What Is a Self-Directed IRA and Are They For You?

But when you establish a traditional IRA with a bank, a brokerage, or a trust company, you are ordinarily limited to a narrow range of investment options, such as CDs, publicly-traded stocks, bonds, mutual funds, and ETFs. The IRA custodian will not permit you to invest in alternative investments such as real estate, precious metals, or cryptocurrency.

You can invest in almost anything other than collectibles such as art or rare coins, life insurance, or S corporation stock with a self-directed IRA. Investment options include, but are not limited to the following:

• Real estate
• Private businesses
• Trust deeds and mortgages
• Tax liens
• Precious metals such as gold, silver, or platinum
• Private offerings
• LLCs and limited partnerships
• REITs
• Livestock
• Oil and gas interests
• Franchises
• Hedge funds
• Cryptocurrency
• Promissory notes

Aside from the vast array of investment options, a self-directed IRA is the same as a traditional IRA and subject to the same rules.

The income the investments in your IRA earn is not taxed until you take distributions, but distributions before age 59 1/2 are subject to a 10 percent penalty unless an exception applies.

You can also have a self-directed Roth IRA for which distributions are tax-free after five years.

  Avoiding Prohibited Transactions with Your Self-Directed IRA

But you must avoid self-dealing and other prohibited transactions or your self-directed IRA could lose its tax-advantaged status.

The tax code contains strict rules that bar self-dealing and other prohibited transactions with your self-directed IRA.

You will suffer if you violate the rules. For example, a violation could wipe out your self-directed IRA’s tax-advantaged status and subject you to substantial cash penalties.

Unlike the self-directed IRA, when you have a traditional IRA, you don’t need to worry about inadvertently violating the rules, because your custodian generally alerts you or even prevents you from violating them.

The prohibited transaction rules don’t restrict what your self-directed IRA can invest in. Rather, the rules bar your self-directed IRA from transacting with a disqualified person—this includes:

• you (a logical culprit);
• your spouse;
• your lineal descendants, ascendants, and their spouses;
• a beneficiary of the IRA;
• investment advisers and managers;
• any corporation, partnership,
• or estate that you have at least a 50 percent stake in;
• and your trustee, custodian, or anyone providing services to the IRA.

Prohibited transactions include:

• sale, exchange, or leasing of property between your IRA and a disqualified person;
• extending credit or a cash loan between your IRA and a disqualified person; and
• furnishing goods, services, or facilities between your IRA and a disqualified person.

Thus, neither you nor any other disqualified person can borrow money from your self-directed IRA, sell property to it, use it as security for a loan, or buy property for personal use with self-directed IRA funds.

 

For example, your self-directed IRA cannot:

• purchase a rental property you personally own;
• buy a home that you lease to your child;
• purchase a vacation home as a rental property or Airbnb rental that you or other family members use personally for one day or more per year;
• pay you a salary from a self-directed IRA-funded business;
• purchase a business more than 50 percent owned by you or a family member;
• buy a property and lease it to a company of which you own over 50 percent;
• or hire you to repair rental property owned by the self-directed IRA.

Do You Want Checkbook Control?

Establishing a self-directed IRA need not be too difficult. You first open an account with a custodian that offers self-directed investments. You can also acquire checkbook control over your self-directed IRA by forming a limited liability company to own all the IRA investments.

There are two basic types of self-directed IRAs:

• custodial self-directed IRAs and
• checkbook self-directed IRAs.

With a custodial self-directed IRA, each investment is individually owned by the IRA. The IRA custodian handles all the IRA’s funds and assets, and all transactions must go through the custodian. The custodian must approve, execute, and fund each transaction. This type of IRA can result in large fees and administrative delays.

With a checkbook self-directed IRA, the only investment the IRA makes directly is the purchase of a 100 percent interest in a limited liability company (LLC) that is managed by you. The IRA’s LLC purchases the investments. The LLC may own any number of assets and have its own checking account, which you control

As manager of the LLC, you may sign contracts and make decisions on the LLC’s behalf. This greatly reduces the IRA custodian’s involvement, it reduces fees, and it has received Tax Court approval.

