaries of the plan (custodian or trustee)
- Investment managers and advisors
- Any corporation, partnership, trust, or estate in which the IRA holder has a 50% or greater interest
Note: According to Internal Revenue Code Section 4975, siblings, aunts, uncles, cousins, and friends are not included in the definition of Disqualified Persons.
Q: What is a Prohibited Transaction?
A: Internal Revenue Code Sections 4975 & 408 prohibit fiduciary and other Disqualified Persons from engaging in certain types of “prohibited transactions”. “Prohibited transactions” are any direct or indirect:
- sale or exchange, or leasing, of any property between a plan and a disqualified person;
- lending of money or other extension of credit between a plan and a disqualified person;
- furnishing of goods, services, or facilities between a plan and a disqualified person;
- transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
- act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account; or
- receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.
Fiduciary prohibited transactions appear to be the most common type of prohibited transaction in the self-directed IRA context. The IRA owner is a fiduciary to a self-directed IRA and cannot use the IRA funds to directly or indirectly benefit himself or any disqualified person. The fiduciary prohibited transaction rules under Code Section 4975(c)(1)(D) and (E) are applicable, regardless of whether there is a disqualified person on the other side of the transaction.
Q: What types of transactions are treated as a “disqualified transaction”?
A: Under Internal Revenue Code Section 408, the acquisition by an IRA or an individually-directed account under a qualified retirement plan of any collectible is treated as a distribution from the IRA or account in an amount equal to the cost to the IRA or account of the collectible (Code Sec. 408(m)(1)). A collectible is any work of art, rug or antique, metal or gem, stamp or coin, alcoholic beverage, or any other tangible personal property specified by IRS for this purpose (Code Sec. 408(m)(2)). In general, under Code Section 408, an IRA cannot invest in life insurance contracts or collectibles defined below:
- Any work of art
- Any metal or gem
- Any alcoholic beverage
- Any rug or antique
- Any stamp
- Most coins
- Baseball cards
Custodian Consent Before Investment
Q: Do I need to ask permission to make an investment with my Self-Directed IRA LLC?
A: No – not with a Self-Directed IRA LLC with “checkbook control.” All investment decisions are made by you, as manager of the Self-Directed IRA LLC. It’s simple – when you want to make an investment, you write a check, use your debit card, wire funds, etc. All documents can be signed by you, as manager of the LLC. With our Self-Directed IRA LLC, you will have total control over your IRA funds and you will no longer have to get each investment approved by the custodian of your self-directed IRA.
Traditional IRA vs Self-Directed IRA LLC
Q: What is the difference between a Traditional IRA with no Checkbook Control and Self-Directed IRA LLC with Checkbook Control?
A: Many “traditional IRA” custodians advertise themselves as offering a Self Directed IRA with “checkbook control”, but what that really means is that you can direct your IRA as long as you direct into one of their offerings. In other words, with a regular self-directed IRA with no “checkbook control”, you are generally only permitted to invest your IRA funds in investments in equities, mutual funds, bonds or investments offered by the custodian. Whereas, in the case of a Self Directed IRA LLC with “checkbook control”, a limited liability company (“LLC”) is established that is owned by the IRA account and managed by the IRA account holder. The IRA Holder’s IRA funds are then transferred by the Custodian to the LLC’s bank account providing the IRA (you) with a wide range of investment opportunities, such as real estate, tax liens, precious metals, cryptocurrencies, notes, private businesses, etc..
Custodian Control vs Checkbook Control
Q: What is the difference between Custodian controlled Self-Directed IRA vs. Self-Directed IRA LLC with Checkbook control?
A: A custodian controlled Self-Directed IRA offers an IRA investor more investment options than a financial institution Self-Directed IRA. With a custodian controlled Self-Directed IRA, a special IRA custodian will serve as the custodian of the IRA. Unlike a typical financial institution, most IRA custodians generate fees simply by opening and maintaining IRA accounts and do not offer any financial investment products or platforms. With a custodian controlled self-directed IRA, the IRA funds are generally held with the IRA custodian and at the IRA holder’s sole direction, the IRA custodian will then invest the IRA funds into traditional as well as alternative asset investments, such as real estate.
