Self Directed IRA
So what is a Self Directed IRA and how does it work?
A Self Directed Individual Retirement Account (SDIRA) is an IRA that requires the account owner to make investment decisions and investments on behalf of their retirement plan. The IRS requires that a custodian or a qualified trustee holds these assets for the IRA owner. Self directed IRA accounts can be held in a variety of assets including traditional investments of stocks, bonds and mutual funds, as well as other IRS-permitted investments. These permitted investment options include real estate (both domestic and foreign), private equity, tax liens, franchises and mortgages. A self directed IRA allows more investment choices. In most circumstances, the custodian/trustee maintains the assets and the records pertaining to all the self directed IRA transactions. They will issue account statements, file the required IRS reports, are an advisor to the owner on regulations pertaining to these transactions, and they perform the administrative work on behalf of the owner of the self-directed IRA for the life of the account.
Prohibited Activities, Penalties
Having a self-directed IRA allows investment diversification, since there are numerous investment options. If you are interested in a self-directed IRA, it is imperative that you educate yourself to be sure that the choices you make are in compliance with current IRS regulations. Your custodian/trustee will not be able to provide you with legal or tax advise. If you are 59 ½ years old or younger, there is a 10% early withdrawal penalty for distribution from your IRA. Be aware that some investments are not permitted within your IRA. These include life insurance, collectibles and prohibited transactions with disqualified persons as defined by the Internal Revenue Service in IRC 4975 (c) (1.) Real estate and other investment assets employed for personal benefit, other than for a return for the IRA, may not qualify and may become immediately taxable. A self-directed IRA will give you options for building a strong retirement fund and it’s up to you to know the rules and plan accordingly.
Limited Liability Company (LLC) Self Directed IRA Structure
Some self directed IRA investors choose to use a Limited Liability Company structure as a means of reducing fees and to streamline paperwork and transaction processing. The account holder manages the limited liability company himself, and directs the custodian/trustee to invest in the LLC, enabling him to execute transactions as the LLC without involving the IRA custodian/trustee. This is often done to bypass custodial fees and avoid transaction delays. Profits for the LLC have nearly identical tax-favorable treatment for the IRA with this scenario. Internal Revenue Code Section 401 does not require use of a custodian, and this structure is frequently referred to as ‘checkbook control” since the IRA holder likely has sole signing authority for the LLC. There has been discussion that the IRA LLC strategy was legitimized by a 1996 tax-court case, Swanson vs Commissioner, 106 TC 76, although some disagree with the validity of the case.
Types of Self Directed IRAs, Contributions and Limits
Contributions limits (2007, 2008) are $5000 under age 50, and $6000 age 50 and older. Traditional IRAs can be either deductible or nondeductible. A nondeductible is an option if you do not qualify for a deductible IRA or a Roth IRA. A deductible IRA allows you to deduct all or part of your contribution from your taxable income. If you are under 70 ½ years old and do not have a retirement plan at work, you can invest in a deductible IRA and deduct the entire contribution from your taxes. If you have a retirement plan, such as a 401K, where you work, you may fully or partially deduct your contribution if your adjusted gross income (AGI) qualifies. If you are not eligible to contribute to a deductible IRA, you may qualify for a Roth IRA. For the Roth IRA, your AGI should be below $114,000 if you are single, or below $166,000 married and filing jointly. The 2007 guidelines for eligibility on a deductible IRA are $62,000 or below for a single head of household, and $103,000 or less for married filing jointly. For those not covered by and IRA but with a spouse who is, an AGI below $166,000 may still qualify you for a full or partial deduction.
Choosing a Self Directed IRA
A nondeductible IRA is a way to grow your savings in a tax-deferred environment if you do not currently qualify for a deductible or Roth IRA plan. If you expect to be in a higher tax bracket at retirement than you currently are in, a Roth IRA will probably be your better option. Whichever plan you choose, you will be taking steps to fund your future and retirement years. The self directed IRA offers an investor the most hands-on control over retirement savings and investments in his/her individual retirement account.
Investing in Real Estate Notes Using a Self Directed IRA
Does your current IRA custodian allow real estate and/or trust deed investments within your retirement account? Most don’t in a traditional or Roth IRA. And yet, these can be both the safest and most lucrative retirement investments when purchased within your IRA, helping you avoid income and capital gains taxes. The larger amount of money you have in your 401k, the more you should consider this option. If the current custodian does not allow real estate, trust deeds, mortgages, promissory notes and private stocks/bonds within your retirement account, you can convert with a 401k rollover to a self-directed IRA and afford yourself more investment options.
There are numerous custodians that specialize in self-directed IRAs for you to choose from. The management and transaction fees for these will vary, but are usually higher than fees for a normal IRA. You can check out the list of self-directed IRA custodians here, and compare the fee structures to determine which best suits your needs, considering the size of your account, the frequency of trades you anticipate making, and the types of investments you will be purchasing.
Your next step is to combine IRA accounts, being aware that you cannot combine a Roth IRA with a non-Roth IRA. If you have more than one IRA, you will have a bigger investment fund to work with by combining these, and will find it more cost-effective and efficient to manage one self-directed IRA. You’ll save on fees and transaction costs with one individual retirement account.
