At InSight, our clients know that when you understand the rules you make better decisions. Our InSight-Full® plan is about marrying the goals that you have with the right Rules of Self-Directed IRAs and the right strategy. We cannot stress enough the importance of knowing the rules and how to avoid problems both now and in the future.
By Kevin T. Taylor AIF® and Peter Locke CFP®
The first rule is when you open a self-directed IRA you’re not the owner. The tax code requires the assets in a Self-Directed IRA (SDIRA) and its owner remain separate and not used in a way that one indirectly enriches the other (beyond permitted rules). When you think about investing into something using your IRA think of it as solely an investment and not for personal use. The IRA owner and anyone else responsible for the account is prohibited from commingling their vested interests of the SDIRA with its owner or any “disqualified persons” which includes:
- The fiduciary of the account including the SDIRA owner
- Family member (ancestor, spouse, lineal descendant, or spouse of a lineal descendant
- Corporation, partnership, trust, or estate where 50% or more of the shares/profits/beneficial interests are owned by any of the above
- Officer, director, or 10% or more shareholder or partner of an entity above
If someone is a disqualified person, they’re prohibited from directly or indirectly transacting between the SDIRA and the disqualified person in the following manners:
- Transfer, use, or benefit of the assets
- Lending or extending credit (both ways)
- Sale, lease, or exchange of property
- Furnishing of goods, services, or facilities
- Dealing assets for your own benefit as the fiduciary
- Personally receiving consideration as a fiduciary from a third party that engaged in a transaction with the IRA
This means that if any of these transactions listed above with any disqualified person occur even if done at fair market value, will be subject to severe consequences. The standard penalty is 15% of the amount involved in the transaction which is imposed on any disqualified person engaged in the transaction. Furthermore, if it’s not resolved by the end of the year in which the violation occurred, the penalty is increased to 100% of the transaction amount. And to top it off, the entire account loses its tax-deferred status and is treated as if the entire account was liquidated and distributed as of the current year.
The majority of clients for asset protection purposes and clean book keeping manage their self-directed IRA inside of an LLC. Don’t have your IRA own the property, have your IRA own an LLC that has a bank account that you’re the manager of. Then the LLC is the owner on the contract. This like any other rental property gives you the ability to have limited liability in the event someone comes after your assets.
These are investment assets not personal assets, this is definitely a breach of rules of self-directed IRAs. You cannot live there, your parents, kids, or grandparents cannot live there. You cannot sell your own property or buy a piece of property from yourself using the IRA. Don’t take a salary or commission (prohibitive transaction). Any repairs or maintenance must be done by a third party. The reason is if you were to work on it on your own then you’re self serving and this could be viewed as a contribution to the IRA which is prohibited. Also, if you own a property management company and are a 50%+ owner, your company cannot do work on the property. The easiest thing you can do is separate yourself completely from the investment and let third parties do the work.
If you follow through with the purchase, keep all accounting separate. You don’t want to accidentally make a mistake and disqualify yourself by accidentally mixing personal use assets with your Self-Directed IRA. For example, if you think you can use a credit card to pay for the repair of something you cannot. All expenses come out of the IRA not your bank account.
Another prohibited transaction in this type of account is transacting with prohibited parties or disqualified persons such as kids, parents, spouse, grandparents, spouses of your kids and yourself. Although, siblings are allowed. The rule specifies disqualified persons as ancestors.
Keep your Self-Directed IRA separate from your business where you’re a 50% or more owner. In this case, your IRA is a prohibited party and therefore you cannot loan to an LLC that is associated with your business.
If you’re not putting down the full amount to buy in this case a rental property, you’ll need to get a non-recourse loan. This means the bank will charge a higher interest rate but if you default then they will only take the property. Having a non-recourse loan in an IRA means you will be subject to unrelated debt taxable income (UDTI). UDTI is generated when you finance the purchase of property in an SDIRA. Unrelated Debt Financed Income (UDFI) and Unrelated Business Taxable Income both trigger UBIT (Unrelated Business Income Tax). To even the playing field for everyone (because using leverage in an IRA and collecting income is way to get huge contributions into your IRA which isn’t fair to non-exempt persons) the IRS made it so tax-exempt entities you must pay income tax on the income they realize from the UDFI that year at the Estate Tax level which is much higher than ordinary income levels.
Lastly, invest in what you know. Don’t take unnecessary risk by breaking one of the Rules of Self-Directed IRAs, and don’t invest in your friend’s start-up that you know nothing about. If you know rentals buy rentals, if you know commercial real estate buy commercial real estate. Just like anything we do here at InSight, have the right people, process, and policies set up to hold yourself accountable so you make more informed investments.