The Self-Directed IRA LLC with “checkbook control” has quickly become the most popular vehicle for investors looking to make alternative assets investments, such as rental real estate that require a high frequency of transactions. Under the checkbook IRA format, a limited liability company (“LLC”) is created which is funded and owned by the IRA and managed by the IRA holder. The “checkbook control” Self-Directed IRA allows one to eliminate certain costs and delays often associated with using a full -service IRA custodian. The Checkbook IRA LLC structure allows the investor to act quickly when the right investment opportunity presents itself cost effectively and without delay.
Custodian vs Passive Custodian
Q: What is the difference between a Custodian and Passive Custodian?
A: An IRA trustee, also called a custodian, is the institution that administers your plan. By law, every qualified retirement plan must have a custodian or trustee. A trustee may be a bank, credit union, trust company, such as IRA Financial Trust. IRS regulations require that either a qualified trustee or custodian hold the IRA assets on behalf of the IRA owner. A Self-Directed IRA custodian, also called a passive custodian, allows IRA holders to engage in non-traditional investments (i.e. real estate), but generally does not offer investment advice. IRA Financial Group has a close working relationship with all the major FDIC backed passive custodians.
Use of a LLC
Q: Why use a LLC for making Self Directed IRA investments?
A: A Limited Liability Company (LLC) is a company that has option to be taxed as a partnership, this is beneficial because the LLC won’t pay any taxes on gains, and instead it will be the owner of the LLC who is liable for any taxes just as if they earned the money themselves. Because the owner of the LLC is your IRA (the IRA owner is the manager), there are no taxes unless you are running a business that is unrelated to the purpose of an IRA (making investments), using debt financing or taking a distribution from your IRA. In addition, the LLC offers limited liability and asset protection with respect to the assets of the IRA.
Passive Investment Income
Q: If my Self-Directed IRA LLC generates income from a passive investment, such as rental income, what happens to the rental income?
A: In general, all passive income generated by the Self-Directed IRA LLC goes back into the Self-Directed IRA LLC without tax. The Self-Directed IRA LLC offers the advantages of tax deferral, or tax-free gains in the case of a Roth, allowing you to invest your retirement funds in almost anything, including real estate tax free.
Q: Can my Self-Directed IRA LLC get a mortgage on a piece of property?
A: Yes. The mortgage would need to be a non-recourse type of loan. With a non-recourse loan, if your IRA fails to make the payments, the only recourse the lender has is the property itself. Also, note that if your IRA obtains a loan, unrelated debt financing income tax (UDFI) will apply, which will subject the portion of the income or gains that are debt financed to Unrelated Business Taxable Income (UBTI). “Debt-financed property” refers to borrowing money to purchase the real estate (i.e., a leveraged asset that is held to produce income). In such cases, only the income attributable to the financed portion of the property is taxed; gain on the profit from the sale of the leveraged assets is also UDFI (unless the debt is paid off more than 12 months before the property is sold).
Property Improvements & Renovations
Q: Can I use my Self Directed-IRA LLC funds to make property improvements or renovations?
Yes. If your Self-Directed IRA LLC makes a property investment, all repairs, improvements, or renovations expenses associated with the property must be paid from the Self-Directed IRA LLC’s funds and the repairs and improvements should not be made by you or any other “disqualified person”.
Self-Directed IRA Loans – Sibling
Q: Can I use my Self-Directed IRA LLC to make loans to a sibling?
A: Yes. According to IRC 4975, siblings are not included in the definition of disqualified persons. Thus, a loan to a sibling would not be a prohibited transaction.
Self-Directed IRA Loans – Friends
Q: Can I use my Self-Directed IRA LLC to make a loan to a friend, real estate developer, or business?
A: Yes. As long as the borrower is not a disqualified person (i.e. lineal descendant), a loan to a third-party would not be a prohibited transaction.
IRA Funds for Vacation Property
Q: Can I use my Self-Directed IRA LLC to buy a piece of vacation property?
A: Yes. you may use IRA funds to purchase vacation property; however, you will not be permitted to vacation there or use it any manner.
Use of IRA Assets for a Loan
Q: Can I use my IRA assets to guarantee a loan or personally guarantee an IRA loan?
