Self Directed IRAs: How to Avoid Common Pitfalls
Self-directed IRAs, where a custodian holds an individual’s money and invests it according to his client’s mandate, offer a wider range of investment options than the traditional stock-and-bond make-up of typical mutual fund-based IRAs. Self-directed IRAs may invest in business interests, real estate properties, private placement concerns and other tangible assets.
But do-it-yourself investors are vulnerable to pitfalls if they fail to operate within rigid regulatory guidelines. Simply put: assets of tax-advantaged retirement accounts may not bring an investor personal gain until after they’re distributed upon retirement. But such compliance isn’t always so obvious. (For related reading, see: Self-Directed IRA: The Right Move for You?)
Self-Directed IRA Missteps
IRA expert Ed Slott, writing for Financial Planning, tells of such an example. Ten years ago, Terry Ellis ended his long-term employment with drug-maker Aventis Pharmaceuticals. During his time at the company he accrued $254,206 in his 401(k) plan portfolio, which he subsequently rolled over into his own IRA, dubbed the “Terry Ellis IRA.” The very next day, Ellis used $254,000 of his IRA cash to finance a 98% stake in a used car company he formed, CST LLC, in which Ellis functioned both as general manager and floor salesman. For the former role, Ellis collected $9,754 in compensation, paid directly from a CST checking account seeded by his IRA. This turned out to be a massive regulatory no-no, according to Internal Revenue Code Section 4975(c)(1)(D)(E), which prohibits business operators from receiving compensation if they are the fiduciaries of IRAs owning 50% or more of the affiliated business. Consequently, in 2013, the US Tax Court deemed Ellis a “disqualified person” who engaged in a prohibited transaction, and ordered Ellis to pay 10% in additional taxes and saddled him with a 20% accuracy-related penalty. The U.S. Court of Appeals in St. Louis upheld the ruling.
Ellis isn’t the only one to stumble with his self-directed IRA. In 2008, Barry Kellerman and his wife Dana individually each owned a 50% stake in Panther Mountain Land Development, LLC. To finance a new development project, a partnership was established where Panther had 50% ownership and Kellerman’s self-directed IRA funded the remaining 50%. As part of this arrangement, Panther contributed $160,000 while Kellerman commandeered the custodian of his personal IRA to liquidate his assets in order to make a $40,523.93 cash contribution, while delivering $122,830 worth of real property with plans to funnel additional cash into the partnership over the next several years. Unfortunately, by 2009 the partnership had tanked, and both the Kellermans and Panther Mountain wound up in bankruptcy court. (For related reading, see: Retirement Tips: How to Choose the Best IRA Custodian.)
The Kellermans attempted to designate the IRA as a tax exempt-asset. But like with the Ellis case, Kellerman had discretionary control over his IRA, and was therefore was deemed a fiduciary. His use of his personal IRA as a lending body for acquiring real estate properties was considered a prohibited transaction, which effectively nullified his IRA’s eligibility for bankruptcy protection.
How to Avoid Such Problems
Both Ellis and the Kellermans encountered troubles with their self-directed IRAs. But these vehicles don’t automatically have unhappy endings. Those who remain compliant can greatly benefit from the tax-advantaged status self-directed IRAs bring — especially with prudent real estate investments. When in doubt, investors should remember that an individual and his or her self-directed IRAs are two discrete entities. The lines separating an individual and his or her retirement account should remain clearly distinct from one another. And IRA funded real estate investors can accomplish this by heeding the following simple rules:
Avoid accepting rental income. Ignore the temptation to personally pocket rental income from tenants, who should instead funnel monthly rent directly back into an IRA account. While accepting a rent check made to your personal checking account, then writing a check for the same sum to your IRA seems like a no-harm, no foul practice, this could easily raise a red flag.
Avoid transacting with “disqualified persons.” Be careful who you deal with in all of your self-directed IRA transactions. For example, buying property from one of your lineal descendants, or even hiring one to maintain your properties, is considered a prohibited transaction and could incur penalties. Consequently, most self-directed real estate IRA investors hire outside property management companies to do on-site maintenance.
Maintain a cash cushion. All expenses associated with a self-directed IRA property must be funded strictly by cash held inside the IRA. So if there is an urgent $10,000 repair needed on an apartment complex but the IRA only has a $1,000 reserve, an investor could face a significant dilemma that can be easily avoided by maintaining appropriate preservation capital in the IRA account.
The Bottom Line
The broader investment choices make self-directed IRAs an attractive option for investors looking to build a nest egg with more diverse tax-advantage portfolios. But investors should exercise caution in avoiding prohibited transactions that could sock them with oppressive tax penalties. (For related reading, see: Self-Directed IRAs vs. Traditional IRAs.)