A Self-Directed IRA (SDIRA) can be highly beneficial for many investors, as it allows for a wide range of investments that are not available in regular IRAs. From being able to invest in real estate abroad to the ability to obtain a loan from your SDIRA, a multitude of benefits exist.
One drawback is that SDIRAs have strict rules and making mistakes during set-up or when investing and/or managing investments can have significant consequences. The entire SDIRA could be dissolved, resulting in income tax on the entire deemed distribution.
In this article, we explain the advantages of self-directed IRAs and the rules you need to be aware of.
Table of Contents
- What is a Self-Directed IRA (SDIRA)?
- Benefits of an SDIRA
- Self-directed IRA owning an LLC
- Non-Recourse Loans from a SDIRA
- Risks of a self-directed IRA
- Prohibited transactions for SDIRAs
- Transactions with Disqualified Persons
- Self-dealing transactions
- SDIRA Rules
- The Exclusive Benefit Rule
- The Step Transaction Doctrine
- The Plan Asset Rule
- Risks and Limitations for the IRA/LLC Structure
- UBIT and UDFI taxes
- Is a Self-directed IRA right for you?
What is a Self-Directed IRA (SDIRA)?
In a self-directed IRA (SDIRA), the custodian allows the owner of the IRA to choose any type of investment that is allowable by law. A SDIRA can be any type of an IRA: Roth, Traditional, SEP, Inherited IRA or SIMPLE.
A self-directed IRA investment must be held in the name of the IRA and must be executed by the custodian. The IRA custodian acts only upon the written direction of you, the IRA owner.
You cannot sign for the IRA. Instead, you must instruct the self-directed IRA custodian to sign any investment documents. The custodian will then sign for the IRA and will send the funds to the seller/issuer of the investment.
Benefits of an SDIRA
As mentioned, the primary advantage that SDIRAs have is the ability to invest into assets that standard IRAs usually cannot access. A self-directed IRA can invest into any investment allowed by law.
Attractive investment options that a standard IRA cannot invest in include:
- Real estate
- Private company stocks
- Private equity funds
- Venture capital funds
- Oil and Gas Tax Liens
- Mineral Rights
- And more
Self-directed IRAs offer significant benefits to US citizens and residents. Foreign self-directed IRAs enable you to invest in international opportunities, such as real estate located outside the United States or small-cap funds investing solely overseas.
Despite the vast array of possibilities, some investment types remain prohibited.
Specifically, you cannot invest in collectibles like art or stamps, in life insurance, and in stock of an S Corporation.
Furthermore, there are many risks associated with a self-directed IRA which are not present with a standard IRA.
It is important to understand the rules, so you don’t run afoul and risk major penalties.
Self-directed IRA owning an LLC
A self-directed IRA has additional benefits when it comes to business structure.
For example, it can have ownership in an LLC, which yields yet even more possibilities.
When your Self-Directed IRA has ownership in an LLC, you can be the manager of the LLC. This way you can directly manage the funds that are being invested. You don’t need the custodian to sign for the IRA.
For example, with this kind of setup, you can have a real estate investment that you rent out. This would otherwise be administratively infeasible since the custodian would be the one who would have to manage the renting activities.
When your self-directed IRA owns an LLC, you are the manager of the LLC, and the LLC owns the real estate, you can directly manage and guide the rental activities as the manager of the LLC.
Another benefit of the self-directed IRA/ LLC structure is that the LLC offers certain liability protection for the IRA, the custodian and for you personally.
Non-Recourse Loans from a SDIRA
Another benefit of a self-directed IRA is that you can take out a non-recourse loan to finance the IRA investments.
A “non-recourse loan” means that the lender (your IRA) can only pursue the collateral (the specific investment). It cannot seize any other assets from you to recoup the loan.
You cannot take out a loan using your own personal credit since that would break the prohibited transaction rules (more about those rules later).
However, a non-recourse loan does not violate the rules because it is not based on your credit and personal assets, and it does not require you to sign or guarantee the loan.
In a non-recourse loan, the bank extends credit based on the asset or investment being purchased by the IRA. The bank’s money is always secured by the asset on which they lent money. There are banks that specialize in non-recourse loans for IRA real estate investments.
Non-recourse loans are not without risks. This type of loan has certain qualification requirements so that it stays an allowed transaction. (We explain allowed and prohibited transactions in a moment.) Not all non-recourse loans meet the requirements.
It is important to go through everything with your accountant to make sure that the loan is meeting the requirements.
Risks of a self-directed IRA
While a self-directed IRA offers many benefits that a standard IRA does not, there are also certain risks that come with it. It is important to be aware of these risks and to take appropriate steps to avoid them.
These risks include:
- Making transactions that are not allowed (prohibited transactions),
- Using the IRA assets for prohibited purposes,
- Distributing money out incorrectly,
- And more.
We explain each risk in detail in a moment.
Such risks can involve remarkably high penalties and fees. They can even lead to the distribution of the entire IRA, with all applicable taxes and penalties. Your IRA will simply cease to exist, and you bear all the consequences. This is why you need a good accountant to guide you through the process.
Prohibited transactions for SDIRAs
There are two types of transactions that are strictly prohibited in an SDIRA.