A: No. A “prohibited transaction” is a transaction that, directly or indirectly involves loan of money or other extension of credit between a plan and a disqualified person. Normally, when an individual purchases real estate with a mortgage, the traditional loan provides for recourse against the borrower (i.e., personal liability for the mortgage). However, if the IRA purchases real estate and secures a mortgage for the purchase, the loan must be non-recourse; otherwise there will be a prohibited transaction.
S Corporation Investment
Q: Can my Self-Directed IRA LLC make an investment in a “S” Corporation?
A: In general, under the “ S” Corporation rules, an IRA is not permitted to be an “S” Corporation shareholder. In order to be considered an “S” corporation, shareholders must be U.S. citizens or residents and must be natural persons, so corporate shareholders, partnerships, and multi-member LLCs are excluded. The IRS has ruled in a Revenue Ruling that an IRA is not a qualified shareholder for “S” Corporation purposes.
Investments Owned by Disqualified Persons
Q: Can my Self-Directed IRA LLC invest in an entity or business which is currently owned by a disqualified person?
A: The answer is generally no. It is good practice to not invest retirement funds into any closely held entity that is owned by yourself or a disqualified person. Clearly one can invest retirement funds and personal funds in a widely held company, such as Apple. The tax code under Internal Revenue Code Section 4975 holds that any corporation, partnership, trust, or estate in which the IRA holder holds less than 50% interest in would not be treated a s a disqualified person. In other words, the IRA and the IRA owner cannot invest 50% equally in a joint venture without triggering a prohibited transaction. However, various case law suggests that investing retirement funds in a closely held entity which is owned by a disqualified person who holds less than 50%, even as low as 10%, can trigger a prohibited transaction.
Investments Outside of the U.S.
Q: Can I use my Self-Directed IRA LLC to invest in property outside the United States?
A: 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. IRC 4975 does not prohibit retirement funds from purchasing real estate and does not distinguish between domestic and foreign real estate.
Performing Multiple Investments
Q: Can I make multiple investments with my Self-Directed IRA LLC funds?
A: Yes. You are permitted to make multiple investments with your Self-Directed IRA LLC as long as they are not prohibited transactions. For example, you can use a portion of your IRA funds to purchase real estate and use another portion to buy mutual funds.
Self-Directed IRA LLC Business Investments
Q: Can I use my Self-Directed IRA LLC to invest in a business?
A: Yes. As long as the business is not owned by the IRA owner or a disqualified person you are permitted to use your Self-Directed IRA LLC funds to invest in the business. However, any business regularly carried on or by a partnership or LLC of which the Self-Directed IRA LLC is a partner or member is an unrelated business and may trigger the unrelated business taxable income tax. For example, the operation of a shoe factory, the operation of a gas station, or the operation of a computer rental business by an LLC or partnership owned by the Self-Directed IRA LLC would likely be treated as an unrelated business and subject to UBTI. The only legal way to use retirement funds to buy a business the IRA holder or any disqualified person will be personally involved in is the Rollover Business Start-Up (ROBS) solution.
Q: Which government agency has jurisdiction over determining whether a transaction is a prohibited transaction?
A: Through an arrangement between the IRS and the Department of Labor (DOL), it is the DOL’s responsibility to determine whether a specific transaction is a prohibited transaction and to issue prohibited transaction exemptions. When the IRS discovers what appears to be a prohibited transaction in an individual’s IRA, it turns the matter over to the DOL to make the determination. The DOL reviews the situation and responds to the IRS, which in turn responds to the taxpayer. If the IRA grantor wants to apply for a prohibited transaction exemption, he or she must apply to the DOL. The DOL has the authority to issue prohibited transaction exemptions. Some, known as “prohibited transaction class exemptions” (PTCEs), are available for anyone’s reliance, while others, called “individual prohibited transaction exemptions” (PTEs), are issued only to the applicant.
Multiple IRA Accounts
Q: Can I have multiple IRA Accounts in my Self-Directed IRA LLC?
A: Yes – you may have multiple IRA accounts in your Self-Directed IRA LLC. Each account would be a member of the LLC and have an interest in the LLC based on the amount contributed. Profits and losses would be allocated to the IRA accounts based on the accounts percentage interest.
Q: Can I have a Traditional IRA and Roth IRA account in one Self-Directed IRA LLC?
A: Yes – you may have a Traditional IRA and Roth IRA account as members of your Self-Directed IRA LLC.Note: you should keep separate records for each account as the distribution and tax rules are somewhat different.
