One thing all investors know is that liquidity and the ability to obtain loans can be the difference between success and failure. Still when it comes to Self-Directed IRAs, there are a few more considerations to keep in mind.
Liquidity and Self-Directed IRAs
Real estate investments periodically require large cash infusions. For example, you may need to replace a roof and spend $20,000 in the process. But you can only contribute a maximum of $5,500 or $6,500 depending on your age to a Self-Directed IRA. This can easily cause liquidity problems if the Self-Directed IRA owner is not careful.
The mistake many Self-Directed IRA owners make is not keeping enough liquid funds in reserve within their IRA. This creates problems when the IRA owned assets have expenses that exceed the available balance of the IRA account.
To raise the additional funds, the owner has the following options:
- Roll money over from another retirement account
- Borrow the money via a non-recourse loan to the Self-Directed IRA. But that could generate unrelated debt-financed income tax as described above, in future years.
- Put off the repair until their Self-Directed IRA has the cash available in it, either from selling other assets within the IRA, rolling eligible accounts over into the IRA, or accumulating future year contributions and earnings
Loan Guarantees and Self-Directed IRAs
Borrowing money within IRAs is not prohibited. Personally guaranteeing a loan is not prohibited for non-IRA transactions. But providing a personal guarantee on a loan made to your IRA is prohibited.
Unfortunately, a couple of investors had to learn that lesson the hard way. They provided a personal loan guarantee for an entity within their IRAs (their IRAs jointly owned the entity). The IRS got wind of it, and disallowed it. They went to tax court, which ruled against the two investors, costing them $45,000 in penalties.
It’s easy to see why they got confused: The rules clearly state that you cannot make a loan directly to your IRA. But not too many people think of loan guarantees as a loan. Even the IRS doesn’t think of loan guarantees as an immediate benefit, which is why recipients of guaranteed loans aren’t taxed on the proceeds.
But when it comes to Self-Directed IRAs, the IRS took a much harder line.
Consequences for not understanding these compliance issues can be extreme, including penalties and taxes from the disallowance of the entire Self-Directed IRA. It’s important for taxpayers to use caution when investing and administering Self-Directed IRAs.
Furthermore, it’s vital to use advisors who have experience specific to Self-Directed IRAs. Many rookies and generalists do not have a detailed understanding of how Self-Directed IRAs work – leading to problems like the ones described above. American IRA is an administrator who has been in business for 10 years and has a team comprised of people who are both experienced investors and IRA experts. This blend of expertise ensures transactions flow smoothly as their team is uniquely qualified to communicate with professionals (advisors, CPAs, attorneys, etc.) about investments at all levels within a Self-Directed IRA. American IRA does not give investment/financial advice in relation to any investments.
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