Self-directed IRA investors have increasingly become interested in looking beyond traditional stock market investments for alternative investments like real estate.
The IRS regulates these investments to protect IRAs against prohibited transactions. They cannot invest in properties owned by you or disqualified persons as this would violate IRA regulations.
When investing with partners or other individuals, the same rules must be observed.
Unrelated Business Income Tax (UBIT)
Unrelated business income tax (UBIT) is an income tax payable by non-profit organizations and IRAs on certain activities that constitute trade or business operations, such as trading profit-oriented goods for profit on an ongoing basis. An IRA may generate income through several investments such as partnerships, businesses or debt financed real estate properties.
When investing in real estate via crowdfunding offerings or LLC investment partnerships with the intent to buy and sell, IRA investors may be subject to UBIT tax due to passive income generated from debt leveraged against your IRA assets. Another form of taxation known as UDFI applies when purchasing active property under IRC Section 512 with borrowed money; investors in such an IRA should file IRS Form 990-T in order to report and pay this tax as it may also apply in some instances with royalties and rent from rental properties.
Disqualified Person Transactions
When an IRA holder, their spouse, or another disqualified person receives any personal benefit as a result of transacting with an entity owned by their IRA, it constitutes prohibited conduct – commonly known as self-dealing – which could result in heavy penalties and lead to the disqualification of both their IRA or pension plan.
An example of a prohibited transaction would be using your SDIRA to purchase and use vacation property for personal use – such as staying there over the weekend with your spouse and/or children. Lending money or providing credit from your SDIRA to disqualified people also constitutes prohibited transactions.
To avoid such situations, IRA owners should invest only in entities where the owner is neither an equity investor or officer/director/employee of that entity. Also it would be wise to refrain from taking loans between your IRA and disqualified individuals or third-parties that might create conflicts of interest.
Asset Valuation Reporting
Investment valuation is of paramount importance when investing in self-directed IRAs. Any prohibited transaction could jeopardize an IRA’s legality and lead to its retroactive dissolution with serious tax ramifications for all account holders involved.
Fleck v. Comm’r, 140 Tax Court 12 (2013) provided an excellent example. Here, an IRA owner invested in an acquisition entity which purchased a fire alarm and fire protection company using seller financing from his IRA account, guaranteeing his note obligation to him directly. As per IRS ruling, this action constituted indirect self-dealing because even though no personal compensation was received by this individual from this transaction.
Here is just one example of the complex rules governing self-directed IRAs, and their potential violation. As a result, it is crucial that investors use a custodian who understands these complexities and provides guidance – one such custodian being IRA Financial with prohibited transaction reviews, education programs and investment advice being among our many services provided for SDIRAs – learn more here about our top-rated SDIRA service!
Self-Dealing
Self-directed IRAs allow owners to invest in a wider and riskier range of assets than what traditional custodians allow; such as real estate, private placement securities, precious metals and commodities trading platforms and crypto assets.
Self-directed IRAs present investors with their own distinct set of rules that should be observed carefully to prevent accidentally engaging in prohibited transactions. Before initiating any self-directed IRA investments, investors should consult their tax adviser to avoid inadvertently engaging in prohibited transactions.
As an IRA holder, one should never use property owned by his or her IRA to use for personal benefit or guarantee debt financing of investments held within it; doing so may incur unrelated business income tax (UBIT).
The IRS has implemented certain rules designed to prevent self-dealing and ensure IRAs are used solely for retirement savings purposes. If these rules are broken, a violation may lead to immediate distribution and an early withdrawal penalty of 10% (if applicable), as well as disqualifying an entire account altogether and subjecting all earnings to UBIT taxation.