Co-Invest in a Self-Directed IRA LLC
Q: Can my spouse and I use one Self-Directed IRA LLC entity to make IRA investments?
A: Yes. You and your spouse’s IRA can co-invest in one Self-Directed IRA LLC entity. Each spouse’s IRA would own a percentage of the LLC based on the amount contributed. In some cases, it may make sense for each spouse to use a separate Self-Directed IRA LLC entity to make their investments. Instances such as investment disputes and/or divorce could end up complicating matters.
Q: Can I invest in Gold with my Self-Directed IRA LLC?
A: Yes. Under Internal Revenue Code Section 408, the acquisition by an IRA or an individually-directed account under a qualified retirement plan of any collectible is treated as a distribution from the IRA or account in an amount equal to the cost to the IRA or account of the collectible (Code Sec. 408(m)(1)). A collectible is any work of art, rug or antique, metal or gem, stamp or coin, alcoholic beverage, or any other tangible personal property specified by IRS for this purpose (Code Sec. 408(m)(2)). However, the following are not considered collectibles for this purpose:
- one, one-half, one-quarter or one-tenth ounce U.S. gold coins (American Gold Eagle coins are the only gold coins specifically approved for IRAs. Other gold coins, to be eligible as IRA investments, must be at least .995 fine (99.5% pure);
- one ounce silver coins minted by the Treasury Department;
- any coin issued under the laws of any state;
- a platinum coin described in 31 USCS 5112(k) ; and
- gold, silver, platinum or palladium bullion (other than bullion that is made into a coin) of a certain fineness that is in the physical possession of a trustee that meets the requirements for IRA trustees under Code Sec. 408(a)
It is important to remember that all IRS approved gold or coins must be held in the physical possession or a bank or depository and should never be held personally at home.
Unrelated Business Taxable Income
Q: What is Unrelated Business Taxable Income (UBTI)?
A: For many retirement account investors, understanding how the Unrelated Business Taxable Income Rules work, also known as UBTI, UBIT, or debt-financed income rules, and how they may potentially apply to ones retirement account investment has been a challenge. The main reason for this is that the majority of IRA or 401(k) plan investors invest in traditional types of investments, such as equities, mutual funds, ETFs, which do not trigger the application of the UBTI tax rules since most passive investments that a retirement account might invest in are exempt from the UBTI rules, such as interest, dividends, and capital gains. However, for retirement account investors seeking to make alternative type of non-real estate investments with their retirement accounts, such as options, stock short sales, commodity future contracts, understanding the potential impact of the UBTI rules are crucial. In general, the UBTI tax rules are triggered in three instances: (i) use of margin to buy stock, (ii) use of a non-recourse loan to buy real estate, and (iii) investment in a business operated through a flow-through entity, such as an LLC or partnership. The tax imposed by triggering the UBTI rules is quite steep and can go as high as 37 percent.
Unrelated Debt Financed Income
Q: What is UDFI?
A: In general, when it comes to using a retirement account to make investments most investments are exempt from federal income tax. This is because a retirement account is exempt from tax pursuant to IRC Sections 401 and 408. IRC Section 512 of the Internal Revenue Codes exempt most forms of investment income generated by an IRA from taxation. 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. Whereas, the type of income that generally could subject a retirement account to UBTI is income generated from the following sources:
- Income from the operations of an active trade or business – i.e. a restaurant, gas station, store, etc.
- Business income generated via a passthrough entity, such as an LLC or partnership
- Using a non-recourse loan to purchase a property (in the case of an IRA)
- Using margin on a stock purchase
These rules can be found under Internal Revenue Code Sections 511-514 and have become known as the Unrelated Business Taxable Income rules or UBTI or UBIT. If triggered, the income generated from that activities would generally be subject to close to a 37% tax for 2019. The UBTI rules apply to both IRA and 401(k) plans, however, there is one unique exemption found under IRC 514(c)(9) which would allow a 401(k) plan investment to purchase real estate and use non-recourse leverage without triggering tax.
