A Closer Look At Self-Directed IRA Prohibited Transactions

Self-Directed IRAThe Self-Directed IRA is a tremendously flexible and adaptable savings vehicle, compatible with a vast range of investment contexts and strategies.

But there are some important restrictions, as well – especially the Congressionally imposed list of prohibited transactions detailed in IRC Section 4975(c)(1). If you own a self-directed IRA, or are considering making use of the strategy, it’s critical to understand all of the prohibited transactions. Many have gotten lose or careless with these restrictions – and gotten some nasty surprises when IRS agents disallowed their self-directed IRAs, costing them substantial taxes and penalties.

In most cases there was no good reason for it: The prohibited transactions generally amount to common sense rules that prohibit Self-Directed IRA owners from abusing the structure to shelter themselves from taxes, rather than to use the powerful tax advantages as Congress intended: To help build a firm foundation for a secure retirement income.

Disqualified Persons

The first concept to understand is that of ‘disqualified persons.’ It’s related to other tax rules that make use of the Self-Directed IRA‘arms-length’ transaction concept: The IRS takes a dim view of transfers of assets between close relatives – especially at prices below market value – because of the potential for abusing the provision to avoid taxes that would otherwise be due.

Section 4975(c)(2) forbids the transfer of IRA assets between the IRA owner and certain counterparties, called ‘disqualified persons.’ Specifically, the IRS restricts transfers of IRA assets with the account holder’s spouse, lineal descendants, lineal ascendants and spouses of any lineal ascendants and descendants. The law also prohibits Self-Directed IRA owners from transferring IRA assets entities in which any prohibited individual listed above owns a 50 percent interest or more, as well as some directors, employees or partners in those businesses – all of these are considered ‘disqualified persons’ under the law.

Advisors who act as fiduciaries advising the client on the IRA or other account may also be considered disqualified persons.

Penalties

If a disqualified person or entity buys, sells, borrows or lends assets to or from an IRA, the IRS may disqualify the entire IRA, and deem the entire account to have been distributed that year. This may result in income tax (for traditional IRAs, 401(k)s, SEPs and SIMPLES (Roth IRA distributions are tax free if the assets distributed have been in the Roth for five years or more) as well as applicable penalties. The taxpayer forfeits the tax-exemption benefits of the IRA and the entire value is deemed taxable immediately.

[tweetthis twitter_handles=”@iraexpert” hidden_hashtags=”#SelfDirectedIRA #ProhibitedTransactions”]Prohibited transactions…common sense…Self-Directed IRA owners[/tweetthis]

Prohibited TransactionsSelf-Directed IRA

You cannot sell, exchange, lease or lend any IRA assets to or from a disqualified person. That transaction would fall under IRS prohibited transaction rules. The prohibition applies to direct and indirect transfers alike. That is, you cannot avoid the tax liability by employing a middleman or a straw buyer or seller.

Under this rule, even small transactions can have major tax consequences: If you own a real estate IRA and you hire your own child to help paint the fence for minimum wage, and the IRS finds out, they may disqualify the entire IRA, costing you thousands of dollars in taxes and penalties.

Exception: While 401(k) plans and IRAs have similar provisions concerning disqualified persons, it is possible for 401(k) account holders to borrow from their own 401(k) accounts, if the plan sponsor allows for it.

Borrowing Rules

IRAs and other self-directed retirement accounts may employ leverage – that is, borrow money – in order to make investments. However, it may borrow only on a non-recourse basis. The lender can take no collateral or guarantee other than assets within the account. They can have no claim against the IRA or other account holder, personally.

If the account owner signs a personal guarantee for a loan to his or her IRA, the IRA will deem it to be a prohibited transaction. Some owners of IRAs that contain LLCs have been stung by this rule because banks and other lenders commonly ask LLC principals to sign personal guarantees for business loans outside of the IRA context, and don’t always change their procedures to account for IRAs. If the owner doesn’t see the trap, or if the lender doesn’t know the rule, and the account owner signs the form and takes the loan, a prohibited transaction will have occurred.

IRA owners cannot act as cosigners or guarantors on loans – including business accounts of companies held within the IRAs, such as frequently happens when IRAs hold LLCs in so-called “checkbook IRA” arrangements.

