ARTICLES
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Self-Directed IRA FAQsBy Pierre Mouchette | Real Property Experts LLC
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What is a Self-Directed IRA?
A Self-Directed IRA unlike other IRAs is unique because of the investment options available and the investing direction comes from the IRA owner. With the self-directed IRA, you invest your tax-advantaged retirement dollars in investments you know and understand.
Why have I not heard of a self-directed IRA before?
Self-directed IRAs have been around since the IRA was established in 1974. Investing in alternatives to stocks, bonds, and mutual funds has always been allowed by the IRS (see IRS Publication 590). Self-Directed IRAs have not received large attention because many custodians who offer IRAs (banks and brokerage firms) typically offer traditional investments.
A self-directed Individual Retirement Account is an IRA, provided by some financial institutions that allows alternative investments for retirement savings. Some examples of these alternative investments are real estate, private mortgages, private company stock, oil and gas limited partnerships, precious metals, horses, and intellectual property. The complexity of the rules for self-directed IRA's prompted the SEC to issue a public notice in 2011 against an increased risk of fraud.
Prohibited asset types
Internal Revenue Code Section 408 prohibits IRA investments in life insurance and in collectibles such as artwork, rugs, antiques, metals (there are exceptions for certain kinds of bullion), gems, stamps, coins (there are exceptions for certain coins minted by the U.S. Treasury), alcoholic beverages, and certain other tangible personal property.
IRS regulations prohibit transactions that are an improper use of the value in the account or annuity by the account owner, the account owner's beneficiary, or any other disqualified persons, as defined under Internal Revenue Code Section 4975. In essence, IRA prohibited transactions are transactions that Congress has deemed inappropriate between IRAs and certain people associated with those IRAs. The IRS prohibited transaction rules apply to all Individual Retirement Accounts, such as Traditional IRA, Roth IRA as well as SEP plans and SIMPLE IRA plans. These rules are generally designed to prevent self-dealing or conflict of interest transactions, which are transactions that directly or indirectly benefit the IRA holder or a disqualified person, and not the IRA or plan. Disqualified persons include the IRA holder, a fiduciary (e.g., the IRA holder or plan participant) and members of the IRA holder’s family, such as the spouse, ancestor, lineal descendant (e.g., children), any spouse of a lineal descendant, and persons similarly financially related to the IRA holder.
The self-dealing and conflict of interest types of prohibited transactions, as outlined in IRC sections 4975(c)(1)(D) and 4975(c)(1)(E), are the broadest and most complex categories of prohibited transaction. To trigger a self-dealing or conflict of interest transaction, the IRS simply must show that a disqualified person received some direct or indirect personal benefit. If the account owner or beneficiary engaged in a prohibited transaction, the account is treated as distributing all its assets to the IRA holder at their fair market values on the first day of the year in which the transaction occurred. The distribution would be subject to any taxes or penalties associated with an early distribution: generally, a 10-percent early withdrawal penalty and treatment of the distribution as ordinary income for the purposes of income taxes.
Permitted investments
The Internal Revenue Code does not describe what a self-directed IRA can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 and 4975 prohibit Disqualified Persons from engaging in certain types of transactions.
An IRA can purchase any type of real estate if the provider (aka custodian) of that IRA handles real estate. IRA providers that handle real estate are often called self-directed IRA providers. If the IRA does not have enough cash to pay the full purchase price, then the IRA can partner with a person, company/entity, or another IRA, or it can secure a non-recourse loan to buy real estate. Whether the IRA is whole or part owner, IRA funds are used for purchase, maintenance, and expenses. When the property generates cash either with rental income or from sale, those funds go directly back to the IRA. The IRS prohibits certain actions. For example, neither the IRA holder nor any disqualified persons to that plan may live in or vacation in the property. The IRA holder makes the decisions about how the asset is maintained but cannot do the work themselves.
The IRS allows IRAs and other retirement accounts to make loans. The IRA holder assumes the responsibility of choosing the borrower, the principal amount and interest rate, length of the term, payment frequency and amount of the loan. The holder also negotiates whether or not the note will be secured.
A Self-Directed IRA unlike other IRAs is unique because of the investment options available and the investing direction comes from the IRA owner. With the self-directed IRA, you invest your tax-advantaged retirement dollars in investments you know and understand.
Why have I not heard of a self-directed IRA before?