When an IRA buys real estate that is leveraged with mortgage financing, it creates Unrelated Debt Financed Income (UDFI), a type of UBTI on which taxes must be paid. The UBTI tax is approximately 37 percent for 2019. But with a 401(k) plan, you can use leverage without being subject to the UDFI rules and UBTI tax. This exemption under IRC 514(d)(9) provides significant tax advantages for using a 401(k) plan versus an IRA to purchase real estate. In order to take advantage of the exemption under 514(c)(9), the loan must be a bona fide non-recourse loan and the loan must be used to acquire real estate. A non-recourse loan is type of loan that is secured by collateral, which is usually property. If the borrower defaults, the issuer can seize the collateral but cannot seek out the borrower for any further compensation, even if the collateral does not cover the full value of the defaulted amount
Q: How is UDFI calculated on the sale of a debt-financed asset?
A: When a debt-financed asset is sold, a special rule applies for the purpose of calculating the taxable gain. The property’s average adjusted basis is the average of the adjusted basis as of the first day during the year in which the property is held by the organization and on the day the property is sold or disposed of. The percentage of gain taxed is the percentage that the average adjusted basis on sale or other disposition of debt-financed property is of the highest amount of acquisition indebtedness with respect to the property during the twelve-month period ending with the date of the sale or other disposition. The regulations permit adjustments to basis that include decreases in basis for depreciation for periods since the acquisition of the property and increases in basis for capitalized improvements or additions.
Real Estate Transaction & UBTI
Q: What are some of the factors the IRS or the Courts may consider when determining whether a real estate transaction may be subject to UBTI?
A: In general, the determination of whether a transaction or series of real estate transaction involving a self-directed IRA will trigger the Unrelated Business Taxable Income (UBTI) tax is based off the facts and circumstances. The maximum tax rate for UBTI is 37% so it is important to have a good handle on whether the tax could be triggered. In general, the following the IRS and the courts will look at the following factors to determine whether the retirement account transaction triggered the UBTI tax:
- Frequency of transactions
- Level of continuity
- Level of improvement
- The proximity of sale to purchase
- Purpose for which the asset was acquired
- Personal activities of taxpayer
Q: What is the UBTI tax rate?
A: Internal Revenue Code Section 511 taxes “unrelated business taxable income” (UBTI) at the rates applicable to corporations or trusts, depending on the organization’s legal characteristics. Generally, UBTI is gross income from an organization’s unrelated trades or businesses, less deductions for business expenses, losses, depreciation, and similar items directly connected therewith. A Self-Directed IRA subject to UBTI is taxed at the trust tax rate because an IRA is considered a trust. For 2019, a Solo 401(k) Plan subject to UBTI is taxed at the following rates:
- $0 – $2,550 = 10% of taxable income
- $2,551 – $9,150 = $255 + 24% of the amount over $2,550
- $9,151 – $12,500 = $1,839 + 35% of the amount over $9,150
- $12,501 + = $3,011.50 + 37% of the amount over $12,500
Q: What are the filing requirements for UBTI?
A: In computing UBTI, a specific deduction of $1,000 is permitted. If a Self-Directed IRA LLC has gross UBTI of $1,000 or more during its fiscal year, it must file a completed IRS Form 990-T to report such income and pay any tax due. The Form 990-T is due at the same time as the Form 990, however, if the Self-Directed IRA LLC expects its annual UBIT (after certain adjustments) to be $500 or more, then it must make estimated tax payments throughout the year. The Form 990-T is not subject to public disclosure like the Form 990.
Prohibited Transaction Penalties
Q: What are the penalties if I engage in a “prohibited transaction” or a “disqualified transaction”?
A: Your investment may be disallowed under Internal Revenue Code Section 408 or result in a “Prohibited Transaction” under Internal Revenue Code Section 4975 and could result in the immediate disqualification of your IRA. Although IRAs are generally not ERISA plans, the Department of Labor has jurisdiction over these plans for purposes of the prohibited transaction rules, including individual requests for exemptions from those rules. There are two different consequences for incurring a prohibited transaction under the Code:
- For the IRA owner, the IRA is deemed immediately disqualified as of January 1 of the year in which the prohibited transaction occurred (an extremely severe tax consequence), resulting in current income tax treatment of a traditional IRA and possible excise tax penalty for a premature withdrawal from an IRA. If this deemed “distribution” occurs, it will be subject to ordinary income tax and, if you were under the age of 59 1/2 at that time, a ten (10%) percent excise tax on premature distributions may also be assessed.
