Self-Directed IRA Article Series – Part 2 – What Clients are Doing and Why

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[To view Part 1 (“Formation”), click here.]

In 2011, I published a six-part article series entitled “Investing Retirement Funds into Non-Traditional Assets using a Self-Directed IRA”.  Because readers found that information to be useful as a “starting point” for learning about self-directed IRAs (perhaps because it was less “technical” than many other articles I have written), I have now revamped those articles and will post them periodically .  Part 2 is below… 

In my last article, The Self-Directed IRA – Part 1: Formation, I began to discuss a method of investing retirement assets into “non-traditional” types of investments (e.g. real estate, loans, privately-held businesses, precious metals, etc.) using a specialized type of IRA (often referred to as a “self-directed IRA”).  Some 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.  The reason for this is that the LLC operates almost entirely out of a business checking account, with the “Manager” of the LLC being the authorized signer on the account.  However, special care must be taken to avoid significant legal/tax pitfalls when investing using self-directed IRA or IRA-owned LLC.

One question that people ask me on a regular basis is WHY a client would invest in this manner.  Based on thousands of conversations I have had with individuals and groups of investors, these self-directed IRA structures appear to have grown dramatically in popularity due to many different factors, including:

  • Many people have a general distaste for “traditional” stock market investments.  Many clients start our first conversation with a statement like, “I don’t trust 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. 2010-2014) or down (e.g. 2008-2009).  Personally, I don’t take a position on whether a client should or should not invest his or her retirement funds in the stock market – that is a job for the client’s financial advisor.
  • 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.  The particular year in question, the advisor achieved a 35% return despite the market appreciating by “only” 25%.  Despite this result, the client requested that all of his assets be removed from the stock market.  When the advisor asked why, 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 10-15 years has only made the problem worse.
  • With diversification in mind, 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.  For numerous reasons, 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 (i.e., assets that are not easily turned into cash).  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” (under Section 4975 of the Internal Revenue Code) 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 (or IRA-owned LLC).  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 [note: this topic will be addressed in much more detail in a later part of this article series].
  • 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.  Many of my clients have been very successful investing their personal funds into real estate (for example), so there is a natural tendency for these clients to lean torwards these types of investments within their IRA as well.
  • Many clients, particularly individuals who have been involved in real estate or private equity investment personally (i.e., people with specialized knowledge), feel that there are “a lot of opportunities”.  This is particularly the case because self-directed IRA structures most often purchase assets using all cash (no debt), and clients often tell me that they know a lot of people that “need cash right now,” which results in various investment opportunities.

The second question that people ask me about self-directed IRAs is: WHAT are my clients investing into using these structures.  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:

  • 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 as passive investments.  Although using debt-financing in these types of transactions is possible, it can be tricky (for example, the debt must be “non-recourse” and the income from the property becomes partially taxable to the IRA).  Also, purchasing real estate with the intension of developing or “flipping” it can lead to current taxes to the IRA.  This is because operating an active business out of an IRA (or IRA-owned LLC) is not exempt from the “unrelated business taxable income” (UBTI) rules.  [Note: UBTI will be examined in detail in a future part of this article series].  Clients have also invested into all of the following types of real estate: commercial property, raw/vacant land, condominiums, etc.
  • Loans / Promissory Notes / Hard Money Lending.  These investments generally involve 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 interest 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).  Of course, the biggest downside of loans is that the borrower could default, which can leave the IRA will little or no recourse (depending the client’s ability to secure the IRA’s loan at the outset).
  • 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., 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.  Further, because an IRA (or IRA-owned LLC) is not an eligible “S” corporation shareholder, investments in S Corps should not be contemplated.
  • 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 (i.e., in an attempt to mirror the investment returns of gold, silver, platinum, etc.) through a traditional securities account.
  • Publicly-traded securities.  The idea of investing an IRA into publicly-traded securities (i.e., stocks, bond, mutual funds) 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 establishes 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.  Also, if the “non-traditional” asset that the client wants to invest into (e.g., loans) is not currently available, many clients want to “keep the extra cash invested into something”).

To be continued…