Self-Directed IRAs: Are They for You?Tax Planning
Tired of being restricted to plain-vanilla investments in your IRA such as stocks, bonds, and mutual funds? If you want to walk on the wild side and invest your retirement money in assets such as real estate or cryptocurrency, a self-directed IRA could be for you.
What Is a Self-Directed IRA?
As far as the IRS is concerned, you can invest in anything through an IRA (or SEP-IRA or SIMPLE IRA) other than collectibles such as art and antiques, life insurance, and S corporation stock.
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 publicly traded stocks, bonds, mutual funds, ETFs, and CDs. The IRA custodians in these instances will not permit you to invest in alternative investments such as real estate, precious metals, or cryptocurrency.
On the other hand, if you establish a self-directed IRA, you are not subject to these custodian-imposed restrictions.
Instead, you are free to invest in a wide array of assets, including, but not limited to the following:
- Real estate
- International real estate
- Private businesses
- Trust deeds and mortgages
- Tax liens
- Precious metals such as gold, silver, or platinum
- Private offerings
- Private equity
- Private placements
- Limited partnerships
- Oil and gas interests
- Hedge funds
- Crowd funding
- Promissory notes
The self-directed IRA has the basic tax benefits of the traditional IRA, and it’s subject to the same basic rules. You don’t pay taxes on the self-directed IRA’s income until you take out the earnings—but if you take the money before age 59 1/2, you 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.
Key point. Self-directed IRAs are more complex to administer than the traditional IRAs, and there are potential tax land mines you need to avoid.
How to Open a Self-Directed IRA
Opening a self-directed IRA is simply a matter of finding an IRA custodian that allows self-directed investments, signing an IRA trust account agreement (IRS Form 5305), and opening an account. You can roll over a traditional IRA into a new self-directed IRA or do the same with a company 401(k) when you retire or change employers.
There are dozens of custodians offering self-directed IRAs. Make sure the custodian permits you to invest in the assets you’re interested in. Some have restrictions. Fees vary. Fees can be structured as
- a flat fee,
- a per-asset fee,
- a percentage fee based on the account’s value, or
- a combination of the three above.
Do You Want Checkbook Control?
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.
For example, Jim forms a single-member LLC that operates a sales business. The LLC collects the income and pays the bills, but it is disregarded for tax return purposes. The LLC’s income and expenses are reported on Jim’s Form 1040 Schedule C.
In the case of a self-directed IRA-LLC, it’s possible that the LLC will have unrelated business income that’s subject to tax and possible that it will have to file IRS Form 990-T.4 We discuss this later in this article.
With a checkbook self-directed IRA, your custodian has no involvement with purchasing or administering investments for the IRA. The custodian need not sign any purchase agreements or disburse funds. Your LLC handles purchases and disbursements.
For example, if your self-directed IRA/LLC purchases a rental property, the LLC deposits the tenants’ rents into the LLC bank account. The LLC uses its funds from its bank account to pay property taxes, insurance premiums, utility bills, property repairs, and maintenance.
How to Invest with Your Self-Directed IRA
A self-directed IRA requires more work on your part than a traditional IRA and can involve more risk.
Self-directed IRA custodians ordinarily don’t offer investments or provide investment advice. Their role is to process your investment requests and transactions. It’s up to you to decide what to invest in and conduct due diligence on the investment.
Obviously, investing in alternative assets such as cryptocurrency is riskier than stocks, bonds, and mutual funds.
- The rewards can be great, as we’ve seen with recent returns for cryptocurrency investors.
- And the damage to your investment portfolio can be substantial, as we’ve also seen during the past year.
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.
Avoiding Prohibited Transactions with Your Self-Directed IRA
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 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.
If your self-directed IRA engages in a prohibited transaction, it can lose its tax-favored status as an IRA, and if that happens, then the tax code treats your failed IRA as if it had distributed all of its assets to you, the IRA owner, at their fair market value on the first day of the year in which your prohibited transaction occurred.
- You likely would now have a tax bite on the taxable gain that’s includible in your income.
- You also would likely be subject to a 10 percent additional tax on early distributions unless an exception applies.
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.
Here are five takeaways from this article:
- 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) manages 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 rental property or owns an active business.