- For the Disqualified Person involved in the transaction, the initial tax on a prohibited transaction is 15 percent of the amount involved for every year (or portion thereof) in the “taxable period,” which is the period beginning when the transaction occurs and ending on the date of the earliest of (1) the mailing of a notice of deficiency for the tax, (2) assessment of the tax, or (3) correction of the transaction. The 15% excise tax is followed by an additional tax of 100% if the disqualified person is recalcitrant.
The prohibited transaction rules are extremely broad. Thus, the IRA owner self directing his investments must be especially cautious in engaging in transactions that could compromise his best judgment or result in indirectly benefiting him.
Self-Directed IRA Setup
Q: How long does it typically take to set-up the Self-Directed IRA LLC structure?
A: It generally takes anywhere from 7-12 days to set-up the Self-Directed IRA LLC structure. Our in-house retirement tax professionals will complete all the necessary IRA rollover or transfer paperwork in order to help transfer your existing retirement funds tax-free to the new passive custodian so that your funds will be available for investment in a matter of days.
IRA for Real Estate
Q: What is a Real Estate IRA?
A: A real estate IRA also known as a Self-Directed IRA or a checkbook control IRA is a retirement investment structure that allow ones to use their retirement funds to make real estate as well as any IRS approved investment tax-free and without custodian consent. A real estate IRA is a tax court and IRS approved structure that offers one the ability to take more control over their retirement funds and make real estate and other investments tax-free! A real estate IRA with checkbook control that offers one the ability to purchase real estate and much more on their own without requiring the consent of the custodian.
With a real estate IRA, a limited liability company (“LLC”) is established typically in the state where the real estate investment will be made. For example, if the individual IRA holder will be buying real estate in Texas, a Texas real estate IRA LLC should be formed. The real estate IRA, care of the IRA custodian, will own the LLC and the IRA holder (you) or any third-party can serve as the manager of the LLC. Once the retirement funds have been transferred to a new IRA custodian, which allows for real estate investments, the IRA custodian will then transfer the IRA funds directly to the new IRA LLC bank account tax-free. The new IRA LLC bank account can be opened at any local bank or credit union. As manager of the LLC, you will have checkbook control over the IRA funds allowing you to make a real estate investment by simply writing a check directly from your IRA LLC bank account. Once the real estate investment is made, all income and gains would generally flow back to the Self-Directed IRA LLC tax-free.
Q: What is a Checkbook Control IRA?
A: The Self-Directed IRA LLC with “checkbook control” has quickly become the most popular vehicle for investors looking to make alternative assets investments, such as rental real estate that require a high frequency of transactions. Under the checkbook IRA format, a limited liability company (“LLC”) is created which is funded and owned by the IRA and managed by the IRA holder. The “checkbook control” Self-Directed IRA allows one to eliminate certain costs and delays often associated with using a full -service IRA custodian. The Checkbook IRA LLC structure allows the investor to act quickly when the right investment opportunity presents itself cost effectively and without delay.
A “checkbook control” Self-Directed IRA LLC is popular with retirement investors seeking to invest in alternative assets, such as rental properties, fix and flips, tax liens, or cryptocurrencies that require a high frequency of transactions. Using a Checkbook Control IRA to buy real estate or make other investments has a number of advantages, including tax-deferral, diversification, and protection against a falling U.S. dollar.
Q: What is a Roth IRA?
A: In 1997, Congress created a new form of IRA, called a Roth IRA. No deduction is allowed for contributions to a Roth IRA, but qualified distributions are excluded from gross income. In general, so long as the Roth IRA holder is over the age of 59 1/2 and the Roth IRA has been opened and funded for at least five years, all Roth IRA distributions would be tax-free. In addition, Roth IRAs are not subject to the required minimum distribution (“RMD”) rules.
The maximum Roth IRA contribution for 2019 is $6,000 or $7,000 if over the age of 50. However, for 2019, the ability to make a Roth IRA contribution begins to phase out when your adjusted gross income (AGI) exceeds $193,000 (for joint filers) and $122,000 for single filers. In addition, you are not permitted to make a contribution at all when your AGI exceeds $203,000 (for joint filers) or $137,000 (for single filers). Furthermore, unlike traditional IRAs, you may contribute to a Roth IRA for as long as you continue to have earned income (for a traditional IRA – you can’t make any contributions after you reach age 70 and ½.
