[In a continuing series of articles, Warren L. Baker is writing on the topic of “self-directed” IRAs – from the basic formation process to the complex tax and legal ramifications involved when investing using these structures.]
In my last article, The “Self-Directed” IRA – Part 1: Formation, I began to discuss a method of investing retirement assets into “alternative” types of investments (e.g. real estate, promissory notes, mortgages, tax liens, privately-held businesses, precious metals, etc.) using a specialized type of IRA custodian. Many of these self-directed IRAs are used to purchase 100% ownership of a newly-formed Limited Liability Company (“LLC”), which can greatly reduce the involvement of the IRA custodian (read: decreased transaction costs). The reason for this is that the LLC operates almost entirely out of a business checking account, with the “Manager” of the LLC (i.e. the account holder of the IRA) being the authorized signer on the account. However, as I will discuss in my Part 3 article, “prohibited transactions” are a big concern because the account holder has a lot of power over the IRA/LLC’s assets.
One question that people ask me on a regular basis is WHY a client would invest in this manner. Based on hundreds of conversations I have had with individuals and groups of investors, these “self-directed” IRA structures seem to be growing in popularity due to many different factors, including:
(1) Many people have a general distaste for “traditional” stock market investments. Many clients start our first conversation with a statement like, “I hate the stock market.” Amazingly, my experience is that clients have this same preconceived notion regardless of whether the stock market is going up (e.g. 2009, 2010) or down (e.g. 2008). Personally, I don’t take a position on whether a client should be invested into the stock market – that is a job for the client’s financial advisor.
(2) Stock market volatility drives many people crazy. I was speaking with a financial advisor colleague recently that told me a story that fits well with this idea. The advisor was investing $1,000,000 for a client in the late-90s. The particular year in question, the advisor achieved a 35% return despite the market appreciating by 25%. Despite this result, the client removed all of his funds. When the advisor asked why the client was removing his funds, the client said that he “drove himself nuts watching the daily ups and downs of the market” despite a very good yearly return. The ability to go online and see the value of your retirement assets on a minute-by-minute basis is a stomach-churning experience for many people – and the increased volatility of the market over the past few years has made the problem worse.
(3) Diversification. Many clients will use only a portion of their current retirement assets to fund a new self-directed IRA and/or fund the new IRA with only their Traditional or Roth assets. As I will discuss in more detail in future articles, I believe the plan of not having “all your eggs in one basket” is particularly important in these structures. For example, if the client needs to take regular personal distributions from his or her retirement assets, self-directed IRA structures can result in liquidity problems (e.g. only illiquid assets like real estate are held within the structure). Also, in general, the more a client needs to filter money through the self-directed IRA custodian, the more transaction fees are involved. Finally, if the client triggers a “prohibited transaction” and his or her IRA becomes invalidated, the pain will be much worse if the client has all of their retirement funds within the self-directed IRA. This is because the entire IRA (not just the amount involved in the transaction) is treated as distributed to the client if a prohibited transaction occurs.
(4) Clients want to base their retirement future on assets they can “see and touch”. Clients tell me on a daily basis that they feel more comfortable having some (or all) of their retirement assets invested in something “tangible”. This idea is normally interrelated to the “stock market fears” described above. However, many of my clients have been very successful investing their personal funds into “hard assets” (e.g. real estate), so there is a natural tendency for these clients to lean forwards these types of investments within their IRA as well.
(5) Many clients, particularly individuals who have been involved in real estate investment personally, feel that there are a lot of real estate opportunities right now. This is particularly the case because self-directed IRA structures often purchase properties using all cash – meaning that a tight credit market can actually be helpful (i.e. less competition). Clients often tell me that they know a lot of people that “need cash right now”, which results in various real estate and lending opportunities.
The second question that people ask me about self-directed IRAs is: WHAT are my clients investing into using self-directed IRAs. Of course, because of attorney-client confidentiality, I cannot disclose names or specifics. However, as a general matter, the following are the most common categories of investment strategies that my clients employ:
(1) Real estate. Within the general category of “real estate”, the most common investment is all-cash purchases of residential rental properties, which are then held “long-term” as passive investments. As I will describe in a future article, using debt-financing in these types of transactions is possible, but can be tricky (for example, the debt must be “non-recourse”). Also, purchasing real estate with the intension of developing or “flipping” it can lead to current taxes to the IRA. I have also had clients invest into all of the following types of real estate: commercial property, raw/vacant land, condominiums, trailer parks, and vacation rentals.
(2) Loans / Promissory Notes. These investments generally involved the self-directed IRA loaning money to an individual or business entity in exchange for points and interest. One positive aspect of loans is that the income is tax-deferred to the IRA (however, situations where the loan is actually for “disguised equity” in an active business can lead to a current tax to the IRA). Of course, the biggest downside of loans is that borrower occasionally defaults, which can leave the IRA witl little or no recourse (depending the client’s ability to secure the IRA’s loan at the outset).
(3) Privately-held businesses. A self-directed IRA can invest into privately-held businesses, but clients need to be aware of numerous potential issues. The type of business entity involved (e.g. Limited Partnership, LLC, Corporation, etc.) can impact the tax consequences to the IRA. Also, the client’s (or their family’s) personal involvement in the business needs to be examined closely. Because an IRA (or IRA-owned LLC) is not an allowable “S” corporation shareholder, investments of S Corps are not an option.
(4) Precious metals. One of the general limitations on IRAs is that they are not allowed to invest into “collectibles” (e.g. artwork, rugs, wine, rare coins, etc.). However, certain types of coins and bullion are excluded from the definition of collectibles. Thus, it is possible for an IRA to own precious metals, but the manner in which these metals are held must be considered. An IRA (or IRA-owned LLC) can also own commodities through a traditional securities account.
(5) Publicly-traded securities. The idea of investing an IRA into publicly-traded securities is certainly nothing new – and it might seem counter to some of the reasons why clients form self-directed IRA structures in the first place (see above). However, many clients I speak with form IRA-owned LLC structures where the LLC subsequently forms a brokerage account. From there, the Manager of the LLC invests into a wide variety of publicly-traded investments on behalf of the LLC. Clients often complain that their “old” retirement account (e.g. a former employer’s 401(k) plan) did not allow a diverse array of investment options and the self-directed IRA/LLC structure provides them the additional benefit of more “traditional” investment possibilities.
Next up: Part 3 – Prohibited Transactions…
DISCLAIMER: The above information is for educational purposes only and does not constitute legal advice. Under no circumstances shall this correspondence create an attorney-client relationship.