- Transactions with disqualified persons
- Self-dealing transactions
The prohibited transaction consequences differ, depending on whether the IRA owner engages the IRA into a prohibited transaction or whether a third party engages the IRA into a prohibited transaction (e.g., broker, financial advisor, etc.)
If an IRA owner engages his or her IRA into a prohibited transaction, then the consequence is disqualification of the IRA and distribution of the entire account. The IRA owner is subject to all consequences of distribution, including possible taxes and penalties.
If an IRA engages into a prohibited transaction independent of the IRA owner (e.g., the broker or advisor engages the IRA), then the consequence is an excise tax of 15% on the amount involved to the disqualified person in the transaction. In addition, a 100% penalty may apply if the prohibited transaction is not corrected.
Transactions with Disqualified Persons
The investments of the IRA must not involve transactions with any disqualified persons.
Disqualified persons are:
- You personally as the owner of the IRA
- Certain family members
- Company majority owned/controlled by you or certain family members
- Key persons in a company owned 50% or more by disqualified persons
Here are some examples of what a self-directed IRA cannot do:
- Buy a real estate property from you personally.
- Buy or invest in any assets owned by certain family members, such as parents or siblings.
- Take out a loan from a company where your father or other disqualified person is a partner.
Another type of a prohibited transaction is the so-called Self-Dealing Prohibited Transaction. This type of a transaction occurs when you or another disqualified person benefits from the IRA’s investments.
For example, if a disqualified person is an agent in the investment purchase agreement, and receives some sort of compensation for his services, that is a self-dealing prohibited transaction.
Another common example is when an IRA owns real estate, a disqualified person cannot use it for their own personal use under any circumstance since that is a self-dealing prohibited transaction.
Also, you cannot buy an investment property in your SDIRA to obtain an investment visa.
Self-directed IRAs have specific rules that are designed to prevent prohibited transactions and other mistakes.
- Exclusive Benefit Rule
- Step Transaction Doctrine
- Plan Asset Rule
Let’s look at each rule in detail.
The Exclusive Benefit Rule
This rule requires an IRA to pay and receive fair market value for its investments.
Any special treatment because of a relationship to you as the IRA owner, regardless of whether the person is a disqualified person, will always violate this rule.
So, if you rent to someone, who’s not disqualified but close to you, you can’t give them a preferential rate. It must be fair-market value.
The Step Transaction Doctrine
This is a legal principle applicable to structuring IRA investments. It prevents you from unfairly adding additional steps into a transaction in an effort to avoid a prohibited transaction.
An example of the step transaction doctrine is using a “straw person” instead of a disqualified person. The straw person would later forward the transaction to the disqualified person in order to avoid a prohibited transaction.
The Plan Asset Rule
This Plan Asset Rule states that assets of a company can be deemed assets of a retirement plan, and thus, the laws affecting retirement plan investments apply to the company where the plan is invested.
For example, if your self-directed IRA invests into an investment company partnership and owns 40% of the equity ownership of the company, then under the Plan Asset Rule, the company is subject to the rules affecting your IRA investments. The consequence of this is that the company is subject to the prohibited transaction rules and cannot engage in a transaction with a disqualified person to your IRA.
Risks and Limitations for the IRA/LLC Structure
When the IRA owns an LLC, there are additional risks and limitations, including:
1. You can be the manager of the LLC; however, you must not receive any compensation for the work performed. That would be a prohibited transaction.
2. You can serve as the manager of the IRA/LLC, however the services you provide are restricted to administrative and investment oversight functions.
You must not perform any work that would result in a contribution of value. For example, you cannot personally paint the house that your IRA owns.
3. The LLC bank account must be strictly used for the IRA/LLC’s investments. It should receive all income of the IRA/LLC and pay all expenses of the IRA/LLC. It cannot be used for personal purposes.
The account should also not be commingled with your personal funds or other disqualified persons. All contributions and distributions to and from you must go through the IRA custodian.
For real estate investments, this means that the rental income must go to the LLC, not to the owner.
4. The setup of the LLC and the legal paperwork must be done very carefully since there is a lot of room for errors. This can result in the dissolution of the IRA and the automatic distribution of all the funds and corresponding taxes and penalties.
UBIT and UDFI taxes
There are two taxes that can apply to income received by a retirement plan like an IRA.
These taxes are:
- Unrelated business income tax (“UBIT”) and
- Unrelated debt financed income tax (“UDFI”).
UBIT applies when an IRA receives ordinary income, as opposed to passive income, from its investments. However, there are a vast number of exemptions under which most of typical IRA investments fall.
UDFI tax only applies when debt, such as a nonrecourse loan, is used in connection with an IRA purchase. This includes both rental income and capital gains income, which are exempt from UBIT tax.
Is a Self-directed IRA right for you?
Self-directed IRAs have proven to be a powerful investment tool for many investors. While they aren’t for everyone, they are an excellent tool for individuals who have profitable investment opportunities in non-publicly investments.
Self-directed IRAs allow for greater control and enable an individual to invest into assets they know.
As we laid out, with the significant benefits come major potential pitfalls. This is not a DYI investment approach as the consequences of making mistakes are huge. Get professional help to set up your SDIRA correctly.