IRAs & Retirement

Most people have some form of retirement account into which they have saved up funds over the years. It may be an IRA or a 401K or a 403(b) or even a Roth IRA, but the common feature of all these accounts is that they allow you to contribute tax free money into the account, which is then invested and will accumulate the earnings tax free until you retire or begin to take the money out of the account. Most accounts are invested by the custodian of the account, who may give a list of choices of investment, or may just invest them mutual funds based on your risk preference. Many people have lost significant amounts in the recent market downturns and are confused about how they should invest. The stock market is very unstable, but fixed instruments are paying historically low returns right now.

No one can say what the best investment strategy is now, but a new way of allowing the owner of the account to make the decisions for him or herself is becoming very popular. It is called a Self Directed IRA LLC. Just as the name implies, this means that an LLC will be set up and then the money from your IRA will be transferred to the bank account of the LLC where you will be given checkbook control over the investment of your funds. You can't use the funds for your personal benefit, or engage in what are called “prohibited transactions”, (more on this later) but you can invest real estate, oil and gas, foreign transactions and many other things that are not available through a traditional custodian like Fidelity or your local bank. Generally speaking, the only investments you can't make are in insurance or collectibles.

Video - Checkbook Control of your IRA funds

7 Steps to a Checkbook control Self Directed IRA

In order to set up and make investments from your own Self Directed IRA LLC it will be necessary to complete the following steps:

  1. Form a Limited Liability Company (LLC) in the state of your choice.
  2. Prepare a specialized Operating Agreement that meets the specific requirements for a Self Directed IRA LLC.
  3. Establish a Self Directed IRA account with an independent IRA Custodian that permits truly self directed IRA investments.
  4. Fund your new Self Directed IRA custodial account or transfer funds from your existing retirement account to the new custodial account.
  5. Direct your new Self Directed IRA Custodian to make an investment in your new Self Directed IRA LLC.
  6. Find a suitable investment vehicle in which you want to make your investment.
  7. Purchase the new investment in the name of your new Self Directed IRA LLC.

By using this simple method your Self Directed IRA LLC can invest in real estate and other investment vehicles without the red tape normally involved in obtaining approvals and without the administrative fees normally involved when using your IRA directly to make the investment.

Prohibited Transactions & Unrelated Business Income

1)  Prohibited Transactions in a Self Directed IRA LLC

The only investments that the IRS says that you cannot purchase using your Self Directed IRA LLC are Collectibles and Life Insurance. You are also not allowed to have any “self dealings” which are prohibited transactions. In general, Internal Revenue Code Section 4975 defines a prohibited transaction as a transaction between a plan (your account) and a disqualified person. Generally, “disqualified persons” are defined to be the account holder, other fiduciaries, certain family members (lineal descendents and spouses of lineal descendents), and businesses under the account holder’s (or disqualified person’s) control. Transactions not allowed are:

1. A sale or exchange, or leasing of property between a plan and a related party.

2. Lending of money between a plan and a related party.

3. Furnishing goods, services or facilities between a plan and a related party.

4. Transfer to, or use by, a related party of the income or assets of a plan.

5. Act by a related party whereby he deals with the income or assets of a plan in his own interest or for his own account.

6. Receipt of any benefit for his own personal account by any related party in connection with a transaction involving the income or assets of the plan.

disqualified person is you, your children, grandchildren, spouse, or parents. It is also any business owned 50% or more by any of the above. According to the IRS, siblings, aunts, uncles, cousins and step relations are not included in the definition of disqualified persons.

If you engage in a prohibited transaction the IRS will consider your IRA fully distributed. However there are hundreds of exceptions granted each year to the prohibited transaction rules. The Department of Labor has been given the power to grant these exceptions. One of the most important exceptions is 96-62 which says that you only have to demonstrate that your requested transaction is substantially similar to two or more individual exemptions granted within the previous five years. This is called a “class exemption”.

For further information please see U.S Department of Labor Class Exemptions

Essentially if your transaction is an arms length transaction that is a legitimate investment you can probably find similar exemptions that have been approved. For example if you wanted to loan money from your IRA to your wholly owned corporation it would probably be allowed if you charged your corporation the same interest rates your bank would charge.

2)   What is Unrelated Business Taxable Income (UBTI)?

The tax advantage of an IRA is that income is tax-free until distributed. In general, an exempt organization is not taxed on its income from an activity that is substantially related to the charitable, educational, or other purpose that is the basis for the organization’s exemption. Such income is exempt even if the activity is a trade or business. However, to prevent tax-exempt entities from competing unfairly with taxable entities, tax-exempt entities are subject to unrelated business taxable income (UBTI) when their income is derived from any trade or business that is unrelated to its tax-exempt status.

UBTI is defined as “gross income derived by any organization from any unrelated trade or business regularly carried on by it” reduced by deductions directly connected with the business. An exempt organization that is a limited partner, member of a LLC, or member of another non-corporate entity will have attributed to it the UBTI of the enterprise as if it were the direct recipient of its share of the entity’s income which would be UBTI had it carried on the business of the entity.   UBTI also applies to unrelated debt-financed income (UDFI).   “Debt-financed property” refers to borrowing money to purchase the real estate (i.e., a leveraged asset that is held to produce income). In such cases, only the income attributable to the financed portion of the property is taxed; gain on the profit from the sale of the leveraged assets is also UDFI (unless the debt is paid off more than 12 months before the property is sold). There are some important exceptions from UBTI: those exclusions relate to the central importance of investment in real estate – dividends, interest, annuities, royalties, most rentals from real estate, and gains/losses from the sale of real estate. However, rental income generated from real estate that is “debt financed” loses the exclusion, and that portion of the income becomes subject to UBTI. Thus, if the IRA borrows money to finance the purchase of real estate, the portion of the rental income attributable to that debt will be taxable as UBTI.

For an IRA, any business regularly carried on or by a partnership or LLC of which it is a member is an unrelated business. For example, the operation of a shoe factory, the operation of a gas station, or the operation of an computer rental business by an LLC or partnership owned by the Self Directed IRA LLC would likely be treated as an unrelated business and subject to UBTI.

Although there is little formal guidance on UBTI implications for self-directed real estate IRAs, there is a great deal of guidance on UBTI implications for real estate transactions by tax-exempt entities. In general, Gains and losses on dispositions of property (including casualties and other involuntary dispositions) are excluded from UBTI unless the property is inventory or property held primarily for sale to customers in the ordinary course of an unrelated trade or business. This exclusion covers gains and losses on dispositions of property used in an unrelated trade or business, as long as the property was not held for sale to customers. In addition, subject to a number of conditions, if an exempt organization acquires real property or mortgages held by a financial institution in conservatorship or receivership, gains on dispositions of the property are excluded from UBTI, even if the property is held for sale to customers in the ordinary course of business. The purpose of the provision seems to be to allow an exempt organization to acquire a package of assets of an insolvent financial institution with assurance that parts of the package can be sold off without risk of the re-sales tainting the organization as a dealer and thus subjecting gains on re-sales to the UBIT.