By David E. Bowers, LL.M., and Rachel L. Sears
An individual retirement account (IRA) such as the traditional IRA, Roth IRA, simplified employee pension (SEP) IRA, and savings incentive match plan for employees (SIMPLE) IRA, provides investors with tax benefits for retirement savings and most IRA custodians typically limit investments to common securities such as stocks, bonds, certificate of deposit (“CD”), and mutual or exchange-traded funds (ETFs). Certain investors, however, wish to invest their resources in other asset classes and choose to do so through a self-directed IRA. While a self-directed IRA has the capacity to house diverse alternative investments such as real estate, cryptocurrency, gold, and private equity; however, it also comes with potential pitfalls from a legal perspective that investors should be aware of.
Selecting a Custodian: A Crucial Decision in Self-Directed IRAS
A key pitfall of self-directed IRAs is their limited regulatory oversight compared to traditional investments. While traditional IRA custodians are required to adhere to federal laws and regulations related to selling investment products, providing investment advice and typically restrict investments to firm-approved securities, self-directed IRAs don’t face such limitations. Self-directed IRA custodians, on the other hand, do not offer investment advice, are not required to evaluate the quality or legitimacy of an investment, and do not verify the accuracy of the financial information investors provide to them. They solely manage and administer assets. This is where the “self-directed” part comes in. Investors bear full responsibility for understanding and ensuring compliance with intricate tax laws, as violations can lead to penalties, additional taxes and legal problems.
When selecting a custodian for your self-directed IRA, it’s crucial to recognize that not all custodians are created equal. The IRS licenses over 50 companies to provide these services, and their reputations and expertise in specific investment categories may vary significantly. Therefore, diligent research is essential. Below are a few factors that an investor should consider when deciding who should be the custodian of their self-directed IRA investments.
First, an investor should check if the custodian is listed as an Approved Nonbank Trustee and Custodian by the IRS and also consider the custodian’s experience and track record, as a longer history typically indicates stability and competent management. Investors should also evaluate the fee structure of each custodian, as pricing can differ between firms. Some charge based on specific services, while others have flat annual fees, so it’s vital to understand the total annual cost. Investors should keep in mind that self-directed IRA custodians typically have higher fees due to the complexity of alternative investments. Additionally, investors should inquire about the custodian’s expertise in the specific type of investment they are planning on investing in. Lastly, it’s imperative that investors inquire about custodian’s cybersecurity measures, such as up-to-date encryption, for example, to ensure the data is secure.
Prohibited Transactions and Disqualified Persons
Self-directed IRA owners need to be aware of the prohibited transaction rules. Prohibited transactions include, but are not limited to, activities such as buying, selling, or leasing property to or from a disqualified person. Disqualified persons include family members, fiduciaries, an entity in which the IRA owner has a controlling interest (i.e., ownership of 50% or more), or the IRA owner themselves. Additionally, IRS regulations strongly prohibit the IRA owners from using the rental property—whether directly or indirectly—for personal use. For example, using the property as a vacation home or paying themselves or a disqualified person to manage the property may disqualify the entire IRA resulting in taxable income on the full value and potentially result in unexpected unrelated business income penalties (as discussed in more detail below), thereby eroding the returns on the investment. It is essential for investors to seek legal advice to avoid inadvertently engaging in prohibited transactions in their self-directed IRAs.
Complex Estate Planning and Tax Rules
Estate planning becomes more complex with self-directed IRAs, especially when alternative assets are involved, such as real estate, private equity, or cryptocurrency. To hold these alternative assets, complex legal structures such as limited liability companies, partnerships, or trusts are created. If these legal structures are not set up correctly or do not comply with state and federal laws, distributions from your self-directed IRA may be audited by the IRS for understatements of income tax and, alternatively, negligence or disregard of rules or regulations, which may result in penalties and other potential legal issues and liabilities.
