A self-directed Individual Retirement Account refers to any IRA that allows one to direct the IRA’s assets to be invested in nontraditional investment vehicles. 
Examples of these might include real estate, collectibles, and limited partnership interests, and may be done with either a traditional or Roth IRA. In order to participate in such a vehicle, a trustee or custodian that specializes in this unique area must be identified and retained. One must also become well acquainted with the prohibited transaction rules. These rules require that only the IRA benefits from its transactions; not the owner or their family.
Just about any type of real estate may be invested in via a self-directed IRA, including direct ownership, a limited partnership interest, etc. One may even invest their IRA in a business venture. However, as previously mentioned, extreme caution must be exercised to ensure that a prohibited transaction does not occur. If one does occur, the account stops being treated as an IRA as of the first day of the year, and is treated as distributing all of its assets to the owner at fair market value. The 10% premature distribution penalty may also apply, if the owner is younger than 59 1/2 years of age.
What, then, is a prohibited transaction?
A prohibited transaction occurs when there is any improper use of an IRA by the owner, beneficiary, or other disqualified person. The latter would include an IRA fiduciary (one who exercises any discretionary authority in managing/administering the IRA) or family member. One who provides investment advice may also fall into this category. Examples of a prohibited transaction with an IRA include: borrowing money from it; selling property to it; buying property for personal use with IRA funds; receiving unreasonable compensation for managing it; and others.
Related read: Important Considerations for Non-Spouse Beneficiaries
In a recent court case, an individual established a limited liability company to operate his business. He funded the new venture by rolling over his 401(k) account from his former employer into an IRA. The IRA then became the majority owner of the LLC. The individual, acting as the general manager of the business, was paid nearly $10,000 in compensation for his duties. The court found that this act constituted a prohibited transaction, since the taxpayer was a fiduciary of the IRA, and he created a situation where the IRA-owned business paid him compensation. He was dealing with the income or assets of the IRA for his own interest, which is known as “self-dealing”. He was not being paid for his services provided to the IRA, which would not have been subject to the prohibited transaction rules. Therefore, the IRA was deemed to have been distributed to him, and was fully taxed, along with the application of the 10% penalty.
In today’s day and age of low investment returns, it may be tempting to invest one’s IRA (which may be that individual’s most valuable asset) in a business or real estate vehicle. This may be especially true for a Roth IRA, since a qualified distribution from a Roth is tax-free.
However, when one considers the potentially onerous tax and penalties that may arise if a prohibited transaction occurs, extreme caution must be exercised. The process must start by speaking with your tax advisor, and by engaging a qualified fiduciary who has considerable experience with self-directed IRAs.
To explore the potential pitfalls of a self-directed IRA, please contact one me at gsigman@zinnerco.com or 216-831-0733. I’m ready to start the conversation and help you guide your retirement plan.
