John Worley Blog

Common Mistakes Made by Self-directed IRA Investors

John Worley - Thursday, June 22, 2017

Understanding the world of self-directed IRAs isn’t easy for any investor. There rules and regulations, of course, but there are many nuances and subtleties, which make it easy to fall into a trap.

This post examines common mistakes self-directed IRA investors make because it’s easy to think you’re doing the right thing when, in fact, maybe it’s not the best course of action.

Here are some examples.

About that Credit Card in the Name of an LLC . . .

Scenario: You go into a bank to set up an LLC checking account and the teller asks if you’d like a credit card for the account. Or, because credit card companies are always looking for new customers from newly-formed businesses, you get an application in the mail. In either case, you think there’s no harm and go ahead and do it.

Response: Say no thank you to the teller. Throw the mailed application in the trash.

Why: In signing for a credit card in the name of an LLC, you will be issuing a personal guarantee on behalf of the LLC, which is a Prohibited Transaction. You’ve just personally guaranteed the LLC’s debt and repayment. The execution of that personal guarantee constitutes an “extension of credit” and is automatically prohibited, even if it is never exercised.

Additionally: For the same reasoning, never apply for overdraft protection or a line of credit for the account.

Best Advice: If you are unsure of what to do or better yet not to do, consult an attorney experienced in self-directed checkbook IRA LLCs.

If You Intend to a Purchase with IRA Funds . . .

Scenario: You’re not unlike many investors. You find a great rental property you want to buy as an IRA investment. Problem is you have not established a self-directed IRA account or have engaged the services of an IRA custodian.

Why is this a problem? You may lose out on the deal because you don’t have immediate access to your IRA funds and you cannot personally deposit your own earnest money or enter into a purchase agreement.

Remember: It takes at least 30 days to establish a self-directed IRA. The IRA needs to buy the property, not you. Every investment made must be for the exclusive benefit of the self-directed IRA and not for a non-IRA benefit or another person.

Best Advice: Be diligent to avoid any direct or indirect “Prohibited Transactions.” And if you are unsure of what these are, consult an attorney experienced in self-directed checkbook IRA LLCs.

Making a Contribution to an IRA . . .

Scenario: You want to make an annual contribution to an IRA by depositing it directly into the IRA/LLC checking account.

Best Advice: Don’t do that! If you make an annual contribution directly rather than through an IRA custodian you are personally interacting with your IRA/LLC and that’s a no-no and considered a prohibited transaction. If confused, consult with an attorney experienced in self-directed checkbook IRA LLCs.

About those UBTIs . . .

Scenario: An IRA owner wants to passively invest in a business but the business activity itself is not passive. Should that investment be made in a pass-through entity such as an LLC, the IRA could generate unrelated business taxable income (UBTIs) on any profit derived by the businesses’ activity.

Best Advice: You’ve heard this enough now, but it still holds true: Consult with an attorney experienced in self-directed checkbook IRA LLCs if you have questions about unrelated business taxable income.

Using Personally-Owned Assets to Benefit IRA . . .

Scenario: You want to develop IRA-owned property, you have the heavy equipment to do so, and you don’t mind doing the work.

What’s the Problem? It’s considered another prohibited transaction. For one: You’re using personally-owned assets. Another thing: You’re contributing “sweat activity.” Both constitute a de facto contribution that would break the contribution limits.

Best Advice: You got it. Consult with an attorney experienced in self-directed checkbook IRA LLCs and familiar with prohibited transactions.

About Transactions with a Non-Disqualified Party . . .

Scenario: Many investors believe that transactions with a non-disqualified party cannot be prohibited transactions.

Reality: This is simply not true. As an IRA holder, you have a fiduciary responsibility to do what is in the benefit of your IRA.

An example: As an IRA holder you could purchase rental real estate and allow a brother and his family to live on the property. It would not necessarily be a prohibited transaction, BUT it does set up the potential to violate the exclusive benefit rule if the rent was not set at fair market value or the terms of the property agreement were not enforced.

In the End: Not acting in the best interest of the IRA could result in a prohibited transaction.

Best Advice: You got this by now.

About Disguising Active Investments . . .

Scenario: Self-directed IRA holders attempt to “disguise” active investments that generate UBTIs by placing a newspaper ad to show their intent to rent an IRA investment property. Problem is they can’t find the right tenants so they use this as an excuse to sell.

What’s Going On? The IRA holder thinks this plan will avoid UBTI because the intention was to rent the property as a passive investment. Yeah, it’s a bit shady. Even if true, case law says that the most dominant factor is the purpose at the time of sale, not at the time of initial purchase. It may be a perfectly passive non-business purpose going in, but if that purpose is changed at the time of sale it’s a business-type transaction and subject to UBTI.

Best Advice: You know what to do.

A Few Other Mistakes . . .

  • If you’re an IRA owner AND a real estate agent, you cannot receive a commission on the buying or selling of IRA property. You cannot take personal compensation for any self-directed IRA investment.
  • A self-directed IRA enters into a de facto partnership by loaning money to a developer, but instead of creating an interest and payment schedule the IRA holder accepts a share of profits. This wouldn’t be a problem if the IRA lent the money for a what-the-market-bears interest rate and payment schedule, but in the profit-sharing scenario it’s simply disguised equity that’s made to look like a loan.
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