Personal Use of Real Estate in IRAs

Account holders who own real estate directly within their IRAs may not use the property for their own pleasure or benefit, nor for that of any other disqualified person. You can’t even stay overnight in the property if you paid the IRA the fair market rental rate for the property, nor can any other disqualified individual.

The more active an individual is in conducting transactions within a self-directed IRA, the greater the potential for a prohibited transaction. The hazard is particularly acute when IRA owners are operating LLCs or C corporations within a self-directed IRA and signing off on many transactions. It is very easy to accidentally commingle personal and IRA assets, or sign a personal guarantee on a short-term loan to the IRA, and jeopardize the entire tax structure.

American IRA, LLC is a leading expert on self-directed IRA administration and compliance. With offices in Charlotte and Asheville, North Carolina, and with clients across the country, American IRA is a go-to expert when it comes to executing self-directed IRA strategies.

For a no obligation consultation, call us today at 866-7500-IRA(472), or peruse our exclusive library of information and resources at www.americanira.com.

 

 

 

 

 

 

Images by: presentermedia.com

Beware of Accidental Self-Directed IRA Prohibited Transactions

Self-Directed IRA Prohibited TransactionsA recent tax court case illustrates the importance of understanding and abiding by Self-Directed IRA prohibited transaction rules that govern self-directed IRAs and other retirement accounts. Yes, on the surface, these rules seem simple enough. But the Devil, as always, in the details – and so we still see owners of self-directed IRAs run into problems as courts apply the rules in unexpected ways.

Here’s what happened:

Two taxpayers wanted to buy an existing business for their IRAs. The two taxpayers were not related. The two taxpayers founded a new corporation in August of 2001, then in the very next month, each of these taxpayers had their self-directed IRAs purchase 50 percent of the stock, and then within days directed the new corporation to acquire the assets of the older existing corporation.

They structured the purchase, in part, using a promissory note to the seller, which they secured via personal guarantees.

Over the next few years, these two taxpayers converted their self-directed IRAs from traditional to Roth accounts. In 2006, both individuals directed their IRAs to sell the company, at a profit, to a third party buyer, who was also unrelated.

Personal Guarantees on IRA Loans Lead to Trouble

The IRS took a close look at the transaction and found a problem: The personal guarantees, the IRS held, violated Self-Directed IRA prohibited transaction rules. As most of our clients are aware, if you do use leverage within your self-directed IRA, you cannot pledge anything outside of the IRA as collateral. The loan must be on a non-recourse basis. A personal guarantee, even if not tied to a specific asset, still provides recourse to the borrower – in this case against everything the guarantors own outside of the IRA.

The law defining a Self-Directed IRA prohibited transaction, in this case a loan, is pretty broad: Section 4975(c)(1)(B) prohibits lending of money “or other extension of credit,” whether direct or indirect. So even though the loan was not secured by any piece of property outside of the IRAs, the loan guarantees, the court held, still involved the indirect extension of credit by a prohibited third party.

That wasn’t all: The IRS claimed upheld that the company’s payment of wages and salary to the taxpayers was also a prohibited transaction, as was the shell company’s payment of rent on property that was owned by an entity controlled by the two taxpayers’ spouses. As it turned out, the issue was moot, because the court disqualified the IRAs as of the date of the loan guarantees. Had the guarantees not been an issue, though, the IRAs would still have been in significant jeopardy of disqualification on these two counts, as well.

The court also disallowed the use of a shell company as a defense: If a prohibition on a transaction between two disqualified entities could be “easily and abusively avoided simply by having the IRA create a shell subsidiary,” that would not cut the legal mustard. The protections against potential conflicts of interests posed by improper transactions with prohibited entities, the courts ruled, were substantive and not merely cosmetic.

The penalty, in this case, was substantial: The immediate disqualification of the IRA, and an immediate and heavy tax liability to the respondents – made worse because of penalties, interest, court costs and attorneys’ fees.

The Importance of a Qualified, Expert Custodian or Administrator

The case underscores the importance of having an experienced custodian or third-party administrator in the process of running your self-directed IRA. It also underscores one of the drawbacks of a pure ‘checkbook IRA’ approach: The checkbook IRA model advanced by some may be appropriate for some, but without some serious and frequent consultation with tax and legal experts, it leaves taxpayers too directly exposed to administration mistakes that can have disastrous consequences. Had these individuals used American IRA, LLC (that’s us!) or some other similarly qualified administrator or custodian to handle transactions on their behalf, some of these transactions may have raised a risk flag in time to correct the issue before the IRS got involved.