Roth IRA Contribution
Q: How does the Roth IRA contribution work?
A: Assume individual Jane decides to set aside $1,000 of her pretax income for an IRA contribution. She could contribute the entire $1,000 to a traditional IRA because the deduction for the contribution would effectively eliminate any current tax on the $1,000. Since a contribution to a Roth IRA is not deductible, she could contribute to a Roth IRA only the amount remaining after paying tax on the $1,000. Assume T is, at all times, taxed at a flat 30 percent. She could therefore make a Roth IRA contribution of $700 ($1,000 less 30 percent thereof).
Roth IRA Contribution Rules
Q: What are the contribution rules for Roth IRAs?
A: The maximum Roth IRA contribution for 2019 is $6,000 or $7,000 if over the age of 50. However, for 2019, the ability to make a Roth IRA contribution begins to phase out when your adjusted gross income (AGI) exceeds $193,000 (for joint filers) and $122,000 for single filers. In addition, you are not permitted to make a contribution at all when your AGI exceeds $203,000 (for joint filers) or $137,000 (for single filers). Furthermore, unlike traditional IRAs, you may contribute to a Roth IRA for as long as you continue to have earned income (for a traditional IRA – you can’t make any contributions after you reach age 70 and ½) even if your income is high and you are covered by an employer’s plan. However, you may not be able to deduct the contribution on your return.
Roth IRA Distribution Rules
Q: What are the Distribution rules for Roth IRAs?
A: Distributions from Roth IRAs are not subject to the required minimum distribution rules. Qualified distributions are excluded from gross income. A “qualified distribution” from a Roth IRA is excluded from gross income. To be treated as a qualified distribution, the Roth IRA distribution must satisfy both of the following requirements:
- It must not occur before the fifth taxable year following the year for which a Roth IRA contribution was first made by the taxpayer or the taxpayer’s spouse.
- It must be made after the account owner reaches age 59 1/2 or becomes disabled, be made to the owner’s beneficiary or estate after the owner’s death, or be a “qualified special purpose distribution.”
Q: If I start a Roth IRA or rollover a Traditional IRA into a Roth IRA, is there any holding period requirement before being permitted to take tax-free distributions?
A: Generally, distributions from a designated Roth account are excluded from gross income if they are treated as a “qualified.” In general, so long as the Roth IRA holder is over the age of 59 1/2 and the Roth IRA has been opened and funded for at least five years, all Roth IRA distributions would be treated as “qualified” and would be tax-free.
Taxable Roth IRA Contributions
Q: Are Distributions that consist of my Roth IRA Contributions ever subject to income tax?
A: No. The portion of your Roth IRA that consists of your contributions is never subject to income tax when it comes out – even if you take it out the day you made the contribution. That is because all contribution you made were nondeductible – meaning you already paid tax on the money. In addition, any distribution you take from a Roth IRA is presumed to be a return of your contributions until you have withdrawn all contributions you made to it over the years. In other words, all contributions all recovered before earnings before earnings are recovered.
Roth IRA Tax-Free Distributions
Q: If I establish a Roth IRA is there a certain amount of time I am not allowed to take tax-free distributions of investment returns?
A: In general, you should not take a distribution of your investment returns for five years and until you are over the age of 59 1/2 so that the distribution will be treated as “qualified” and not subject to tax. Simply satisfying the five-year requirement will not automatically make a distribution qualified. It must also be at least one of the following:
- A distribution you take after reaching 59 and 1/2
- A distribution you take after becoming disabled
- A distribution to your beneficiary or your estate after your death
- A distribution you take to purchase a first home (up to a lifetime withdrawal limit of $10,000)
Therefore, if your distribution satisfies the five-year requirement and falls into one of the above categories, it will be qualified and, hence, entirely tax-free.
Required Distributions for Roth IRA
Q: Are you required to take distributions from a Roth IRA during your lifetime?
A: No. You are not required to take distributions from a Roth IRA during your lifetime – no RMDs.
IRS Form for Roth Distributions
Q: Do I have to file a form with the IRS just because I received distributions from a Roth IRA?
