Don’t Fall Off The IRS “No, No” Cliff
Self-Directed IRAs can be a great tool when used properly, but they’re not for everyone. With a Self-Directed IRA, there is a lot more responsibility put on the account holder. As a “Self-Directed Investor”, you have to be proactive and willing to pay attention to what’s going on with your investments. If you don’t have the desire or the time to spend on managing your account, then a Self-Directed IRA might not be for you. There are many pitfalls to watch out for when making your investments. Here are three that I think are very important:
1. PROHIBITED TRANSACTIONS
Through a Self-Directed IRA, you can invest in just about anything you want, other than non-allowable assets, such as life insurance and collectibles. Also, according to the rules and guidelines, the only catch is that you may not make any investments with disqualified parties. So who are disqualified parties? Well, a simple definition is yourself, your spouse and any lineal descent, more specifically family members (Mom, Dad, Grandma, Grandpa, your kids, & their spouses, etc.). This is by no means a complete definition and if you ever have a question about whether or not someone would be considered a disqualified party, be sure to consult a CPA or tax attorney. To see the IRS definition, click here http://www.irs.gov/irm/part7/irm_07-027-020.html.
Now that you know who disqualified parties are, let’s talk about some other types of IRA prohibited transactions. We now know that an investment with a disqualified party or purchasing life insurance or collectibles would be a prohibited investment transaction, but what else? A prohibited transaction may occur anytime you try to use your IRA to benefit you personally or vice versa. For instance, if you use your IRA to purchase a investment beach house in Miami, you cannot go stay in it for a week (or any amount of time for that matter). Even if you are paying your IRA a fair rental rate for the time that you are there, it would still be considered a prohibited transaction.
Another question I get a lot goes like this, “I’ve got this great little piece of land that I own personally, can I sell or assign it to my IRA?” The answer to this is easy, “NO!!!” This would be considered a prohibited transaction. We already know that YOU are considered a disqualified party to your own IRA, so that eliminates selling it to your IRA because you cannot purchase anything from a disqualified party. Second, all contributions to an IRA must be made in cash. A piece of land is obviously not cash, so this eliminates the possibility of assigning anything to your IRA.
2. DO YOUR DUE DILIGENCE
This one is extremely important and I can’t stress it enough. As we all know, there are tons of dishonest people in World. More and more often we pick up the newspaper to see people like Bernie Madoff, who have swindled people out of millions through their Ponzi schemes. The last thing you would ever want to do is have your precious retirement account fall prey to these scam artists.
My advice to you is to do your research. Look into the company. Ask questions. Don’t make any rash decisions. If a company is pressuring you to make a quick decision or offering you incentives and bonuses to get your money to them more quickly, these should be “red flags” that something is suspicious. Remember, there’s no such thing as a free lunch. If something sounds too good to be true, it probably is.
While self-directed IRAs can be a safe way to invest retirement funds, investors should be mindful of potential fraudulent schemes when considering a self-directed IRA. Investors should understand that the custodians and trustees of self-directed IRAs may have limited duties to investors, and that the custodians and trustees for these accounts will generally not evaluate the quality or legitimacy of an investment and its promoters. www.nsaa.org.
3. Unrelated Business Income Tax “UBIT” – This is a BIGGIE
What is UBIT? Unrelated Business Income Tax or UBIT applies to certain types of investments through your IRA. It’s basically put in place to keep IRA investments from having unfair advantages over regular, tax-paying businesses. Your IRA may be subject to Unrelated Business Income Tax if it is involved in any of the following:
- Operates a trade or business,
- Receives certain types of rental income,
- Receives certain types of passive income from a business entity it controls,
- Invests in a pass-through entity, such as a partnership, that conducts a business, or
- Uses debt to finance investments.
If you have any questions about UBIT or whether or not an IRA investment that you are involved with will be subject to UBIT, we strongly urge you to consult a CPA or tax attorney.