Steve Metzenthin, CPA, CFP, CVA
One of the drawbacks to garden variety IRA’s is that you are limited in your choice of investments to financial assets such as certificates of deposit, stocks, bonds, and mutual funds. In the current market, cd’s don’t earn anything and the volatility in the public equity and fixed income market scares many off.
In a self directed IRA, the account owner is able to invest in a broader range of alternative asset categories, including private equity and corporations, real estate, and partnerships. This is appealing to some IRA owners. Opening a self directed IRA is as easy as filling out some forms and arranging a trustee to trustee transfer from an existing IRA.
But as is usually the case, there are traps to be avoided. Let’s run through them.
First is the matter of fees. Your plain vanilla IRA is essentially free these days, but you will pay up to several hundred dollars a year for the administration of a self directed IRA, and possibly considerably more.
Second, there are restrictions on prohibited assets and prohibited transactions that apply to all IRAs. IRS regulations specifically prohibit IRA investments in life insurance and collectibles. The purpose of the prohibited transaction rules is to prevent self-dealing, i.e., improper use of the assets in the account by the account owner, the account owner’s beneficiary, or any other disqualified person. The penalties for violating these provisions are severe.
Third, there are two basic flavors of self directed IRA’s, and not everyone agrees on the validity of the second type. The more conservative type requires the trustee/custodian to approve all investments made by the IRA. While safe, this can prove cumbersome if there are numerous or tricky investments. It can also be expensive if there is a separate transaction fee charged by the custodian. The second type of self directed IRA, sometimes referred to as a “checkbook” IRA, involves two entities: the IRA itself and a newly formed limited liability company (LLC), which the IRA invests in. The LLC is controlled by the IRA owner and makes the investment purchases without having to gain approval of the trustee/custodian. While convenient to the client, there are IRA administrators who believe that this second type of self directed IRA doesn’t work, and will eventually run into IRS problems.
Finally, regardless of which type of structure is selected, there are two taxes that can pop up to complicate matters: unrelated business income tax (UBIT) and unrelated debt financed income (UDFI). The important thing to know about these taxes is that if they apply, they will cause the IRA itself to owe income tax. Investments made in operating businesses by the IRA can throw off UBIT. Even if the income is exempted from the tax ordinarily, it might be taxed if it is generated by debt.
For example, take an investment by an IRA in a limited partnership where the business of the limited partnership is to acquire and lease apartments. If either the funds to buy the interest by the IRA or the acquisition of the apartments by the partnership are made with debt, taxes may be due, thereby reducing the investor’s after tax rate of return.
Self directed IRA’s might be the ticket for certain taxpayers in certain situations, but be aware of potential traps before you dive.
