Before making a Self-Directed IRA investment, there are three important questions one must ask him or herself to ensure that it does not violate IRS rules and is tax efficient. The three questions are:
- Is the investment a prohibited transaction?
- Will the investment trigger the UBTI tax?
- How should I structure the investment?
Before I discuss the three aforementioned questions, I think it is important to briefly address what a Self-Directed IRA is and why it so popular with retirement investors.
- A Self-Directed IRA gives anyone the ability to invest in just about anything
- A prohibited transaction occurring in an IRA could disqualify the plan
- The UBTI tax could make an investment very “unfriendly”
What is a Self-Directed IRA?
Individual retirement accounts, or IRAs, exist in many forms. In general, if you have income from working for yourself or someone else, you may set up and contribute to an IRA. 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 their own products, which bring in extremely profitable commission and fees for them.
A Self-Directed IRA is not a legal term, it is simply an IRA that is administered by a custodian that allows the IRA owner to invest in anything not prohibited by the IRS. Regulated trust companies, such as IRA Financial, exist to serve investors that wish to diversify their retirement assets and gain exposure to alternative asset investments.
The following are some of the more popular Self-Directed IRA investments:
- Residential or commercial real estate
- Raw land
- Private loans
- Investment funds
- Private businesses
- Limited Liability Companies
- Private placements
- Precious metals and certain coins
- Foreign currencies
Advantages of the Self-Directed IRA
The primary advantage of a Self-Directed IRA is that one can use their retirement funds to better diversify their retirement assets as well as invest in investments they know and understand, such as real estate. There is a growing portion of retirement savers that don’t want to have all their personal and retirement savings tied into Wall Street exclusively. The Self-Directed IRA allows them to invest in hard assets outside of the financial markets.
However, the most important reason why using an IRA to make alternative asset investments is so popular is that, in general, all income and gains generated by the investment will be tax-deferred or (tax-free in the case of a Roth IRA). So long as the investment remains inside the IRA, it is not taxable.
Question 1 – Is my Investment a Prohibited Transaction?
Before making an investment with your IRA, the first question an IRA owner should ask is whether their investment would violate the IRS prohibited transaction rules.
The IRS and the Internal Revenue Code do not describe what an IRA can invest in, only what it cannot invest in. IRC Sections 408 & 4975 prohibits disqualified persons from engaging in certain types of transactions.
In general, under Section 408, a Self-Directed IRA may not purchase life insurance contracts or collectibles. Collectables are defined as antiques, rugs, stamps, certain coins, etc. Note – there are exceptions for pure gold, silver, and palladium bars (99.99% pure), as well as American eagle and other coins minted by the Government. IRS-approved precious metals must be held in the physical possession of a U.S. trustee, such as a depository.
The broadest category of prohibited transactions is found under Section 4975. The IRS has restricted certain transactions between the IRA and a “disqualified person.” The rationale behind these rules was a congressional assumption that certain transactions between certain parties are inherently suspicious and should be disallowed.
Under Code Section 4975, a “disqualified person” means:
- A fiduciary (e.g., the IRA holder, participant, or person having authority over making IRA investments),
- A person providing services to the plan (e.g., the trustee or custodian),
- A 50% owner of C or D above
- A family member of A, B, C, or D above (family members include the fiduciary’s spouse, parents, grandparents, children, grandchildren, spouses of the fiduciary’s children and grandchildren (but not parents-in-law)
- An entity (corporation, partnership, trust or estate) owned or controlled more than 50 percent by A, B, C, D, or E. Whether an entity is a disqualified person is determined by considering the indirect stock holdings/interest which would be taken into account under Code Sec. 267(c), except that members of a fiduciary’s family are the family members under Code Sec. 4975(e)(6) (lineal descendants) for purposes of determining disqualified persons.
- A 10% owner, officer, director, or highly compensated employee of an entity controlled by a disqualified person.
The types of prohibited transactions can be best understood by dividing them into three categories: Direct Prohibited Transactions, Self-Dealing Prohibited Transactions, and Conflict of Interest Prohibited Transactions.
Direct Prohibited Transactions
A “Direct Prohibited Transaction” generally involves the direct or indirect sale, exchange, leasing of property, lending of money, extension of credit, the furnishing of services, or the transfer of the income or assets of an IRA to a “disqualified person.”
Here are some examples of direct prohibited transactions:
- Ben sells an interest in a piece of real estate owned by his IRA to his daughter.
- Kelly lends her son $15,000 from her IRA.
- John is in a financial jam and takes $7,000 from his IRA to pay his credit card bill.
Self-Dealing Prohibited Transactions
A “Self-Dealing Prohibited Transaction” generally involves a “disqualified person” dealing with the income or asset of the IRA for his or her own interest.
The following is an example of a self-dealing prohibited transaction:
- Valerie, who is a real estate agent, uses her IRA funds to buy a home and earns a commission from the sale.