To have a self-directed IRA with checkbook control you must:

• form a manager-managed LLC in your state with an LLC operating agreement tailored for using a self-directed IRA;
• choose someone to serve as manager of the LLC: this can be you (or any other person you choose);
• set up a business checking account in the LLC’s name;
• establish a self-directed IRA account with a custodian;
• fund your self-directed IRA account;
• direct your self-directed IRA custodian to invest your IRA funds in your LLC;
• find an investment for your self-directed IRA; and
• purchase the investment in your LLC’s name.

When your IRA owns 100 percent of your LLC, the LLC is considered a single-member LLC and is disregarded for tax purposes.  The term “disregarded” is misleading. It simply means that the LLC is not a taxable entity on its own.

It assumes the tax status of its member or activity

Investing in alternative assets such as cryptocurrency is riskier than stocks, bonds, and mutual funds.

• The rewards can be great, as you’ve seen with recent returns for cryptocurrency investors.
• And the damage to your investment portfolio can be substantial, as we’ve also seen over the years.

When it comes to alternative investments, you need to know what you are doing or have an investment professional you trust to do this for you.

Taxes on Self-Directed IRA Income

Self-directed IRAs can become subject to two taxes on their earnings:

• unrelated business income tax (UBIT) and
• unrelated debt-financed income tax (UDFI).

The UBIT and UDFI tax is paid at the tax rate for trusts, which tops out at 37 percent on income over $12,500.

Fortunately, most popular self-directed IRA investments are not subject to either tax.

UBIT. A self-directed IRA that earns $1,000 or more of gross income from an unrelated business must file Form 990-T with the IRS and pay the UBIT. Investment income from passive investments is exempt from UBIT, including real estate rental income, interest income, capital gain income, dividend income, and royalty income.

But UBIT may be due if a self-directed IRA owns an ordinary income-producing business through an LLC or other pass-through entity such as a limited partnership. If the business is a C corporation, no UBIT is due because the corporation must pay corporate tax on its profits. UBIT also may be due on income from the sale of real estate acquired for immediate resale.

UDFI tax. The UDFI tax is a form of UBIT. UDFI tax is due only when a self-directed IRA uses debt financing to acquire property.

UDFI tax must be paid on any income derived from such debt.

For example, if your self-directed IRA buys a rental property worth $100,000 with $25,000 of nonrecourse financing, 25 percent of the net income from the property is subject to UDFI tax.

If the net income is $10,000, $2,500 is subject to the UDFI tax. Because of the debt, the IRA also must pay the UDFI tax when it sells the property. 10 The IRA can avoid UDFI taxes by not using debt financing.

  Takeaways

When you have an IRA, you are permitted to invest in anything other than collectibles, life insurance, and S corporation stock. Custodians for traditional IRAs typically limit your investments to publicly traded stocks, bonds, mutual funds, ETFs, and CDs.

By opening an IRA with a custodian that allows self-directed investments, you can use your IRA to invest in real estate, cryptocurrency, private offerings, and many other alternative investments.

You can have checkbook control over your self-directed IRA by forming an LLC to own all assets in the account. You (or another person you choose) manage the LLC and controls its bank account. This gives you near-total control over your self-directed IRA.

When you have a self-directed IRA, you must take care to avoid engaging in prohibited transactions with your IRA. If you violate the complex prohibited transaction rules, your IRA can lose its tax-advantaged status and incur penalties. Prohibited transactions include any transaction between you and your close relatives and the IRA.

In some cases, self-directed IRAs must pay unrelated business income taxes. This usually occurs when a self-directed IRA uses debt financing to purchase a rental property or owns an active business.

If you have any questions or need my assistance, please call me on my direct line at 509-543-7600 or send a request HERE.

February 2022

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