If you want to reap the full benefits of your self-directed IRA account, here are some of the things you should know to avoid putting your tax-deferred status at risk.
In this article:
- Making Prohibited Investments and Transactions
- Buying and Selling Investments With Disqualified Persons
- Getting Indirect Benefit
- Paying Unrelated Business Income Tax (UBIT)
Self-Directed IRA | Rules Taxpayers Need to Know Right Now
1. Making Prohibited Investments and Transactions
When choosing assets to add to your IRA, there are some investments and transactions taxpayers cannot make. Pursuing a prohibited investment may lead to the disqualification of your self-directed IRA.
The IRS does not allow the improper use of self-directed IRAs by the owner, beneficiary, or any disqualified person(s). A disqualified individual or entity includes your fiduciaries and certain members of the family.
Additionally, there are certain IRA investments that count as prohibited transactions. Apart from investing with disqualified persons and individuals, the IRS prohibits investments that qualify as self-dealing and indirectly beneficial.
The IRS does not explicitly state what investments you can make. Rather, they only dictate what investments they prohibit.
Prohibited IRA investments include certain coins, life insurance, and collectibles such as stamps, artworks, antiques, gems, and rugs. When you’re not sure if you can make an investment or not, please refer to the IRS Publication 590.
2. Buying and Selling Investments With Disqualified Persons
Self-dealing is the act of buying and selling investments to a disqualified person. Doing so goes against the Internal Revenue Code Section 4975.
Generally, you must keep your self-directed IRA investments at “arms’ length distance”. The IRS defines this as a scenario where a willing buyer and seller come together to deal with no outside influence from any third party.
Disqualified persons are entities or individuals with whom the IRA account holder cannot buy or sell investments. This includes engaging in any direct or indirect sale, leasing real estate properties, lending money, furnishing goods, or transferring/permitting the use of IRA assets/income.
According to the Internal Revenue Code Section 4975, disqualified persons include:
- Family Members: This includes your spouse, parents, children, grandchildren, great-grandchildren, grandparents, great-grandparents, and the spouses of your children, grandchildren, and great-grandchildren.
- Fiduciaries: According to the self-directed IRA, this includes you as the account holder.
- IRA Custodian/Service Providers: This includes your self-directed IRA custodians, financial advisors, brokers, CPAs, and tax advisors.
- Self-Beneficial Entities: Corporations, partnerships, companies, trusts, and estates where a fiduciary or IRA service provider owns at least 50% of the entity. This also includes partners who jointly own 10% of the entity.
Note: Under the Internal Revenue Code Section 4975, siblings, aunts, uncles, and cousins are not disqualified persons.
3. Getting Indirect Benefit
The main purpose of a self-directed IRA is to save up money that may potentially create retirement funds you can access in the future. The IRS generally prohibits account holders from making transactions and investments for any use other than a retirement plan.
Indirect Benefit Examples
Here are some examples of indirect benefit transactions that the IRS prohibits:
- Using property you purchased through your self-directed IRA as your personal residence, vacation home, office space, or retirement home.
- Lending yourself money or taking out money to pay for the debt you used to pay for the renovation of a property you purchased through your self-directed IRA.
- Using your IRA funds to purchase a vacation home that you and/or your family will use and benefit from.
Generally, any type of transaction that cheats the system is not allowed by the IRS. If you feel that a transaction goes against the main purpose of your self-directed IRA account, then it might be best not to go forward with it.
4. Paying Unrelated Business Income Tax (UBIT)
Unrelated Business Income Tax (UBIT) Definition: According to the IRS, the UBIT is the tax placed on income derived from unrelated business activities from an entity that was otherwise tax-exempt.
If your IRA account holds an asset/interest that generates unrelated business taxable income, then you may have to pay UBIT. This applies to your self-directed IRA if all of the following conditions are true:
- Income comes from business or trade activities including the sale of goods/services.
- The exempt status does not cover the business.
- The organization runs the business regularly and continuously.
Overall, most types of IRA investments that generate UBIT are:
- Limited Partnerships (LP)
- Limited Liability Companies (LLC)
- Any investment asset that generates debt financing or engages in an unrelated business matter
Should taxpayers and investors avoid assets that generate UBIT? The answer: not necessarily.
While it does generate larger taxes for your IRA to pay, diversifying your IRA portfolio through alternative investments that generate UBIT might be a solid way to increase your profits.
Of course, it might be beneficial to speak with a trusted financial adviser before you invest in alternative assets. Just know that UBIT is not illegal, and it’s not necessarily something you need to avoid.
These are just some of the most important self-directed IRA rules taxpayers need to keep in mind. Overall, the IRS prohibits any activity that abuses or misuses IRA investments.
Note that these are for educational purposes only. For personalized legal advice, it’s best to consult with a CPA or tax specialist you can confide in.
What self-directed IRA rules are you unsure about? Post them in the comments section down below!
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