As it stands now, the taxpayers lost their IRA, wound up paying a substantial amount in taxes, fees and penalties, and have no recourse to recoup their losses.

If you want an independent review of your IRA strategy – especially if you currently include or are interested in using self-direction as part of your strategy, call us today at 866-7500-IRA(472), or visit us at www.AmericanIRA.com. We look forward to working with you.

 

 

 

 

Image by: presentermedia.com

Avoiding Self-Directed IRA Penalties: Why You Need American IRA

Self-Directed IRA PenaltiesHere’s a sad Self-Directed IRA Penalties case from the “Kids, Don’t Try This at Home” files:

A recent case from Federal Tax Court slapped an innocent taxpayer with taxes on a $114,000 worth of income that he wasn’t expecting – plus an additional $11,400 in excise taxes for the “early withdrawal” penalty, since he wasn’t age 59½ yet.

Here’s what happened:

A taxpayer named Guy Dabney had an IRA account at Charles A. Schwab & Co., – a well known and respected investment company and popular IRA custodian. Mr. Dabney was attracted to the advantages of self-directed IRA investing, and after conducting research himself online and finding that tax rules allowed it, he bought real estate with funds from his IRA at Schwab. Specifically, he bought some land in Utah.

Dabney contacted Schwab and directed them to wire $114,000 from his IRA directly to the seller – so Dabney never took possession of the funds. Furthermore, Dabney also had the property titled in the IRA’s name, rather than his own.

This was altogether right and proper under the law and under IRS rules. The problem: It didn’t work.

Not all IRA custodians are equal

Schwab has a long track record of success as a mass-market investment company and is very good at serving the mass market, which invests almost wholly in financial products like mutual funds, stocks, bonds and money markets. The mass market is its core competency and the heart of its business model. But their expertise does not extend to non-traditional assets, asset classes and self-directed retirement investing.

They themselves are aware of this, of course, and therefore do not even deal with self-directed accounts at all. You can buy traded REITs in a Schwab account, and REIT funds, but they just don’t do self-directed real estate IRAs. Their internal policies don’t allow for it, and there’s nothing in the law that says they have to act as custodian for these kinds of accounts.

As a result, they wound up accidentally titling the Dabney’s land in his own name, rather than in the name of the IRA (a bookkeeping error they later corrected), and then treating the entire amount as a distribution.

They even sent Dabney and the IRS a 1099 – R form stating he had actually taken a taxable distribution of $114,000 – generating the immediate tax liability plus a 10 percent penalty.

Wait – it gets even worse:

Dabney later sold the land for $127,226, and directed the money be wired back into his Schwab IRA account. Indeed, it appears that he wasn’t truly aware or cognizant of the fact that his money was no longer in the Schwab IRA. Schwab loves having assets under management, naturally, and so they accepted the money. But because the source of funds was a taxable account, and not a tax-advantaged retirement account such as an IRA or 401(k), Dabney wound up making a huge excess contribution to his IRA – and exposed him to a 6 percent penalty every year the money remains in the IRA. That would result in a tax bill of about $7,000 each year.

Think the courts would give him a break? In a way, they did: The courts disallowed a 20 percent “accuracy-related” penalty on the basis that Dabney’s actions were “reasonable,” based on his online research. So it’s not as bad as it could have been, but he will still have a substantial and needless tax bill that could have been avoided had he used American IRA, LLC, to handle the transaction.

A better way

The way to avoid Self-Directed IRA Penalties and the problem that Dabney encountered is to verify that your IRA custodian will even handle self-directed retirement accounts to begin with – and what kinds of assets, specifically, they will accept. Had Dabney checked with Schwab first – and believed them about their own internal policies – he may well have taken a different course of action. For example, he could have opened an account with American IRA, rolled the IRA funds from Schwab directly into his American IRA account, and then directed us to have his IRA purchase the property from the seller on his behalf.