List of Self Directed IRA Custodians
The process for your 401k rollover to transfer to a self-directed IRA will take from 1-4 weeks depending on the processing time of the chosen custodian. Once your account has been transferred to a self-directed IRA, it can be invested into real estate, trust deeds and promissory notes, and a variety of non-traditional investments.
Restrictions, Prohibited Transactions; Self-Directed IRA
You may now buy real estate, notes and private stock within your self-directed IRA, but there are restrictions and prohibited transactions to be aware of:
- Arms length transaction – you cannot buy/sell assets to your IRA from/to yourself or certain family members (disqualified persons – see list).
- You and your family members cannot use the asset personally. Example: You cannot buy a house with your IRA and live in it, or rent it to your children. You can buy a vacation rental, but you can’t vacation in it.
- You can buy real estate in an IRA and get a loan on it, however you cannot personally sign the loan documents. You will need a special loan called a “non-recourse loan”. There are lenders who specialize in non-recourse loans.
- You (and your disqualified persons) cannot borrow money from your IRA
Disqualified Person – The IRA holder and his or her spouse. The IRA holder’s lineal descendants, ascendents (parents/children) and their spouses (brothers and sisters are ok). Any corporation, partnership, trust, or estate in which the IRA holder has a 50% or greater interest. Anyone providing services to the IRA, such as the trustee or custodian (See IRS Section 4975 for a complete list of prohibited parties.)
Buying Real Estate in an IRA
Advantages of owning real estate with an IRA:
- Capital gains and income are tax deferred (tax exempt if it is a ROTH IRA)
Owning real estate with an Ira – the disadvantages:
- Necessity of keeping cash reserve in the IRA account to cover unexpected expenses.
- No benefit of property depreciation as the IRA is tax exempt.
- All expenses must be paid from the IRA account
- Leveraging / mortgaging a property is more difficult and will be more expensive
- Leveraging a property in an IRA may not be entirely tax free due to “UBT Tax” (Unrelated Business Tax), which may apply to the income generated from the leveraged portion of your asset.
- Real Estate may subject your IRA to exposure for liability (a “slip and fall” suit could go after your other IRA assets.)
- Limits how active you can be in a property management role.
Buying Real Estate with an IRA: the possibilities
- It makes more sense to purchase raw land with an IRA, than it does to buy improved property, because there is no depreciation.
- Buy raw land, subdivide & sell.
- Buy and flip properties (short term) avoiding capital gains tax.
- Buy triple net lease properties (low maintenance, no depreciation) – long term.
- Buy Real Estate Options and Sell them – the benefits of leveraging, without UBT.
- Buy Land Contracts and Sell them – the benefits of leveraging, without UBT.
- Create an LLC, which is owned by your IRA, and have the LLC purchase real estate. This reduces liability exposure, and can also reduce custodian fees. There are several companies out there to help set up an LLC for this purpose. Your LLC setup fees will vary, but normally expect to pay $2500-$5000 to form your LLC.
Investing IRA funds in Trust Deeds and Promissory Notes
Favorable tax treatments and low maintenance requirements, combined with above average yields (12%+) make trust deed investing with a self-directed IRA a very attractive option. It is smart to buy a very safe, low LTV first-position mortgage. Junior position notes are less advisable unless you can keep a substantial cash reserve in your IRA account, to allow for the possibility of advancing funds to a senior lien.
Advantages
- Notes are almost always a positive cash-flow investment – even though an interruption to that cash-flow can occur if the borrower defaults.
- 1st Position Notes rarely have expenses associated with the asset. Possible exceptions are if the borrower defaults on property taxes or fire insurance.
- Your note rate allows accurate forecasting of future yields.
- Owning notes reduces liability exposure almost completely.
Disadvantages:
- Trust Deeds and Notes owned by an IRA cannot easily be leveraged.
You can buy fractional or partial notes within your self-directed IRA. For example, you might decide to purchase a $300,000 note but only have $150,000 in your account. In this scenario, you buy 50% (or $150,000) yourself, and 50% (or $150,000) with your self-directed IRA.
When buying real estate notes, sometimes the borrower defaults, and the note holder must foreclose and take back the property. In this scenario, the IRA would then own the property. Make sure that if you buy notes with a particular IRA custodian, that holding real estate is allowed. You should be clear on this when choosing your custodian. If you take back a property in your IRA, you can sell it or rent it, but you can’t move into it, nor can you use it personally.
There are also infrequent, but lucrative, opportunities to buy discounted notes or an option on a note. These can have a very large tax free rate of return.
Warning: Investing Self Directed IRA funds requires careful attention to IRS laws. Violating IRS laws regarding self dealing, and selling to disqualified buyers can be a serious taxable event and cause your IRA to be effectively distributed and penalized. The IRS has letter rulings on many of these situations. Review these laws with your Self Directed IRA custodian and educate yourself on the rules and regulations that apply to investments you’ll make within your self-directed IRA. You make the choices in your individual retirement account, so learn all you can to invest wisely and secure your retirement dollars.
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