Ten Common Mistakes Self-Directed IRA Investors Make

I work with a lot of entrepreneurs and real estate investors who are utilizing self-directed IRAs as a financing mechanism.  Contrary to what some professional advisors believe, self-directed IRAs are legal under the Internal Revenue Code.  That does not mean, however, that use of this financing mechanism is without risk.

My good friend, Todd Grill of Entrust Midwest – a company which serves as third party administrator of self-directed retirement accounts –  is one of the foremost authorities on the do’s and don’ts of self-directed IRA investments.  Todd has, over time, compiled a list of the ten common mistakes which self-directed IRA investors make, and he has been kind enough to allow me to share it here.

Here are the top ten common mistakes which self-directed IRA investors make:

1. The IRA Holder personally enters into an agreement on property they want to buy with their IRA.  Many investors wait until they find a property in order to engage the services of an IRA custodian or administrator.  Unfortunately, in doing so, they are not allowed under the prohibited transaction code to use personal funds for the benefit of the IRA.  Let’s say you find a great piece of rental real estate you’d like to buy as an IRA investment.  If you have not already established a self-directed IRA account you may lose out on the deal because you don’t have immediate access to your IRA funds and you cannot personally deposit your own earnest money to enter into a purchase agreement.  Remember, the IRA needs to buy and fund the property, not you.

2. Self-directed IRA clients use personally owned assets for the benefit of the IRA.  The use of a personally owned remodeling company or construction equipment to develop or improve IRA owned property would constitute a prohibited transaction.  You the IRA holder cannot personally benefit from nor use personal assets to benefit the IRA investment.  “Sweat Equity” constitutes a non-cash IRA contribution which is not allowed.

3. The attempt by the self-directed IRA holder to take a real estate commission on property purchased or sold by the IRA.  If the IRA holder is a licensed real estate agent, they cannot receive a commission on the buying or selling of the IRA property, which would be considered personal compensation from the IRA investment.  The commission can be used to reduce the sales price which is a benefit to the IRA investment.

4. The IRA holder believes that the transactions with a non-disqualified person cannot be a prohibited transaction.  This is a common belief that simply is not true.  You, the IRA holder, have a fiduciary responsibility to do what is in the exclusive interest of the IRA.  This holds true also when investing with non-disqualified persons such as siblings.  As an example, an IRA holder that lends money should not lend before the fair market rate because it is not in the best interest of the IRA.

5. The IRA holder assumes that no UBIT applies to passive investments into an operating business.   Unrelated Business Taxable Income (UBIT) is generated when an IRA engages in “business activity”.  Often times an IRA owner wants to passively invest in a business entity, but the business activity itself is not passive.  Should the investment be made in a pass-through entity, such as an LLC, an IRA could generate UBIT on any profit derived by the business entity,.  If generated, the IRA is responsible to pay the UBIT.

6. The IRA owner attempts to make a contribution to the IRA by depositing the funds directly in the IRA-owned LLC checking account.  If you make an annual IRA contribution directly into the LLC rather than through the IRA custodian, you are personally transacting with your IRA LLC.  That is considered a prohibited transaction.

7. The IRA holder makes personal guarantees.  You, as the individual holding the IRA account are considered a “disqualified person” and cannot provide a personal guarantee of the IRA debt for an IRA investment or for an entity like an LLC that is owned by the IRA.  Loans to an IRA-owned LLC or credit cards issued by the banks where the IRA LLC sets up an account for checkbook control of the IRA assets, are based on your personal credit and are not allowed.  The execution of that personal guarantee constitutes an “extension of credit” and hence is an automatic prohibited transaction even if the guarantee is never exercised.

8. The self-directed IRA enters into a partnership in which it loans money to an investor, and instead of making the loan secured with interest and payments, it takes a share of the profits.  Although this is allowable, the way that this investment is structured, it will generate UBIT.  This wouldn’t be an issue if the IRA lent the money at fair market rate and created a payment schedule.  But, in a profit-sharing investment, structured to look like a loan with generated equity returns not paying potential UBIT will be an issue.

9. Two self-directed non-disqualified IRA holders enter into a quid pro quo, partnership to utilize their own retirement funds.  For example, each person has a $100,000 self-directed IRA.  They each make a loan out of their respective IRA’s for $100,000 to invest in personal investments.  These loans are “disguised” personal loans that are dependent on the other individual lending the money and could be construed as using one’s own retirement funds for personal benefit.

10. Self-directed IRA holder attempts to “disguise” active investments that can potentially generate UBIT.  Pretending to actively rent the IRA real estate investment by placing periodic ads in the paper to try to prove that you are renting this investment as a passive investment with the intent to avoid paying UBIT while you are actually trying to quick turn the real estate investment, will not change the tax outcome.  Although the intent was to rent the property long term rather than a short term investment, the case law says that the most dominant factor is the purpose at the time of the sale, not at the time of the initial purchase.  So, you could have setup a perfectly passive non-business IRA investment, but because of circumstances that change the purpose or intent, such that at time of sale it was a business type of transaction, you will now potentially have to pay UBIT, which is not all that bad in and of itself.  It just has to be factored into the investment equation.