Be careful with that self-directed IRA

QI have received several emails pitching something called a “selfdirected” IRA. It sounds like they would allow me to use my IRA to invest in things like rental property. Is this a scam or is it something I should consider?

AAccording to the Investment Company Institute, Americans had $10.8 trillion invested in individual retirement accounts (IRAs) at the end of the second quarter. Most IRA assets are invested in traditional publicly traded securities like mutual funds and individual stocks and bonds. However, a growing number of investors are turning to “self- directed” IRAs to invest in other types of assets, including real estate, limited partnerships, LLCs, and even bitcoin.

Self- directed IRAs are legitimate, but investing in non-public assets in an IRA can be tricky. In fact, this space is so treacherous, most large brokerage firms stopped acting as custodians for IRAs with non-public assets several years ago. Their exit gave rise to an entire industry of self- directed IRA custodians. As with any type of business, not everyone in the self- directed IRA business knows what they are doing. If you are going to do this kind of investing, you need to do your homework and understand the do’s and don’ts. Here are few of them.

The Internal Revenue Code prohibits certain types of investments in IRAs. For example, an IRA cannot invest in life insurance policies or collectibles such as artwork, rugs, antiques, gems and stamps. Certain coins that are purchased primarily for their precious metals content are permissible, but coins that are purchased as collectibles are prohibited. Shares in private corporations might be permitted depending on the ownership, but buying stock in S corporations is not allowed.

The Internal Revenue Code also prohibits IRAs from engaging in certain transactions with people known as “disqualified persons.” Disqualified persons include any fiduciary to the IRA (including the IRA owner), members of the IRA owner’s family (spouse, ancestor, lineal descendant or spouse of a lineal descendant), or a corporation, partnership, trust or estate where 50% or more of the shares, profits or beneficial interests are owned by any of these. An officer, director, or 10%- or-more shareholder or partner of one of these entities is also a disqualified person.

Most prohibitions are designed to keep IRA owners from benefiting from the assets in their IRAs without paying taxes on the assets that are used. For example, if an IRA owner buys rental property in her self- directed IRA, the IRA owner is prohibited from allowing any disqualified person from using that property even if fair market compensation is paid for the use.

Likewise, the IRA owner cannot hire a disqualified person to manage the property or to “fix up” or repair the property. Instead, the IRA owner would need to hire an independent person to do the work and payment would need to come from the IRA itself. If the IRA owner paid for the service on behalf of the IRA, the payment would be considered a prohibited transaction or would at least be deemed a contribution to the IRA.

Prohibited transactions can flow either way between an IRA and a disqualified person. For example, the IRA cannot lend to or borrow money from a disqualified person, nor can IRA assets be used as security for a loan to a disqualified person. IRA assets can never be used to buy property for personal use.

The IRS levies steep penalties on prohibited transactions. The standard penalty is a tax on the disqualified person engaged in the prohibited transaction equal to 15% of the transaction amount. If the transaction isn’t promptly corrected, the penalty increases to 100%. In addition, the IRA will also face a penalty, usually equal to 100% of the transaction amount. If the disqualified person is the IRA owner or one of the beneficiaries, the penalty is even more draconian. In that case, the IRA itself is fully disqualified, meaning the entire IRA is deemed to be distributed and the IRA owner is immediately liable for taxes on the entire IRA amount.

Prohibited transaction rules for IRAs are complex and nuanced. The penalties for violating those rules — even unintentionally — can be severe. It makes sense to take time to consult with a trusted and competent adviser before investing your IRA in non-publicly traded assets.

Steven C. Merrell is a partner at Monterey Private Wealth Inc., an independent wealth management firm in Monterey. He welcomes questions you may have concerning investments, taxes, retirement or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to smerrell@montereypw.com.