Pitfalls and Considerations of Self-Directed IRAs

By David E. Bowers, LL.M. and Rachel L. Sears


Traditional individual retirement accounts (IRAs) provide investors with tax benefits for retirement savings and typically limit investments to common securities such as stocks, bonds, certificate of deposits, and mutual or exchange-traded funds. Certain investors, however, wish to invest their resources in alternative asset classes through a self-directed IRA. While a self-directed IRA has the capacity to house diverse alternative investments such as real estate, cryptocurrency, gold, and private equity, it also comes with potential pitfalls that investors should be aware of.

Selecting a Custodian: A Crucial Decision in Self-Directed IRAs
Unlike traditional IRA custodians, who must comply with federal laws governing investment sales and typically limit investments to approved securities, self-directed IRAs lack such constraints. Self-directed IRA custodians refrain from offering investment advice, need not assess investment quality or legitimacy, and do not verify financial information accuracy provided by investors. They focus solely on asset management and administration, defining the “self-directed” aspect where investors carry full responsibility for understanding and complying with intricate tax laws.

When selecting a custodian for a self-directed IRA, recognizing their differences is crucial. The IRS licenses over 50 companies for these services, each varying in reputation and expertise across investment categories. Investors should evaluate factors like IRS approval, custodial experience, fee structures, expertise in specific investments, and cybersecurity measures to ensure data security.

Prohibited Transactions and Disqualified Persons
Self-directed IRA owners need to be aware of the prohibited transaction rules. Prohibited transactions include, but are not limited to, activities such as buying, selling, or leasing property to or from a disqualified person. Disqualified persons include family members, fiduciaries, an entity in which the IRA owner has a controlling interest (i.e., ownership of 50% or more), or the IRA owner themselves. Additionally, IRS regulations strongly prohibit the IRA owners from using the rental property—whether directly or indirectly—for personal use. For example, using the property as a vacation home or paying themselves or a disqualified person to manage the property may disqualify the entire IRA resulting in taxable income on the full value and potentially result in unexpected unrelated business income penalties (as discussed in more detail below), thereby eroding the returns on the investment.

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Triggering Unrelated Business Income Tax Liabilities
IRAs are tax-exempt while assets are accumulated for retirement. However, a self-directed IRA may still be liable for its unrelated business income tax (UBIT), which can be as high as 37%. The UBIT rules prevent exempt organizations from running unrelated businesses without paying taxes on the income produced by that unrelated business.

Self-directed IRAs may invest in businesses, such as rental properties, operating companies, or partnerships. However, if the business is considered an active trade or business, is regularly carried on, and not substantially related to furthering the exempt purpose of the organization—which is to save for retirement in the case of self-directed IRAs—the income generated from such activities may be subject to UBIT. For example, if a self-directed IRA owns rental properties, each property will require ongoing rental maintenance. An IRA owner must ensure that all taxes, maintenance, and expenses are paid from the IRA’s generated funds and not from the owner’s personal funds to prevent a prohibited transaction and inadvertently paying penalties.

Contrary to popular belief, self-directed IRA owners can use leverage, such as obtaining a mortgage, to finance investments. However, owners are prohibited from personally guaranteeing the loan and can only use the underlying asset itself as the sole source of recourse that a lender has available to them in the event of default. To avoid this prohibited transaction, the custodian should be the sole obligor on the loan.

Even if nonrecourse debt financing is used, the income generated from the investment will be subject to UBIT. This is known as unrelated debt-financed income (UDFI). To illustrate, if a self-directed IRA commits $100,000 to a property investment, contributing $60,000 in cash and securing a $40,000 mortgage, the income proportionate to the financed segment (40%) would be susceptible to UBIT.

Final Takeaway
Self-directed IRAs offer unique investment opportunities, but they also come with potential pitfalls that are commonly overlooked by many investors. Investors should seek professional legal advice to help navigate the complexities, regulations, and risks associated with self-directed IRAs.

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David E. Bowers
Jones Foster shareholder David Bowers is chair of the firm’s Private Wealth, Wills, Trusts & Estates and Corporate & Tax practice groups, and has over thirty years of experience in complex tax, trusts and estates, and business planning. Mr. Bowers is a Florida Bar Board Certified Specialist in Tax and has extensive experience in estate planning and estate and trust administration, including IRS audits and business transactions www.jonesfoster.com


Rachel L. Sears

Jones Foster attorney Rachel Sears concentrates her practice in the areas of estate planning, trust and estate administration, and corporate law. Ms. Sears works with clients on estate planning matters and provides counsel to personal representatives, trustees, and beneficiaries in probate and trust administration. In addition, she advises clients on corporate transactions, including transfers of business interests, LLC creation, mergers and acquisitions, and corporate restructuring. www.jonesfoster.com

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