Did you know you can invest your IRA funds in just about anything? There are only three exceptions – you can’t use your IRA funds to buy collectibles or life insurance policies. The third exception involves S Corporations. It’s not an IRA rule; it is an S Corporation rule that prohibits an IRA from owning stock in an S Corporation. Anything else is fair game but there are a lot of traps you can fall into when you venture beyond securities, bank accounts and annuities. Many non-conventional investments are difficult to price. Losses from a poor performing investment cannot be written off in an IRA. Mishandling types of business investments can also result in your IRA being disqualified by the IRS resulting in taxes and penalties.
You will need a custodian or trustee to hold the investment in your self-directed IRA. It is not a simple matter of going out and buying a rental property and calling it your IRA. You should have a competent IRA administrator help you establish your self-directed IRA. A knowledgeable administrator can help avoid mistakes which may lead to a prohibited transaction. All IRA rules will need to be followed which include contribution limits and required minimum distributions when the owner reaches age 70 ½. Calculating the minimum distribution will require an accurate year-end valuation of the IRA assets.
Self-directed IRAs may be a good idea for someone with unique knowledge about unconventional investments like patents, structured settlements, oil & gas leases, and private placements. Administrative fees for this type of IRA will be higher due to the unique nature of the investments and the annual valuations required by the IRS. Typically a third party will need to be hired to provide an appraisal and the cost will be charged to the IRA account.
The type of investment chosen can also lead to unexpected tax consequences even within an IRA. IRA funds invested in an operating business may generate unrelated business income tax (UBIT). UBIT rules are designed to offset what would be considered an unfair competitive advantage of a business held in an IRA that doesn’t pay taxes. The UBIT rules were originally designed for charities and other tax-exempt entities who also run a for profit business competing with taxable entities. Most rental real estate will not be subject to UBIT because it is not considered an operating business.
UBIT is typically a modest outlay but it shouldn’t be ignored. A much larger risk is avoiding prohibited transactions. Self-dealing is one of the most common violations. IRA owners can’t buy real estate from their own IRA or sell real estate they already own to their IRA. This rule applies to spouses, parents, children, grandchildren and in-laws. These transactions are considered off-limits.
Transactions must be kept at arm’s-length. A common mistake made by IRA owners is when they buy a rental property with IRA funds and the property requires repairs. Expenses must also be paid out of the IRA. Using personal funds is considered an IRA contribution and could violate excess contribution rules or worse – be considered self-dealing. A similar type of prohibited transaction is when the IRA owner pays for some expense related to the ownership of the real estate and later is reimbursed from the IRA account. This could easily happen when there is some repair that needs to be done in a timely fashion and the IRA account does not have sufficient cash to pay the expense. The owner pays the vendor for the repair and reimburses himself after income is received by the IRA.
Another common problem associated with rental real estate in an IRA involves the use of borrowed money. An IRA owner cannot borrow from their IRA nor can they use property held in an IRA as collateral for a personal loan. Pledging an IRA as collateral is considered an IRA distribution subject to tax and possibly a penalty. This is not to say you cannot hold a property in your IRA with a mortgage. The mortgage will need to be a non-recourse loan to acquire the property. This means the loan is secured only by the property and not by the IRA owner personally. Be aware that leveraging assets in your IRA can make the IRA subject to UBIT.
There are many pitfalls to be aware of when buying unconventional investments in a self-directed IRA. Many of these mistakes can be avoided by working with a knowledgeable financial adviser who is familiar with the rules.
- There are only three investments that can’t be held in an IRA – collectibles, life insurance policies, and shares of S Corporations.
- Operating businesses held in an IRA may generate unrelated business income tax (UBIT) even though the account is tax-deferred.
- Be wary of prohibited transactions in self-directed IRAs involving self-dealing, borrowing against IRA assets, and co-mingling personal funds with IRA funds.