American IRA, a national provider of self-directed IRAs, in response to questions from clients and potential clients, announces its new webinar “Rules of the Road”. This webinar is packed with information about prohibited transactions, proper acquisition of assets, and much more.
The dates for these webinars will be announced in a future Press Release and will be posted on the American IRA events pages.
In the meantime, here are a few things self-directed IRA investors should know:
Avoiding Common Pitfalls in Nontraditional IRA Investing:
Individual retirement accounts have tremendous benefits for investors. Anyone who has ever qualified to contribute to an IRA should own one, in our view. And for most people, the simplest and most effective assets to invest in within an IRA should be long term investments such as stocks, bonds, mutual funds, and income-generating assets such as REITs.
However, for a select minority of investors – especially those with expert knowledge of a particular asset class, such as real estate, tax liens, currencies, commodity markets, precious metal markets and the like – it may be more appropriate for them to concentrate their efforts in what they know best. If this describes them, then they’ll be happy to know that their IRA – as well as their SEP IRA and solo 401(k) plan, gives them the flexibility to invest in what they know best. This can be an immense benefit to a certain kind of investor. The problem is that not every advisor understands IRA rules and how they apply to non-traditional investments within them.
That’s why it’s important for any IRA investor to have an understanding of the very basic rules of IRA investing, independent of their advisor. If they are currently doing business with a traditional broker or advisor, there is frequently nothing in their training or background that prepares them to advise, say, someone who owns rental property, farmland or a closely-held business within their IRA. Even many professionals don’t know their way around this very specialized field of financial planning.
Rules Against Self-Dealing:
The first thing to understand is that when Congress first designed the IRA in 1974, they built in a number of restrictions meant to prevent IRA owners from using these vehicles to benefit themselves prior to retirement. For this reason, the following transactions are prohibited within IRAs:
- They cannot buy property from their IRA.
- They cannot sell property to their IRA.
- Their relatives, defined as ascendants and descendants and their spouses, may not buy from or sell directly to their IRA.
- Their IRA cannot engage in any of the above transactions with any entities controlled by their ascendants, descendants, or any of their spouses.
- Their IRA cannot engage in transactions directly with their accountant, financial advisor, tax attorney or anyone else who advises them on their IRA, nor with any business entity they control.
- They cannot use their IRA, nor the assets within them, as security for a loan for use outside the IRA (this rule is commonly misunderstood.)
In plain English, this means they cannot use their IRA directly for their own benefit, nor that of those related to them, and their advisors cannot manipulate them into using their IRA to benefit themselves. Their IRA exists for one purpose only: To provide economic security for them after they turn 59½. Anything they cause their IRA to do that is contrary to that purpose runs the risk of generating taxes and penalties.
Tips and Traps
Use Caution with Vacation Homes:
If they own rental property in their IRA, they cannot stay in their own property – even overnight. The IRS considers this to be self-dealing. And because they cannot do business directly with their IRA, they can’t even stay in it if they pay it market rates or above market rates to stay there. By doing so, the IRS is preventing them from making a “back door” IRA contribution that could be in excess of annual contribution limits. The rules prohibit their family from doing the same thing, for the same reasons.
Some people get trapped by this rule – they think that they can use a home themselves for up to two weeks, just as the usual rental home rules allow. This is not the case with properties they hold in their IRA.
Beware of Partnerships and Joint Ventures:
Sure, they can use their IRA money to buy a partial interest in a property. But they can’t do it with a related party as their partner. Even if they don’t do it with a related party, the rules governing IRAs can still cramp their style, because their partner may want to pledge the real estate as collateral for another purpose outside the IRA. This could be problematic, depending on how the property is titled, because IRA rules prohibit them from using their IRA as collateral for a debt outside of the IRA.
Be Careful With Debt:
Yes, they can borrow money within their IRA. However, IRS rules restrict IRA borrowing to “non-recourse” loans. This means that they cannot sign a personal guarantee for the loan, nor secure the loan with anything except the property.
Beware the Liquidity Trap:
Remember, they can only contribute a maximum of $5,000 per year into an IRA. If their IRA owns a tangible asset such as rental property, or contains a small business or farm and they run out of operating cash, they can’t contribute more than $5,000 to it in any one year. They would either have to have a fire sale on assets to raise the capital they need to operate, or the IRA would have to borrow money from someone. But it can’t borrow from them or a related party! They’ll have to line up another resource, via a non-recourse loan, as above.
The Hidden Tax Trap:
Be careful of selling a property within an IRA if they have an existing mortgage outstanding on the property. If they do, the IRS may consider part of the transaction to be “debt-financed income” under IRC 514. In turn, this debt-financed income could result in them getting hit with an unrelated business income tax, or UBIT. Most advisors that don’t specialize in nontraditional IRA investing wouldn’t see this coming! For more information on this little-known tax provision – including how to calculate it – see IRS Publication 598.