The Difference

The difference, of course is in our core competencies: At Schwab, Mr. Dabney’s situation fell well outside of the kind of accounts a mass market investment company is set up to handle. But American IRA, LLC, these kinds of accounts are what we do best. We make it our business to become experts on the unique aspects of self-directed retirement investing and to serve these non-traditional retirement investors. The difference isn’t just in the smoothness and efficiency of a transaction – it’s also in heading needless penalties and taxes off at the pass. As you can see from this example, using a custodian that specialized in real estate IRAs and other non-traditional IRA investments could have saved Mr. Dabney tens of thousands in taxes and Self-Directed IRA Penalties, and who knows how much in legal fees as the case wound its way through the court system, racking up billable hours all along the way.

Are you considering non-traditional IRA investing? Or using self-direction in an IRA or another type of retirement account? Don’t go it alone! There are a number of things to consider and to be sure of before you make a single move. Call us first, at 866-7500-IRA (472) or visit us at www.AmericanIRA.com. We can help you avoid a lot of trouble down the road – and put your retirement security on a much firmer footing.

 

 

 

 

Image by: presentermedia.com

Be Aware of ‘Self-Dealing’ Self-Directed IRA Rules

Self-Directed IRA Rules

The law is clear on Self-Directed IRA rules and to whom your Self-Directed IRA can do business with, right?

The usual documents list prohibited individuals as the IRA owner, the owner’s spouse, antecedents and decedents, anyone who is advising the owner on the IRA in a fiduciary capacity, and any entities controlled by any of the above prohibited counter-parties, right?

If true, that should mean you can use your IRA to buy and sell to or from, or rent to, or lend to, or borrow from your brother, sister, aunt, uncle or cousin, or your own business partner, right?

Not so fast.

Yes, the Self-Directed IRA rules in the law spell out these counter-parties listed above as prohibited individuals for IRA transactions, specifically. But there’s a bit more to it than that: The law not only prohibits IRA owners from conducting business directly with those prohibited individuals; it also prohibits self-dealing.

Well, what does that mean? It means that the list of people who would be possible problematic for your IRA to deal with is broader than a lot of people – even experts in the field – may realize.

Some regulations, including Treasury Regulation Reg. § 54.4975-6(a)(5), expand the list of problematic counter-parties to “family members and certain businesses in which the person is an owner, officer, director, etc.”

The bottom line is this: While your sister, brother-in-law or cousin may not be on the short list of prohibited counter-parties, we suggest it may not be a great idea to try to press the issue with the IRS. The government has enough daylight in the law and in supporting regulations to look very carefully at arrangements with anyone who might possibly represent a conflict of interest – and potentially disqualify the entire IRA as a result.

This would be a terrible tax consequence for the IRA owner, because if an IRA is disqualified by the IRS, it generates an immediate tax bill on every dollar of earnings or profits that has been tax deferred – and a possible early withdrawal penalty, to boot.

If you own a rental property within a self-directed real estate IRA, and the IRS gets wind that your IRA was renting the property to your brother, you could potentially face a lot of scrutiny. Was the rent at or above market rate? Were you using your IRA to provide special favors for your brother? Did you receive a personal kickback in return?

The IRS has a long record of going after taxpayers who violate not only the letter of tax laws, but also the Congressional intent. We suggest that before you go out and engage in business activities with your IRA that could trigger a red flag, that you first speak with a qualified tax expert, such as a tax attorney or CPA – preferably with experience specific to self-directed retirement accounts. This is important so the attorney or CPA is familiar with the most recent case law, private letter rulings, and regulatory changes in the field.

American IRA is a third-party custodian for self-directed IRAs, and as such we do not provide specific legal or tax advice in this regard. Our role is in the facilitation of the transactions you direct us to make.

However, if you are tempted to engage in transactions with people who are close to you in some way, we suggest thinking about it this way: If you were to hire an outside board of directors of totally disinterested experts to approve your IRA’s transactions, with the sole fiduciary responsibility of maximizing its value, would they approve the transaction?

Proceed on that basis.

If you want to know more, or have other questions, visit us on line at www.AmericanIRA.com, or call us at 866-7500-IRA (472).

 

 

 

Image by: presentermedia.com

Life Settlements in Your Self-Directed IRA? Not So Fast!

self-directed IRAWe have been noticing an increase in the number of advisors suggesting that investors place a portion of their self-directed IRA investments in life settlements. These are life insurance policies purchased from the original policy owner who, for whatever reason, no longer needs or wants a life insurance policy. When this happens, the policy owner may surrender the policy back to the insurance company for the cash surrender value. In some cases, though, a third party may be willing to pay more for the right to the eventual death benefit than the insurance company is willing to pay. This is especially true if the insured is in poor health and expected to pass away before his or her normal actuarial life expectancy passes. The third party buys the policy, pays any premiums that come due, and collects the death benefit when the insured dies.

