A self-directed IRA is just what the name implies, you as the investment manager of the IRA determine the investment strategy for the funds. When will you most likely benefit from a self-directed IRA? Perhaps you are 50 yrs. old and just left a job where you and have a 401 K with about $500k – $1M invested in a typical brokerage account well diversified into stocks and bonds. Real estate has already hit bottom in your community and starting to rapidly appreciate in value. The stock market on the other hand is at an all-time high and you are concerned there is a major correction ahead. If you were to roll your retirement into a self-directed IRA and purchase for cash a $500k rental property then you could receive rental income tax-free. Eventually three years later when you are 53, you sell the property for $1M and that gain would also be tax-free. You now have converted $500,000 into a $1M tax-free asset. You can now take that self-directed IRA and roll into a more traditional stock and bond brokerage account like you had before.
Another example would be for you to purchase an entire business with your IRA funds, like a fast food franchise or Car Wash for $1M. The IRA would pay the bills of the business and receive the income from the business. There would no tax on any profits of the business since the IRA owned the business. In this example, 5 years later, the business is sold for twice what you paid or $2M. There is no tax on the $1M profit since the investment was owned by the IRA.
You are now most likely asking this question: How do you create this self-directed IRA? There are many banks and financial institutions that will act as your custodian and create these accounts. The entity of choice in 2013 is a single member LLC to hold the IRA assets and investments. In my opinion this would also be best practices for tax professionals who structure these entities. In a typical LLC structure, the IRA becomes the owner, you are the manager, and the financial institution is the custodian. Structuring the LLC in this way allows for simple owner control. Funds flow easily to purchase the alternative assets like real estate and businesses as the single member LLC gives you what is called “checkbook control” of the IRA. What that means is with this set-up, you make all investment decisions and carry them out at the LLC level. As an added benefit, you avoid the transactional fees involved with running every investment decision through the custodian
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Sounds easy but not so fast. Beware of prohibited transactions as detailed in IRS Section 4975. For example you cannot directly or indirectly personally benefit from any transaction nor can your family. So if the business you purchased retained the services of one of your family that might cause the IRA to become taxable in the year of the prohibited transaction. Or let’s say your rental property purchased by the IRA rents to one of your family. That is a prohibited transaction and the entire investment becomes taxable that year. Also prohibited via Section 408 is the purchase of collectables–art, stamps, coins, antiques, metal or gems as well as life insurance contracts. Oh, one more prohibited transaction worth mentioning here, you can’t personally guarantee a loan, like a mortgage on behalf of the LLC. In fact on May 8, 2013, the US Tax Court just issued an opinion supporting the IRS on this very issue. For those who have some free time and want to read the 24 page opinion, I have included the following link: www.ustaxcourt.gov/InOpHistoric/PeekandFleck.TC.WPD.pdf
There are quite a few of these prohibited transactions to stay clear of that we have not mentioned here in this blog, so it is important to review all your investment strategies with a tax professional such as a CPA or attorney. Make sure to ask the professionals for a written opinion letter stating that the proposed investment is not a prohibited transaction as defined by the IRS Code. As you could see from the above tax court case, failure to obtain the legal advice in writing assuring you that you are in compliance can be very costly indeed.
Thanks for visiting. Kindest regards from Chris Moss CPA your Tax and Financial ProfessionalsCPA
