Posts by author:

Warren

The Self-Directed IRA – Part 2: What clients are doing and why

by Warren on October 31, 2011

[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.

1 comment

The Self-Directed IRA – Part 1: Formation

by Warren on August 18, 2011

[Over the next several months, attorney Warren L. Baker will be posting an article series he wrote on investing retirement funds into "non-traditional / alternative assets" (e.g. real estate) using a "self-directed IRA".]

To start with, what is a “self-directed IRA”?  The vast majority of people that have a retirement plan, whether it’s in the form of an IRA, 401(k), 403(b), etc. have their money invested in “traditional” types of investments, e.g. stocks, bonds, mutual funds.  However, the general rules governing an IRA allow for any type of investment except for investments into “life insurance contracts” and “collectibles” (e.g. rare coins, antiques, wine, etc.).  The most common investments for self-directed IRAs include real estate, loans, tax liens, and privately-held companies.  That sounds great in theory, but in order for an account holder to actually invest retirement funds into assets outside of the stock market the account holder will need his or her retirement plan custodian to allow this type of investment.  In other words, the financial institution that holds the retirement account must be willing and able to facilitate the investment or the account holder is out of luck.  The reality is that most large financial institutions have traditionally not allowed investments outside of publicly-traded securities.  Thus, one of the first steps in the process of forming a self-directed IRA is generally to “roll” or “trustee-to-trustee transfer” some (or all) of the retirement account to a new IRA custodian.  But before we get to that issue, a few other steps will need to occur.

Step #1 – Can the funds be moved?: Prior to selecting a new IRA custodian (discussed more in Step #2), the retirement account owner needs to determine whether his or her retirement account is even eligible to be moved from its current location.  For example, many 401(k) plans significantly restrict the movement of money while the retirement account owner is still working for the company that sponsors the plan.  In other words, if the 401(k)’s underlying “plan document” will not allow the account owner to move their money, transferring funds into a self-directed IRA might not be possible (at least until a “separation from employment” occurs).  This is an issue that the account owner needs to resolve with their current plan administrator.  In general, if the current retirement account is structured as an IRA (or a 401(k) from a previous employer) it can be moved (in whole or in part) to a new custodian without incurring current tax consequences. 

Step #2 – The new custodian: Once the account holder determines that they are eligible to move some (or all) of their retirement funds, they need to select a self-directed IRA custodian.  Often, an experienced professional will help in this selection process.  Although there are an increasing number of IRA custodians that are willing to hold “non-traditional” IRA assets, there are dramatic differences between these custodians.  Some custodians offer very minimal customer service, but have lower fees.  Other custodians claim to offer the opposite.  Another issue to consider is whether the custodian will allow the IRA to purchase a Limited Liability Company (“LLC”), which could be important if the client wants maximum control over the structure (see Step #4). 

Step #3 – Rollover or transfer?: After setting up a new self-directed IRA, the structure needs to be funded, which can be done in one of two ways.  One option is for the account holder to request a “rollover” – meaning that the old retirement plan administrator sends a check to the account holder that is made out to either the account holder personally or the new IRA custodian.  The account holder must then deposit the check into the new IRA within 60 days.  If the client fails to deposit the check in time, the entire amount will generally be treated as a taxable distribution.  The second option involves the account holder requesting a “trustee-to-trustee” transfer – in which the funds move from the old custodian to the new custodian without the client coming into physical possession of the funds.  For numerous reasons, the second options is preferred in most cases.

Step #4 – IRA or IRA/LLC: Let’s assume for a moment that the account holder’s goal is to invest into a piece of residential rental real estate.  Once the new self-directed IRA is funded, the account holder needs to decide whether he or she is going to invest the money directly out of the IRA (i.e. the IRA custodian buys the property on behalf of the IRA) or whether the IRA is going to purchase an LLC and invest using the LLC’s name and bank account.  With the account holder serving as the “Manager” of the LLC, the latter option allows the purchase of property using a check from the LLC, which depending on the custodian’s ability to move quickly, will likely speed up the property purchase.  Also, the IRA/LLC model will reduce the future costs due to reduced custodian involvement (i.e. lower fees).  For tax purposes, because the LLC is a “flow-through” tax entity, investments made using either method are normally tax-deferred (note: there are major exceptions to this tax-deferred treatment; for example, if the LLC operates an active business and/or uses debt-financing, the IRA will incur income that is not entirely tax deferred and the IRA must file a tax return).  However, the control and flexibility allowed by the IRA/LLC creates problems if the client does not operate the structure in a legal fashion.  For example, if the IRA/LLC structure interacts with certain individuals (aka “disqualified people”), the entire IRA can lose its tax-exempt status and be taxable to the IRA account holder all in one year.

2 comments

Self-Directed IRA–Retirement Dream or Tax Nightmare?

by Warren on March 7, 2011

Investing your retirement funds into “alternative” investments, such as real estate, privately-held businesses, private loans, tax liens, etc. can be liberating for many people, but beware of tax landmines.