Advantages

Over time, investors have found that a portfolio of life settlements is a good way to generate solid investment returns with only modest risk – chiefly that the insured individuals don’t die on schedule as expected. Furthermore, life settlements have proven to have no correlation with other asset classes, like stocks or bonds.

Disadvantages

In the context of self-directed IRAs, however, there is one issue that makes using life settlements in IRAs extremely problematic: It’s against the law.

Specifically, Section 408(a)(3) of the Internal Revenue Code specifies that “no part of trust [IRA] funds will be invested in life insurance contracts.” If you do, and the IRS finds out, they may disallow the entire account. When this happens, you may have to pay income taxes on the entire account value, plus penalties – the IRS will potentially deem you to have taken a distribution of all the assets in the account.

In short, there is simply not enough case law on this particular point to establish the legality of the practice. You could have an arguable case, sure – and even a plausible case. But unless the amounts involved are trivial, and you can easily afford to lose, the risks of not getting the verdict you hoped for are simply not worth the risk of attempting to own life settlements within a self-directed IRA.

Other considerations

Even if you could be certain that IRS and courts would allow you to hold a life settlement contract in a self-directed IRA, you should also carefully consider liquidity risk: There is no guarantee that the insured will die on schedule, before you turn 70½. This could cause you to have difficulty taking required minimum distributions – resulting in severe penalties equal to half the RMD amount you were supposed to take. You may be able to borrow money to bridge the gap – but it is impossible to predict the availability of credit years from now. You may not be able to get a loan against the policy to pay RMDs. You could try to sell the policy – but these are relatively illiquid investments, and you may not be able to find a buyer in time.

Simply put, there are too many pitfalls with holding life settlements within an IRA at this point for us to recommend the practice. If you encounter someone who is recommending you hold life settlements within your self-directed IRA, be very careful.

American IRA does not provide specific tax or legal advice. For advice pertaining to your specific situation, it’s important to retain the services of a qualified professional.

Alternatives

Fortunately, there are a lot of alternatives to life settlement investing that don’t present the same legal and practical difficulties. Our clients enjoy the freedom of choice to invest in a variety of assets with their self-directed IRAs including, real estate, private companies, limited liability companies, private placements, private loans, tax liens, gold or other precious metals, and so much more!

For more information, or to open an account with American IRA, call us today at 866-7500-IRA (472). We look forward to hearing from you.

Prohibited IRA Transactions – How you can Avoid Them

Prohibited IRA TransactionsSelf-directed IRAs are one of the most flexible investment methods currently available to the American public because they increase your investment possibilities while potentially providing access to a tax-free retirement nest egg. While this freedom is unquestionably liberating for both beginning and full-time investors, it does come with a number of rules that you should be aware of.

Today’s article focuses on the topic of prohibited IRA transactions that you’ll want to avoid in order to ensure your account remains tax and penalty free. For example, life insurance, art, alcoholic beverages, and collectibles are among the relatively small prohibited asset list. You should also be mindful of prohibited individuals.

For example, some prohibited IRA transactions might involve you, your spouse, your descendants, etc. lending or borrowing from your IRA. Another example of a prohibited transaction might include a situation where these individuals buy or sell assets to your IRA or staying overnight in a property owned by your IRA.

While these rules and regulations may seem restricting at first, they truly pale in comparison to the massive list of assets and transactions that are readily permissible. For example, your IRA can own an LLC, rent out a home, buy gold, or invest in the stock market. These possibilities are part of what makes a self-directed account such a pleasure to own!

Also note that once you turn 59½ years old, many of the restrictions are lifted. For example, if you bought a beachfront property with your IRA and you’ve passed 59½, you can now take a distribution of that asset and use it as a vacation home! A Roth IRA is an ideal vehicle for this strategy because of its tax free nature.

If you have any questions about opening a new IRA account, contact us at 1-866-7500-IRA(472). If you’d like to learn more about prohibited IRA transactions, contact us at 1-866-7500-IRA(472) or info@americanira.com or click here for more information.

 

Jim on Google+