The popularity of alternative investments has sparked an increase in the use of self-directed IRAs by high-net-worth individuals who want to diversify beyond securities and invest in private deals. And, since most HNWIs and UHWNWIs have a big chunk of their wealth tied up in IRAs, it makes sense that sophisticated investors are disciovering the possibility trapping higher tax-deferred returns in self-directed IRAs invested in private offerings and need help from an advisor with expertise in this arcane field.
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Private deals are and will always be a great haven to sleazy operators, and RIAs must consciously steer clients clear of any notion that a self-directed IRA is a way to get rich quick. However, self-directed IRAs can be invested in real estate, start-ups, and precious metals, as well as oddball deals like livestock and third-world currencies. So HNWIs and UHWNIs are seeking help in increasing numbers with investing their IRAs in a friend's string of car washes, laundromat, or a venture manufacturing drill bits designed for use in The Rockies.
I invested some of my IRA money in a private investment at the suggestion of an advisor and I'm very glad I did. So I have some personal experience in this somewhat estoric area and attiorney Mat Sorensen's presentation made me realize this is a fun and, possibly, lucrative niche for advisors.
Mathew Sorensen, a partner with the law firm of Kyler Kohler Ostermiller & Sorensen, LLP in Phoenix, spells out the legal ins-and-outs of self-directed IRAs that advisors must know about at an A4A webinar
“There is a lot of pent-up demand for self-directed IRAs, and there is a lot of bad information out there. Custodians that handle these accounts are dying for advisors who understand the rules (governing self-directed IRAs),” Sorensen says.
Working With Trustees
Under Internal Revenue Service rules, investors must place the assets of a self-directed IRA with a qualified trustee, or custodian. Among firms that take custody of alternative IRA assets, the big names are Millennium Trust Co. and Pensco Trust. Trust Company of American does some of this as well and there are many others. The role of the custodian is to keep records, file IRS reports, issue client statements. Organzing as a trust company is a simpler, less expensive form of business in the U.S. So all of the IRA custodians do business as trust companies and not broiker dealers. I am sure Mat will chime in with details as to why.
The custodian may offer a range of investment choices to the account owner, but does not provide financial guidance. As a result, Sorensen says some custodians maintain lists of financial advisors to recommend to their retail clients, many of whom are high-net-worth investors. If you already custody assets at one of these firms, make sure you're on the company's advisor listing.
Understanding the IRS Restrictions
Some advisors may shy away from alternatives because of a perception that IRS rules are complex and difficult to comply with. Sorensen says the rules get complex but not hard to follow.
The basic principal is that retirement funds are granted tax-free status to encourage people to save for their retirement years, and they should not be used for personal benefit otherwise. So the IRS spells out four restrictions:
· Collectibles (except for certain coins that meet precious metals criteria)
· Life Insurance
· S Corp Stock
· Prohibited Transactions (restricts who your IRA account can transact with)
In its simplest form, the Prohibited Transactions rule prevents account owners from engaging in transactions such as purchases, sales, leases, or exchanges with their own companies, employees, spouse, children, or parents, or with any company in which these persons have an ownership stake of 50% or more. Account owners may, however, engage in transactions with siblings, aunts, uncles, and cousins.
Account owners may leverage transactions with loans, but only if the owner does not guarantee the loan.
The bottom line is that any investment or transaction must be strictly intended as an investment. For instance, if you buy raw land, you cannot then go hunt on that land. Or allow your father to do so. If you invest in a vacation rental property, you cannot stay there, and neither can your children.
These areas can get pretty tricky. For instance, if you use funds in a self-directed IRA to buy stock in a company and you are a member of the board, you may need to prove that the purchase did not grant you more power to dictate your own compensation. What if your spouse is an employee of a start-up company that you want to invest in?
You can’t sidestep these rules by simply having an asset transferred from your spouse, parent, or other prohibited person to a friend, then purchase it from them. That’s called a “step transaction” and the IRS will disregard the middleman.
Penalties Can Be Steep
If a prohibited transaction occurs, the IRS will “distribute” the entire IRA account as of the date of the violation. That means the entire account becomes subject to taxes and distribution rules, which include a 10% penalty for those under 59½ years of age.
Your other retirement accounts will not be affected.
Other Tax Considerations
Transactions conducted through a self-directed IRA are subject to additional taxes under certain circumstances, primarily UBIT (Unrelated Business Income Tax) and UDFIT (Unrelated Debt Financing Income Tax).
UBIT is triggered by investments in private companies such as LLCs or Limited Partnerships that don’t pay corporate taxes, such as restaurants, tech start-ups, and businesses that sell goods and services. This can also apply to real estate development, construction, or active investment (i.e. “flipping” property). Exceptions to the UBIT include interest income, dividend income, royalty income, rental income, and most capital gains.
UDFIT is triggered by leveraging IRA transactions with debt, because borrowed funds did not originate as retirement account money. For a simplified example, if you buy property with 50% retirement funds and 50% loaned funds and sell it later at a profit, half of the gain will be taxable.
For more details and strategies, view the entire webinar
Mat Sorensen’s average rating by webinar participants was 4.7.
These were the comments left by attendees at this sparse summer session:
“Great presenter. He could have used more time for specifics.”
“This was an excellent webinar. Thank you.”
“This is such a great topic and important in our five-tier tax system.”
“Very interesting subject.”
“Very well done. He was knowledgeable and he tailored his presentation to what we needed to learn (benefits and pitfalls) about self-directed IRAs.”
“Very interesting and timely as this is a popular topic today. Many pitfalls were discussed that can render the idea of real estate and other investments in an IRA useless if not set up properly.”