To start with, what is a self-directedIRA? The vast majority of people that have a retirement plan (whether it’s in the form of an IRA, 401(k), 403(b), etc.) have their money invested in traditional types of investments, like stocks, bonds, or mutual funds. However, the general rules governing an IRA allow for any type of investment, except for investments into life insurance contracts and collectibles (e.g. rare coins, antiques, wine, etc.). That sounds great in theory, but in order to actually invest your retirement funds into assets outside of the stock market you will need to place your retirement plan with a specific IRA custodian to allow this type of investment. In other words, the company that holds your retirement account (Charles Schwab, Fidelity, etc.) must be able to facilitate the investment or you are out of luck. This realization leads many people to an internet search engine…

Typing “self directed IRA” into Google will bring a bevy of results. Many of the top results will be sponsored links from companies that would like to assist you in setting up one of these structures. You will also find many articles and commentaries on the topic. However, the information online, as with many complicated topics, will result in a wide variety of information, ranging from very helpful to blatantly wrong. In addition, it’s likely that questions will immediately come to mind, such as: “What does checkbook control mean?”, “What is a ‘custodian’ and what role do they play?”, and, “How do I make this happen?”

There are two basic methods for investing your retirement funds into alternative assets and both require you to first “roll” (aka “transfer”) your current retirement assets into a new IRA held by a specialized type of custodian. This will likely raise the first major snag: am I even allowed to move my retirement funds from their current location? This is a question that you will need to ask your current custodian, but in general, IRAs and most 401(k)s from a previous employer are able to be rolled tax-free into a new IRA. Once you determine that you are allowed to move your retirement account, you will need to decide the exact method you will use to purchase the alternative assets.

Let’s assume for a moment that your goal is to invest into a piece of residential rental real estate. You can either: (1) request that the new custodian purchase the property directly on behalf of the IRA; or (2) you can direct the custodian to first invest the IRA into a Limited Liability Company (LLC) that is thereafter 100% owned by the IRA and purchase the property using the LLC. With you serving as the Manager of the LLC, the latter option gives you the flexibility to purchase the property using a check from the LLC’s checking account, which depending on the custodian’s ability to move quickly, will likely speed up the property purchase. For tax purposes, because the LLC is a “flow-through” tax entity, investments made using either method are normally tax-deferred (but see more on this below), just like investing into stocks, bonds, mutual funds, etc. using an IRA. The method of setting up an IRA-owned LLC structure is normally facilitated by a third-party company or law firm – hence the ads on Google.

Once you have set up your self-directed IRA structure, it is vital to be well-informed of the federal and state rules and regulations prior to investing. According to federal law, if you use the structure in a way that creates a “prohibited transaction,” the IRA will lose its tax-favored treatment and the entire value of the IRA (not just the amount involved in the specific transaction) will be taxable to you in one year. In addition, if you are under the age of 59 ½ and/or the prohibited transaction is discovered (e.g. by an IRS audit) several years after it occurred, you could face substantial penalties and interest charges. The most common way for a prohibited transaction to occur is an interaction between the IRA (or IRA-owned LLC) and a “disqualified person” – which includes the account holder of the IRA, his or her spouse, many of his or her family members, and certain businesses and business partners associated with him or her. Also, if a disqualified person personally benefits from the IRA’s (or IRA-owned LLC’s) investments, a prohibited transaction will occur. The classic violation of this rule occurs when the IRA account holder tries to use the property owned by the IRA (or IRA-owned LLC) for his or her personal benefit – think: vacation property in Hawaii.

In addition to prohibited transaction concerns, it is possible for the IRA (or IRA-owned LLC) to invest in a manner that creates immediate tax consequences to the IRA itself. As mentioned above, an IRA’s investment income is normally tax-deferred until a later date when the IRA account holder removes the money from the IRA. However, if an IRA invests using debt-financing (i.e. a mortgage) or earns income from an active business, the IRA’s income is not tax-exempt and the IRA will have to file a tax return and pay a tax. Although this situation complicates the filing requirements imposed on the IRA (or IRA-owned LLC), it is not illegal.

Finally, if all of the above was not enough, you must also be properly educated on the following issues prior to investing out of a self-directed IRA:
(1) State-specific issues that can apply to alternative types of IRA investments (e.g. possible state, county, and city filing requirements).
(2) Dealing with expenses that arise from alternative types of investments (e.g. real estate maintenance costs, property taxes, etc.).
(3) Proper record keeping in order to prove, if necessary, that none of the above prohibited transaction or tax issues arose.
(4) How to deal with on-going IRA contributions and eventual IRA distributions.

Despite all of the complexities and tax issues that the account holder of a self-directed IRA will need to address (often times with the help of an experienced tax attorney), many clients find these structures to be helpful in achieving their long-term goals of retirement plan diversification and growth.
___________________
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.

Warren L. Baker is a tax attorney with Amicus Law Group in Seattle. As the lead attorney in Amicus Law Group’s self-directed IRA tax consulting group, Warren assists clients in complying with the federal rules and regulations involved when investing their retirement funds into “alternative” assets (e.g., real estate). Warren is also a member of the Amicus estate planning group, and although his tax background and experience allow him to handle even the most complex planning issues, he enjoys working with clients that have a wide range of personal wealth.

Warren earned a Bachelor of Science degree from the University of Washington, a Juris Doctor (J.D.) from Seattle University School of Law (cum laude), and a Master of Laws (LL.M.) in Taxation from the University of Washington School of Law.

1 comment