Don t Get Stiffed By The Rules of the Self Directed IRA

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1 Don t Get Stiffed By The Rules of the Self Directed IRA By Watson CPA Group (Google+) While the traditional IRA is the path many take to fund their retirement, some people like the option of paving their own investment path. Unlike the traditional IRA that invests in stocks, bonds, and mutual funds, the self directed IRA invests in non-publicly traded business alternatives. Investments can range from dairy cows and untapped gold mines, to the more common asset investments of tax liens, mortgages, business start-ups, and real estate. If you want to stay away from Wall Street, self-directed IRAs could be your retirement investment vehicle. Instead of using a traditional brokerage service, selfdirected IRAs are handled by a custodian or trustee. The difference is the brokerage controls the investment decisions while the custodian invests under the direction of the account owner. Performance of a traditional IRA is dependent on the stock market while performance of the self-directed IRA depends on the account owner s investment choices. Simply put, each function as tax deferred retirement account regardless of what they re made of. If you do it right, the rewards could be sizable. If you do it wrong, the results are potentially catastrophic. Getting off to a good start with a self-directed IRA is

2 imperative. First, the investment must be legal and permissible according to the IRS rules. The promise of high returns might be too good to be true! Also, it s the account owner s responsibility to ensure the investment is legit and a good investment. Cross breeding cows might be your hobby, but you might be more familiar with real estate or a small business franchise. Just stay away from life insurance and collectibles because those are off limits according to the IRS rules. It might seem that the investment alternatives for selfdirected IRAs create the most risk. Surprisingly, there is more risk because of failure to follow the strict rules surrounding self-directed IRAs. Read that again. The investment itself can be risky, but screwing up how you direct your IRA could be even riskier. Specifically, what the IRS considers prohibited transactions, which is where most investors make their mistakes. Several types of prohibited transactions include but are not limited to: Buying a home to live in now Paying yourself from proceeds or income generated within the IRA Personally guaranteeing account assets as collateral for loans

3 Loans or extending credit between the plan and a disqualified party (see below) Lending money to children or parents Purchasing collectible items such as art, coins, and gemstones Some prohibited transactions are those considered inappropriate because they involve a disqualified party. What s considered a disqualified party? The IRA account owner or their spouse The IRA account owner s lineal or vertical line of family members (including their spouses) Any person, trustee, etc. providing services to the IRA Any entity owned by a disqualified party owning greater than 50% interest For example, the account owner can direct that the IRA buys a house, rents it out, and the rental income goes back into the

4 IRA account. If the account owner lives in the house or if the rental income is funneled into the account owner s current income, the IRA tax deferred treatment is null and void. Alternatively, the account owner could extend an interest bearing loan to a cousin who wants to open up a car wash. The loan proceeds go back into the self-directed IRA account. However, if the loan is extended to family members in the owner s vertical lineage, once again, the IRA is null and void. Another good example is illustrated in the recent court case, Peek v. Commissioner, 140 T.C. No. 12, (May 9, 2013). Lawrence Peek and Darrell Fleck created self-directed IRAs that purchased a small company for $1.1 million in That company was sold in 2006 and approximately $3.3 million was dispersed among the two self-directed IRAs. Along came an IRS audit that determined the self-directed IRAs were disallowed and Peek and Fleck had nothing more than investment accounts. What went wrong? Peek and Fleck had made the error of personally guaranteeing a note in the company purchase. Oops! That an extension of credit, whether direct or indirect, by an account owner is a prohibited transaction. Peek and Fleck got to keep their money, but walked away with $94,645 in hefty accuracy penalties as well as owing $273,166 in taxes. Yuck! Those poor guys had their eye on the prize and got stiffed on their tax deferred retirement for not following the strict IRS rules. Self-directed IRAs or SDIs can be a great way to jump into the real estate investment scene, especially since prices are still low and credit is thawing out. But don t screw it up- you must get a non-recourse loan (probably 65% LTV max) which means you are not signing for the loan guarantee

5 personally. We can help guide you! Since 1997, The Watson CPA Group has been a team of Colorado Springs CPAs preparing individual and corporate tax returns for a reasonable fee range, and specializing in LLCs, S Corps, small business and corporate taxes, pilot and flight attendant tax deductions, per diem deductions, rental property owners, real estate professionals and expat tax clients.