Proper estate planning is essential to ensure that the self-directed IRA assets are transferred to beneficiaries according to the IRA owner’s wishes and in compliance with tax laws and regulations. Failing to properly plan for the disposition of self-directed IRA assets upon the owner’s death can result in unintended consequences, such as high taxes, financial penalties, loss of the account’s tax deferred status or disputes among heirs. For more information on estate planning considerations for cryptocurrency investors, click here.
Triggering Unrelated Business Income Tax Liabilities
IRAs are tax-exempt while assets are accumulated for retirement. However, despite being tax exempt, a self-directed IRA may still be liable for its unrelated business income tax (UBIT). The UBIT rules prevent exempt organizations from running unrelated businesses without paying taxes on the income produced by that unrelated business. Without a proper understanding of UBIT and its impact on IRAs, owners may inadvertently trigger their self-directed IRA to be taxed at the trust tax rate, which can be as high as 37%.
Self-directed IRAs may invest in businesses, such as rental properties, operating companies, or partnerships. However, if the business is considered an active trade or business, is regularly carried on, and not substantially related to furthering the exempt purpose of the organization—which is to save for retirement in the case of self-directed IRAs—the income generated from such activities may be subject to UBIT. For example, if a self-directed IRA owns rental properties, each property will require ongoing rental maintenance such as repairs, collecting rent, and screening tenants. To prevent immediate tax consequences and penalties, the IRA owner must ensure that all taxes, maintenance and management expenses related to the rental property are paid from the IRA’s generated funds and not from the owner’s personal funds. While not paying these expenses directly out of pocket sounds great in theory, this may present a problem for the self-directed IRA owner and create a prohibited transaction.
For instance, the IRA annual contribution limit for 2023 is $6,500 and $7,500 for individuals 50 and older. What happens if a property encounters a series of major expenses and the IRA balance is too low to cover the rental maintenance, requiring the owner to deposit more money into the account above the contribution limit? In this instance, the IRA owner would be on the hook for penalties due to “overcontributing” and possibly a prohibited transaction.
Contrary to popular belief, self-directed IRA owners can use leverage, such as obtaining a mortgage or loan, to finance investments. However, IRS Code Section 4975 prohibits IRA owners from personally guaranteeing a self-directed IRA loan. In other words, the loan acquired must be “nonrecourse,” which means the IRA owner cannot issue a personal guarantee on the loan to the lender, leaving the underlying asset itself (i.e., the real estate property) as the only source of recourse that a lender has available to them to in the event of default. If a lender does loan to a self-directed IRA and requires a personal guarantee from the owner, this would be considered a prohibited transaction and could result in the entire IRA being taxable. To avoid this, the custodian, and not the IRA owner individually, should be the sole obligor on the self-directed IRA loan and mortgage.
Even if nonrecourse debt financing is used, the income generated from the investment will be subject to UBIT. This is known as unrelated debt-financed income (UDFI). To illustrate, if a self-directed IRA commits $100,000 to a property investment, contributing $60,000 in cash and securing a $40,000 mortgage, the income proportionate to the financed segment (40%) would be susceptible to UBIT. This can be a complex area of UBIT and requires careful consideration and planning to avoid unexpected tax liabilities.
The IRS closely scrutinizes self-directed IRA activities for compliance with UBIT rules. Failing to properly report and pay UBIT can trigger an audit and result in penalties, interest, and other legal consequences. It’s crucial for self-directed IRA owners to understand the UBIT rules and ensure accurate reporting to avoid potential audit risks and penalties.
Self-directed IRAs offer unique investment opportunities, but they also come with potential pitfalls that are commonly overlooked by many investors. As a result of the lack of regulatory guidance from the IRS, it’s essential that self-directed IRA investors choose a custodian that has the industry experience geared towards their investments and seek professional legal advice before making investment decisions to help navigate the complexities, regulations, and risks associated with self-directed IRAs.
© 2024 ALM Global, LLC, All Rights Reserved. This article originally appeared in the Daily Business Review on January 30, 2024.
For additional information or questions regarding self-directed IRAs, we urge you to contact the authors of this article or a representative of Jones Foster here.