Conflict of Interest Prohibited Transactions
A “Conflict of Interest Prohibited Transaction” generally involves a “disqualified person” dealing with the income or asset of the IRA for his or her own account.
The following is an example of a conflict of interest prohibited transaction:
- Sam uses his IRA to lend money to a business that he works for in order to secure a promotion.
In sum, when one elects to make an investment with an IRA, 100% of the direct of indirect benefit should be derived by the IRA. The IRA owner, nor any disqualified person, should receive any benefit from the IRA investment.
Will the Investment Trigger the UBTI Tax?
In general, almost all retirement account investments generating passive income will not be subject to Unrelated Business Taxable Income (UBTI or UBTI) or Unrelated Debt Finance Income (UDFI) Tax, such as capital gains, interest, dividends, royalties, and rental income.
There are essentially only three types of transactions that could trigger the UBTI tax. Because the maximum UBTI tax rate is 37%, it is important to determine whether your IRA investment will trigger the tax before making an investment.
The UBTI tax is only triggered if:
- The IRA uses margin or a nonrecourse loan to buy stock or an investment asset;
- The IRA invests in an active business through a pass-through entity, such as an LLC; and
- The IRA uses a nonrecourse loan to purchase real estate.
What is a Non-recourse Loan?
Since the IRS prohibited transaction rules under IRC 4975 prohibit an IRA owner from personally guaranteeing an obligation of their IRA, any loan involving a retirement must be nonrecourse. A nonrecourse loan is a loan not personally guaranteed by the borrower. The fact that the loan is not personally guaranteed offers more risk to the lender which is why they typically require at least 35% in cash down and will charge a higher interest rate.
What is a Pass-through Business?
A pass-through business is a business, such as a restaurant, that is operated via an LLC or other flow-through entity. Whereas, if a business is owned via a corporation, the UBTI tax would not apply since a C corporation is not a flow-through entity as it has a corporate level tax. Hence, this is why more IRA owners have never heard of the tax since all publicly-traded corporations are C corporations.
IRC 514(c)(9) offers a 401(k) plan an exemption to the UBTI tax if a 401(k) plan uses a nonrecourse loan to acquire real estate. Whereas, if an IRA uses a nonrecourse loan, the UBIT tax could be triggered if there is more than a $1,000 of net income associated with the debt.
How to Calculate the UBIT Tax?
Internal Revenue Code Section 511 taxes UBTI at the rates applicable to corporations or trusts, depending on the organization’s legal characteristics:
For 2023, a retirement plan subject to UBTI is taxed at the following rates:
- 10%: $0 – $2,900
- 24%: $2,901 – $10,550
- 35%: $10,551 – $14,450
- 37%: $14,451 and higher
If the UBTI tax is attached to an investment, you would need to decide if the tax hit is worth it. It some cases, it just might be; in others, not so much. If one does trigger the tax, the IRA must file IRS Form 990-T by April 15 and pay the tax due from the IRA.
How should I Structure the Investment?
Now that you have determined that your IRA investment will not trigger the IRS prohibited transaction rules or the UBTI tax, the last question to ask is whether you want to use an LLC to make your investment. This is known as a Self-Directed IRA LLC or Checkbook IRA.
Two Self-Directed IRA options:
A full-service Self-Directed IRA is the most popular choice. A special IRA custodian, such as IRA Financial, will serve as the custodian of the IRA. Unlike a typical financial institution, which generate fees by selling investments, a Self-Directed IRA custodian generate fees simply by opening and performing IRS administration and does not offer any financial investment products or platforms. With a custodian controlled Self-Directed IRA, the IRA funds are generally held with the custodian and at the IRA holder’s sole direction, the custodian will then invest the funds.
Title to the investment would be made in the name of the IRA and all income and gains would flow back to the IRA without tax. In addition, since the investment is titled in the name of the IRA, each time the IRA owner requires an expense paid or wishes to add more funds to the investment, the IRA owner must go through the IRA custodian.
The Self-Directed IRA LLC with “checkbook control” has been growing in popularity with investors looking to make alternative assets investments, such as rental real estate, that requires a high frequency of transactions. Under the Checkbook IRA format, a limited liability company is created which is funded and owned by the IRA and managed by the IRA holder. This 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.
The LLC can be set up in any state. A bank account is opened in the name of the LLC allowing the IRA owner to have control over the IRA LLC funds. All IRA LLC investments are made in the name of the LLC with full limited liability protection.
The Self-Directed IRA offers investors so many powerful benefits. However, it is important that before one engages in an IRA investment, he or she consider the IRS prohibited transaction rules, the UBTI tax rules, and how best to structure their investment. This is why we encourage anyone thinking about making a Self-Directed IRA investment to contact our team of highly trained tax professionals either by phone, chat or email.
In addition, we offer an annual consulting service that provides our clients with direct access to tax advisory services, IRA tax filing services, including IRS Forms 1065 and 990-T, as well an annual prohibited transaction review.