A: Yes. In general, File Form 8606 if you received distributions from a Roth IRA.
Use Form 8606, Nondeductible IRAs, to report:
- Nondeductible contributions you made to traditional IRAs,
- Distributions from traditional, SEP, or SIMPLE IRAs, if you have ever made nondeductible contributions to traditional IRAs,
- Distributions from Roth IRAs, and
- Conversions from traditional, SEP, or SIMPLE IRAs to Roth IRAs.
Roth IRA Rollover Rules
Q: What are the Rollover rules for Roth IRA?
A: Roth IRAs can be rolled into another Roth IRA, but cannot be rolled into a pre-tax IRA or 401(k) Plan.
Roth IRA Rollover Qualifications
Q: Who qualifies for a rollover from a Traditional IRA to a Roth IRA?
A: Roth IRA conversions are subject to tax on the value of the cash or fair market value of the asset being converted. The amount of the Roth conversion is treated as income and added to your gross income on your personal income tax return (IRS Form 1040). The 10% early distribution tax does not apply to Roth conversions.
When Roth IRA Holder Passes
Q: What happens to the Roth IRA after the holder dies?
A: When a Roth IRA holder dies, if the surviving spouse is the primary beneficiary then the Roth IRA would be transferred to the surviving spouse tax-free. The surviving spouse would then have the option to either keep it as an inherited IRA or become the owner of the Roth IRA. Roth IRAs have no required minimum distribution (RMD) rules for surviving spouses. However, if the Roth IRA was left to a non-spouse beneficiary, then the RMD rules would apply but the distributions would generally not be subject to tax.
Age Limit for Roth Contribution
Q: Is there an age limit on when I can set up and contribute to a Roth IRA?
A: No – you can be any age as long as you have income.
Traditional IRA to Roth IRA
Q: Who should make Traditional IRA-to-Roth IRA conversions?
A: The consensus view is that the conversion route should be considered by taxpayers who:
- have a number of years to go before retirement (and are therefore able to recoup the dollars that are lost to taxes on account of the conversion);
- anticipate being taxed in a higher bracket in the future than they are now; and
- can pay the tax on the conversion from non-retirement-account assets (otherwise, there will be a smaller buildup of tax-free earnings in the depleted retirement account).
Roth IRA to Self-Directed Roth IRA
Q: Can I use a Roth IRA in a Self-Directed Roth IRA LLC?
A: Yes – you may transfer a Roth IRA to a Self-Directed Roth IRA LLC “checkbook control” structure tax-free. By using a Self-Directed Roth IRA LLC structure, all gains are tax-free and any distributions taken after the age of 59 and 1/2 are tax-free so long as the Roth IRA has been opened at least 5 years.
If I decide to take distributions from a Roth IRA, do I have take distributions in a certain order?
In general, you cannot pick and choose the origin of each distribution you take. For example, if you take a distribution before the five-year holding period is up, you would want to take your contributions first, because they are not subject to tax or penalties. However, the ordering rules for determining Roth distributions are quite taxpayer favorable. Roth distributions are deemed to come out in the following order:
- Regular Roth IRA contributions are distributed first
- Next, converted amounts, starting with the amounts first converted
- Earnings come out last
These ordering rules can significant impact the tax treatment of the distributions. For example, if you take a distribution before the five-year holding period is up of if you fail to satisfy the other requirements of a qualified distribution, the withdrawal still won’t be subject to the early distribution tax as long as you have taken less than the total amount of all contributions you have made to your Roth IRAs. Note that for purposes of these ordering rules, all Roth IRAs are considered a single Roth IRA.
Roth IRA Creditor Protection
Q: Are Roth IRAs protected from creditors in a bankruptcy proceeding?
Protection for some IRAs came in 2005 through the Bankruptcy Abuse Protection Act. The law provides debtors in bankruptcy with an exemption for retirement assets in qualified plans, qualified annuities, tax sheltered annuities, and self-employed plans. In addition, the law exempts all assets in an IRA that are attributable to rollovers from a retirement plan described above. If you happen to have a traditional IRA or Roth IRA containing assets that are not attributable to a rollover from some other type of retirement plan (i.e. the assets are from amounts you contributed directly to the IRA), then you will also be allowed an exemption of up to $1 million total for the assets in those contributory IRAs.