The reason many investors flock to Self-Directed IRAs is that they want to keep as much of their own money as possible while they work through a retirement strategy of their choosing. However, this arrangement means that since you will be the one making the decisions, you will also need to stay abreast of any recent changes in tax policy or rulings. That is why we think it is worth highlighting a recent tax court ruling that Self-Directed IRA investors should be aware of.
A Tax Court Ruling Related to Self-Directed IRAs
In the recent court ruling, highlighted at Forbes, entails a taxpayer who had a SEP-IRA. The custodian on this IRA was a leading national bank—not exactly a controversial setup just yet. The taxpayer in question also set up a single member LLC with himself in control. He then set up the bank account of this LLC at the same bank with which he had established the SEP-IRA.
So far, there isn’t too much that would make many people with setups like these blink. However, the investor did then ask the bank to make distributions from the SEP-IRA, on two separate occasions. These distributions were then used to make real estate loans. The taxpayer documented these loans, and then eventually put the proceeds from the borrowers into the SEP-IRA.
The custodian bank, doing as it was required, sent the taxpayer a Form 1099-R to record these taxable distributions on his tax return. However, the investor chose not to report these distributions in his income. The IRS then slapped him with the taxes and penalties associated with early distributions—as you might expect. The taxpayer took this to court, where the court ruled in the favor of the IRS.
What Does this Tax Court Ruling Mean?
When we look at the taxpayer’s investment decisions, it is a clear possibility that the investor may have been trying to use the Self-Directed IRA to make loans—a perfectly good decision, provided all the rules have been followed. However, it was the choice of custodian that may have gotten in the way. “To do that correctly,” writes Forbes, “he needed to move the SEP-IRA to a custodian that allows non-traditional investments such as mortgage loans.” Then the investor could have directed this custodian to make the loans or other investments as part of the SEP-IRA, not requiring early distribution penalties and taxes. Because the investor took these shortcuts along the way, it only spelled financial disaster for the individual.
What does this mean for people who are thinking of using a Self-Directed IRA for something like mortgage loans? It means that it is important to understand the limits of a Self-Directed IRA custodian. By working with a national bank that was not able to meet his needs, the investor went the long route of taking taxes and penalties from early distributions rather than simply directing the IRA to make the loans directly. It is possible to use Self-Directed IRAs for loans in a way that does not incur extra penalties and taxes—but clearly, this investor was not going about it the right way.
This tax court ruling shows how important it is to get on the same page as your Self-Directed IRA administration firm. Rather than try to create imaginary shortcuts for executing transactions within an IRA, an investor should have the trust that they can direct their Self-Directed IRA to do something, and the custodians will then make sure that this is a valid transaction and execute it.