Today, alternative asset investments are the fastest growing segment in the retirement market. In many ways, this is due to the 2008 financial crisis. After the crisis, investors became aware of the advantages that come with self-directing. While self-directed retirement accounts have numerous advantages, it is imperative to know the rules. This article will discuss Self-Directed IRA rules that investors commonly break to raise awareness and help you keep your self-directed retirement account in good standing.
Advantages of Self-Directing
When you use a Self-Directed IRA, you can make traditional and non-traditional investments. Traditional includes stocks, bonds, and mutual funds – the most common asset classes IRA holders invest in.
Non-traditional, also known as alternative assets, include real estate, notes, tax liens, and gold. The IRS has allowed IRAs to hold these kinds of assets since its creation in the early 1970s!
A Self-Directed IRA refers to an individual retirement account that can be invested in traditional assets as well as alternative assets. The best part about using a Self-Directed IRA is that you can invest in what you know and understand.
Traditional IRA custodians will not allow you to purchase non-traditional assets with your IRA and your retirement funds. Therefore, to engage in non-traditional assets, like purchasing real estate and house flipping, choose the Self-Directed IRA LLC.
Self-Directed IRA Rules Investors Break
There are two common Self-Directed IRA rules that investors commonly break (hopefully no IRA Financial clients):
IRS Prohibited Transaction Rules
When it comes to Self-Directed IRA rules, the IRS and Internal Revenue Code (IRC) do not describe what your account can invest in. What they do explain are the investments your account cannot make.
As long as transactions do not involve life insurance, collectibles, or violate the IRC Section 4975 prohibited transaction rules, you can make the alternative asset investment.
Additionally, IRC Sections 408 & 4975 prohibit disqualified persons from engaging in certain types of transactions, such as life insurance, collectibles, or any transaction directly or indirectly involving or benefiting a “disqualified person.”
There are a variety of related scenarios to describe a disqualified person. Essentially, it is the IRA holder and any of his or her lineal descendants, as well as entities controlled by such persons. The IRC doesn’t allow the use of IRA funds that may directly or indirectly benefit the IRA holder.
Consequences of Breaking Self-Directed IRA Rules
You must understand the IRS-prohibited transaction rules. When you trigger any of the rules, the consequences are steep. Engaging in such transactions may lead to your entire IRA becoming disqualified, and a penalty that can be as high as 100%.
There are other rules to keep in mind when using your self-directed IRA in non-traditional investments. For example, if you wish to use a loan for real estate, or to invest in an active business that a pass-through entity operates, you must familiarize yourself with the UBTI rules.
Unrelated Business Taxable Income Rules (UBTI or UBIT)
In general, most passive investments that a Self-Directed IRA might invest in are exempt from UBTI. This includes:
- Interest
- Dividends
- Capital gains
- Rental income
- Royalties
However, several forms of income your IRA generates may trigger the UBTI tax rules:
- Income from the operations of an active trade or business through a pass-through entity, such as an LLC.
- The use of a non-recourse loan to purchase a property (there is an exception for a 401(k) plan)
- Using margin on a stock purchase
IRC Section 511 taxes UBTI at the trust tax rates, which is quite high. For 2024, the highest trust tax rate is 37%.
Learn More: How to Choose the Best Self-Directed IRA Custodian
Getting Around UBTI Taxes
There are two general ways to get around the UBTI tax when using a non-recourse loan to buy real estate:
1. Using a 401(k) plan instead of an IRA
2. C Corp Blocker strategy
1. 401(k) Plan UBTI Exemption for Non-Recourse Loan
Rather than using a self-directed IRA, you can choose the Solo 401(k) retirement plan. Like the Self-Directed IRA structure, a Solo 401(k) offers you the ability to use retirement funds to make alternative asset investments. The income and gains the investment generates typically flow back to the 401(k) plan tax-free.
The reason the Solo 401(k) is a better option is that when an IRA uses a non-recourse loan to finance a real estate, income or gains from the investment often trigger a penalty tax called the Unrelated Debt Financed Income (UDFI) tax. This is part of the UBTI family. UDFI is a type of UBTI that, if triggered, could subject the IRA to taxes.
What is a Non-recourse Loan?
A non-recourse loan is a loan that the borrower does not personally guarantee. However, it is often secured by an asset. In the case of a real estate non-recourse loan default, the lender generally satisfies the outstanding loan amount by the real estate securing the loan.
If you wish to acquire a loan for a real estate investment with your retirement funds, IRC 4975 rules prohibit you from personally guaranteeing the loan. However, you can use a non-recourse loan as a part of a real estate transaction that involves a retirement account. You, the IRA holder, personally guarantee a non-recourse loan.
2. C Corporation Blocker Strategy
Many retirement account investors limit the reach of the UBTI tax by employing a strategy called a “C Corporation Blocker.”
With the C corporation blocker strategy, you must establish a corporation entity. Then, you invest the retirement funds directly into the C corporation before the funds are invested into the intended pass-through investment. This investment may or may not involve leverage.
For example, if you are an IRA investor and you want to invest your funds in an active business operated through an LLC that may or may not be using leverage, you can establish a C corporation. Let’s assume the active business you wish to invest in is a hotel. You will then invest your IRA funds through the C corporation, then have the C corporation invest the funds into the pass-through business that operates the hotel.
All business pass-through income the Corporation receives will be subject to the newly reduced corporate tax rate. This is only 21% as opposed to the 37% maximum UBTI tax rate. Additionally, it’s significantly less than the old maximum corporate tax rate of 35%.
Self-Directed IRA Investments Are EASY
For the most part, using a Self-Directed IRA to make IRS-approved investments is very simple and cost-effective. When you work with the right team of tax professionals, they can help you avoid the Self-Directed IRA rules investors commonly break.
Do you have a Self-Directed IRA and would like to know more about the rules? Get in touch with IRA Financial directly at 800-472-0646. We’ll make sure your IRA stays IRS-compliant!
