Tuesday, Aug. 30 2011 4:05PM
Self-directed IRAs can help add real estate to nest egg
By Scott Devouton, Guest columnist
Print
E-Mail
AIM
Reprint“Self-directed” IRAs are a common method of investing in real estate. Sometimes marketed as “private money lending,” it’s a strategy you might be hearing more about.
With self-directed IRAs, an IRA is used to invest in real estate projects, with all common IRA benefits. Purchased assets include real property ownership rights, secured promissory notes, and ownership rights in various investment entities.
The individual retirement account is a staple of most financial plans. It has been referred to as “the tax shelter of the people” because of its great tax advantages and easy accessibility.
During the last real estate boom, self-directed IRAs gained popularity on the coasts. Sometimes called “real estate IRAs,” self-directed IRAs were also discovered by Missouri and Kansas investors. The term “self-directed IRA” is not found in the Internal Revenue Code. Although firmly rooted in basic IRA law, a self-directed IRA is essentially a marketing term used to describe a particular organization of an IRA’s fiduciary powers and duties.
An IRA is a trust. Under specific statutory language, an investor contributes an asset (cash) to the trust (the IRA account). The trust then “directs” its money to a particular investment, typically stocks, bonds and annuities. A stock broker typically manages the account’s investment (as a fiduciary) and serves as the IRA’s trustee. The broker exercises virtually all fiduciary power in crafting the investment.
With a self-directed IRA, you keep most of this power. While a custodial trustee holds and administers the IRA account, you direct the investment, instead of a broker. You determine which investments are appropriate for the IRA, and you tell the custodian where to invest the IRA account.
The IRS does not put many limits on the types of assets in which an IRA may invest. While IRAs typically invest in public stocks or mutual funds, self-directed IRAs commonly invest in real estate, private business entities and commercial paper. The only investments precluded by the IRS are life insurance, collectibles and certain prohibited transactions.
Therefore, you can use IRA funds to invest in a real estate deal or a promissory note, presuming the transaction comports with IRS rules. Within that investment, any gains (or losses) accumulate with all IRA tax advantages. In fact, all traditional IRA rules apply to self-directed IRAs, including contribution limits, tax deferral or exemption rules, and required minimum distributions.
While the strategy is legal and has a track record, there are a few extremely important points. How does a self-directed IRA work? First, you determine whether a self-directed IRA is appropriate for your portfolio. Next, you or a designated representative sets up a self-directed IRA custodial account. Funds are then deposited, transferred or rolled into the new account. Once the account is funded, you direct those funds to your selected investments. The custodial trustee disburses the funds in exchange for indicia of asset ownership, such as a deed, an LLC membership interest or a secured promissory note. At no point in either setting up an account or funding an investment should you receive a distribution of any part of your IRA account. Setting up a self-directed IRA simply involves the movement of funds from one IRA account to another, presuming you are not creating the self-directed IRA account with a new deposit.
Your fiduciary power and duty are important to the self-directed IRA strategy. You choose which investment is appropriate for your portfolio, and you assume responsibility for assessing risk. It is your responsibility to research, verify and analyze things like market conditions, valuations, financial projections, liquidity and legal parameters.
The law prohibits you and other “disqualified persons” from engaging in a wide variety of transactions. Disqualified people include you, any of your ancestors or lineal descendants and entities in which you hold controlling ownership or management rights. Be mindful of any conflict of interest you might have in any investment made by your Self-Directed IRA.
Roth IRAs present another issue. While a Roth may be used as a self-directed IRA, the IRS will watch it more closely. Any transaction between your Roth and a related person (who may not even be a “disqualified person”) must be reported to the IRS. Be mindful if a Roth is involved in your real estate deal and seek professional advice if you believe you may have a conflict of interest.
If debt is involved in your deal, you may have a few other issues to consider. If your self-directed IRA borrows money, you may not personally guaranty the loan. There is also a “debt financed income tax” that may apply to your deal. A CPA who understands this taxation is an important part of the self-directed IRA team and should be consulted at the start of the investment cycle.
Finally, note the consequences of running afoul of the law. If your self-directed IRA is not executed properly, there is a risk that the IRA will be considered “distributed” to you. Presuming you are not at an age where you may begin taking distributions from the IRA, there will be at least a 10 percent early withdrawal penalty on the amount of the account, plus income tax at your applicable rate. The IRS also places a 15 percent tax penalty on each prohibited transaction, and an additional 100 percent tax penalty on each prohibited transaction that is not corrected within the taxable period.
By using the self-directed IRA strategy, you can incorporate private investments into a perfectly legal retirement structure, and can enjoy gains on a tax-deferred or tax-free basis. You should understand the limits of the strategy, in addition to any benefits that might apply to your particular situation. It’s your job to research, verify and analyze things like market conditions, financial projections, valuation, risk, liquidity and legal parameters. This applies doubly if your IRA will have business partners. If the numbers look promising, but you need help, speak with a professional in the relevant investment’s market.
An IRA is a “personal savings plan” designed to provide for retirement. A self-directed IRA is no different. Retirement is the target with this strategy; you should maintain perspective and map the plan accordingly.
Based in Lee’s Summit, attorney Scott Devouton provides basic estate planning and small business services.