Self-directed IRAs have been around since the IRA was established in 1974. Investing in alternatives to stocks, bonds, and mutual funds has always been allowed by the IRS (see IRS Publication 590). Self-Directed IRAs have not received large attention because many custodians who offer IRAs (banks and brokerage firms) typically offer traditional investments.
A self-directed Individual Retirement Account is an IRA, provided by some financial institutions that allows alternative investments for retirement savings. Some examples of these alternative investments are real estate, private mortgages, private company stock, oil and gas limited partnerships, precious metals, horses, and intellectual property. The complexity of the rules for self-directed IRA's prompted the SEC to issue a public notice in 2011 against an increased risk of fraud.
- Internal Revenue Service (IRS) regulations require that a qualified trustee, or custodian, hold IRA assets on behalf of the IRA owner. The trustee/custodian provides custody of the assets, processes all transactions, maintains other records pertaining to them, files required IRS reports, issues client statements, helps clients understand the rules and regulations pertaining to certain prohibited transactions, and performs other administrative duties on behalf of the self-directed IRA owner.
- The account owner for all IRAs chooses among the investment options allowed by the IRA custodian. For regular IRAs, these options usually include stocks, bonds, and mutual funds, but with a self-directed IRA, the term ‘self-directed’ refers to the significantly broader range of alternative investments available to the account owner. IRA custodians can restrict the types of assets they will handle in addition to Internal Revenue Code (IRC) restrictions.
Prohibited asset types
Internal Revenue Code Section 408 prohibits IRA investments in life insurance and in collectibles such as artwork, rugs, antiques, metals (there are exceptions for certain kinds of bullion), gems, stamps, coins (there are exceptions for certain coins minted by the U.S. Treasury), alcoholic beverages, and certain other tangible personal property.
IRS regulations prohibit transactions that are an improper use of the value in the account or annuity by the account owner, the account owner's beneficiary, or any other disqualified persons, as defined under Internal Revenue Code Section 4975. In essence, IRA prohibited transactions are transactions that Congress has deemed inappropriate between IRAs and certain people associated with those IRAs. The IRS prohibited transaction rules apply to all Individual Retirement Accounts, such as Traditional IRA, Roth IRA as well as SEP plans and SIMPLE IRA plans. These rules are generally designed to prevent self-dealing or conflict of interest transactions, which are transactions that directly or indirectly benefit the IRA holder or a disqualified person, and not the IRA or plan. Disqualified persons include the IRA holder, a fiduciary (e.g., the IRA holder or plan participant) and members of the IRA holder’s family, such as the spouse, ancestor, lineal descendant (e.g., children), any spouse of a lineal descendant, and persons similarly financially related to the IRA holder.
The self-dealing and conflict of interest types of prohibited transactions, as outlined in IRC sections 4975(c)(1)(D) and 4975(c)(1)(E), are the broadest and most complex categories of prohibited transaction. To trigger a self-dealing or conflict of interest transaction, the IRS simply must show that a disqualified person received some direct or indirect personal benefit. If the account owner or beneficiary engaged in a prohibited transaction, the account is treated as distributing all its assets to the IRA holder at their fair market values on the first day of the year in which the transaction occurred. The distribution would be subject to any taxes or penalties associated with an early distribution: generally, a 10-percent early withdrawal penalty and treatment of the distribution as ordinary income for the purposes of income taxes.
Permitted investments
The Internal Revenue Code does not describe what a self-directed IRA can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 and 4975 prohibit Disqualified Persons from engaging in certain types of transactions.
An IRA can purchase any type of real estate if the provider (aka custodian) of that IRA handles real estate. IRA providers that handle real estate are often called self-directed IRA providers. If the IRA does not have enough cash to pay the full purchase price, then the IRA can partner with a person, company/entity, or another IRA, or it can secure a non-recourse loan to buy real estate. Whether the IRA is whole or part owner, IRA funds are used for purchase, maintenance, and expenses. When the property generates cash either with rental income or from sale, those funds go directly back to the IRA. The IRS prohibits certain actions. For example, neither the IRA holder nor any disqualified persons to that plan may live in or vacation in the property. The IRA holder makes the decisions about how the asset is maintained but cannot do the work themselves.
The IRS allows IRAs and other retirement accounts to make loans. The IRA holder assumes the responsibility of choosing the borrower, the principal amount and interest rate, length of the term, payment frequency and amount of the loan. The holder also negotiates whether or not the note will be secured.
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RPE Category (Digital Digest)
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REAL ESTATE | VALUE ADDED STRATEGIES | Estate Planning
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PUBLISHED:
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January 04, 2021
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