5 Self Directed IRA Rules
Studies performed by Preqin, the leading data source for the alternative asset industry, estimate that the alternative investment market will increase from $8.8 trillion (2017) to $14 trillion by 2023. As the alternative market evolves, such investments are no longer relegated to high net worth or institutional investors. Advances in technology and greater consumer awareness allow more people than ever to access these products. As their availability increases, individuals are seeking capital sources for such investments. Many turn to stagnant retirement accounts, which have been earning poor returns, for this purpose. By establishing a Self Directed IRA and investing into alternatives, individuals are afforded the growth potential of alternatives along with IRA tax advantages. However, accountholders must keep in mind the following rules to maintain the tax advantaged status of their Self-Directed retirement accounts:
1 – Prohibited Transactions
Congress enacted the Employee Retirement Income Security Act in 1974 with the intention of encouraging Americans to save for retirement via tax advantaged retirement accounts. Congress imposed “Prohibited Transaction” rules to ensure that individuals do not receive personal benefit from their retirement accounts before distribution. The following formula summarizes what constitutes a prohibited transaction:
Transaction between a “Retirement Plan Asset” and “Disqualified Person” = “Prohibited transaction”
To learn more about who is a disqualified person, what is a prohibited transaction, and some common prohibited investment examples, please read the following article: Prohibited Transactions.
2 – Due Diligence
Most private placements are not required to register with the SEC because their investors are considered “accredited”. This lack of registration can present an additional risk, making proper due diligence very important. Madison Trust recommends that accountholders perform thorough due diligence before placing such investments. Additionally, investors should review the proposed investment with a financial professional to determine whether it is appropriate for their personal financial situation.
3 – Financing
Many investors are surprised to learn that the IRS does not restrict IRAs from obtaining financing for investments. There are several things to keep in mind though:
- Non-Recourse– Loans issued to an IRA must be non-recourse. Such loans are backed by investment collateral, and not by a Borrower’s personal guarantee. In case of default, the lender can only collect the collateral, and may not pursue the Borrower’s personal assets. If one were to personally guarantee a loan issued to their IRA, then they would be providing a benefit to their retirement account. This would violate the prohibited transaction rule. Non-recourse financing provides investors with the capital they need for IRA investments, while avoiding prohibited transaction scenarios.
- Non-Disqualified persons- Loans issued to an IRA must be from a third-party, not from a Disqualified party. To learn more about Disqualified Persons, please click here: Disqualified Persons.
- UDFI– When an IRA uses leverage for an investment, then the earnings attributed to the financed portion are subject to UDFI (Unrelated Debt Financed Income). Your accountant or tax preparer will determine whether such taxes are owed and will report this income to the IRS on Form 990-T if applicable.
4 – IRA LLC transactions:
IRA LLCs allow investors to perform time-sensitive and transaction heavy investments under the umbrella of a Self Directed IRA. One thing to keep in mind is that investment transactions can be performed directly within the IRA LLC, while IRS reportable transactions still need to flow through an IRA custodian. For example, Managers of an IRA LLC can place investments, pay investment expenses, and deposit investment income using their LLC checking account. However, IRA contributions, distributions, rollovers, etc. must pass through an IRA custodian so that they are reported to the IRS. To learn more about how IRA LLCs work please click here: IRA LLCs.
5 – Taxes
When an IRA earns “active income”, the profits are subject to Unrelated Business Income Tax (UBIT). This tax does not apply to most IRA investments as they either earn dividend income, rental income, interest income, royalty income, or capital gains. Some common investments where UBIT does apply is short term flips, real estate development, or active businesses (e.g. a franchise, convenience store, or gas station). When reviewing your IRA investments, your accountant or tax preparer will determine whether UBIT is due and will prepare Form 990-T, if applicable.