The Tax Club Report

IRAs came about in the 1970s to enable people to save money in retirement accounts or trusts for their benefit or that of their chosen beneficiaries. An IRA is a personal savings plan that provides income tax advantages to individuals saving money for retirement purposes. A self-directed IRA is a type of plan that provides the owner a great deal of control over the investments made on the account.

How It Works

All IRAs have to be held by a custodian or trustee.  Investment firms, banks and other financial institutions typically offer “one-stop” shopping for IRA clients where the client can make an IRA contribution and select investments.  Those funds are typically invested either in a company’s proprietary investments, CDs or the wide range of publicly traded stocks, bonds and mutual funds. 

While these IRAs can be considered “self-directed” since the client will make the decision where to invest, most truly “self-directed IRA” custodians will permit their clients to engage in investments in most, if not all, of the IRS permitted investment types. Some of the additional investment options allowed under the regulations include, but are not limited to, real estate, mortgages, franchises, partnerships, private equity, and tax liens.

Investing in Real Estate

Investors have always been allowed to hold real estate in IRAs yet few people seemed to know they could.  Financial institutions had little profit incentive to recommend investments other than stocks or mutual funds.   But there are other firms whose primary job is to serve as the custodian of self-directed IRAs.  

With an investment in real estate, one disadvantage is that investors can’t take a current deduction for most common expenses, such as interest, taxes, insurance, repairs and depreciation. The purchase of the property has to be an all-cash transaction since borrowing is not permitted in an IRA. They also can’t use real estate owned by an IRA as a primary residence, vacation home or business base. Family members, too, could not have owned the property. Once a property is chosen, the IRA custodian – not the account holder – must buy it. Fees vary widely among custodians.

Cash flow can be an issue as well. All property expenses, from taxes to repairs, must be paid from funds in the IRA, which means investors will need to have plenty of liquid funds available. 

If an IRA is used, a Roth IRA works best for handling real estate transactions. Investors won’t owe taxes at distribution, when the investments have appreciated over time. In a traditional IRA, once money is withdrawn, funds are taxed as regular income, not at the lower capital gains rate.

Maintaining a Self-directed IRA

Conducting transactions through a tax-sheltered account is subject to many regulations and can be complicated, and rule breakers face severe penalties. IRS regulations require that either a qualified trustee or custodian hold the IRA assets on behalf of the IRA owner. Generally, the trustee/custodian will maintain the assets and all transactions and other records pertaining to them, file required IRS reports, issue client statements, assist in helping clients understand the rules and regulations pertaining to certain prohibited transactions and perform other administrative duties on behalf of the self-directed IRA owner for the life of the IRA account. An advantage of self-directed IRAs is that they improve the account owner’s opportunities to diversify their IRA portfolio by allowing a wide range of investment choices.

Some investments, such as life insurance,, collectibles and prohibited transactions with disqualified persons, as defined by the IRS, are not permitted in IRAs.  It is important, however, to understand that the IRA account holder is responsible for compliance with all codes and regulations. While a custodian’s job is to follow the directions of the accountholder as a non-discretionary trustee, a custodian cannot ensure compliance or give legal or tax advice. Therefore, those interested in self-directed IRAs should seek education offered by an unbiased source.

Using an IRA LLC Structure

In an effort to reduce fees, paperwork and processing delays, some self-directed IRA investors choose to employ an IRA LLC structure. In such a structure, the accountholder directs his IRA custodian to invest into a limited liability company that he manages himself. The accountholder can then execute transactions on the LLC level without the involvement of the IRA custodian, thus reducing fees and eliminating custodian transactional fees and delays. The profits of the LLC pass through to the IRA with identical tax favorable treatment.

This structure facilitates “checkbook control” because the IRA accountholder often has sole signing authority for the LLC and its bank accounts. Briefly stated, checkbook control is accomplished by setting up a single member LLC which is purchased 100% by the IRA. The IRA holder is subsequently appointed the LLC manager after funding the LLC share purchase. The IRA holder has complete control over all monies of the LLC and therefore the IRA’s monies.

Some claim that this IRA LLC strategy has been legitimized through a tax court case: Swanson v. Commissioner, 106 T.C. 76 (1996). Others disagree on the validity of the court case.  However, in the Swanson case, the prohibited transaction rules were misapplied and the case was pursued without a full understanding of the facts and application of the rules.

Anyone entering into this type of IRA investment must understand the basis in law on which this type of investment structure is built, what the rules are with regards to both prohibited transactions and how to operate a registered business entity.  IRA investments in closely held or “checkbook control” LLCs, because of their high profile, may loom large as a future IRS target. To know if a self-directed IRA is beneficial for you, please contact the Tax Club for a more detailed analysis.

The Tax Club is committed to making information available to small business owners that will allow a better decision making process. If you would like to have a free consultation, please feel free to contact us at 866-840-1829 x5438

This entry was posted on Tuesday, November 17th, 2009 at 5:14 pm and is filed under Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.