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Self-Directed IRA: An Exotic Investment Grocery Store

This type of retirement account is meant for non-traditional types of investments, and the pitfalls can be costly.

By Andy Ives

The term “self-directed IRA” can be confusing, given that account owners choose whichever stock or mutual fund they want to buy within their IRA, and how much to purchase and how much to sell.

A better term for a self-directed IRA might be “non-traditional investment IRA.” A self-directed IRA is like an exotic grocery store where you can find unconventional foods and ingredients. Privately held start-up companies? Aisle 3 in the exotic grocery store. Rental properties? Aisle 6. Cryptocurrency? Aisle 10.

These items are just a few of the non-traditional investments you can own within a self-directed IRA.

“Self-directed” also carries the implication that the responsibility to correctly manage the IRA falls on the account owner. A self-directed custodian will be less “hands on” than a standard IRA custodian. 

For example, if a client wants to invest in a racehorse within a self-directed IRA, they can do so, but the custodian will not provide a valuation for that horse. That responsibility falls to the IRA owner. Additionally, if they take a distribution from your self-directed IRA of non-publicly traded stock, they need to provide a legitimate valuation of that stock so the custodian can accurately report the withdrawal to the IRS on a 1099-R.

We have seen instances in the past where self-directed IRA owners tried to game the system with valuation scams. In the Gist and Berks cases (Steven C. Gist et ux. v. Commissioner, T.C. Summ. Op 2014-1, No. 16065-12S, January 6, 2014; Bernard L. Berks et ux. v. Commissioner, T.C. Summ. Op. 2014-2, No. 26883-11S, January 6, 2014), both individuals took distributions of property from their IRA accounts. However, to minimize taxes due, they claimed the property was worthless. The custodian was uncomfortable with such a valuation and, in turn, issued a 1099-R for the last known value of the property. Since neither Gist nor Berks provided any evidence that the property was, in fact, worthless, the tax court ruled that taxes were due.

Annual valuations are not the only hurdle within a self-directed IRA. Liquidity can be a major obstacle for those who need to take a required minimum distribution. If a person holds an office building as their only IRA investment, they better keep some of those office rents in cash to cover the RMD when the time comes. The same holds true for other real estate, like a beach rental property within an IRA. You can’t cleave off the balcony and take it as your RMD.

Another potential issue with a self-directed IRA is Unrelated Business Taxable Income (UBTI). You might ask, “Unrelated to what?” To that I say, “Unrelated to the purpose of the IRA, which is to provide income at retirement.” Without getting too deep into the weeds on UBTI, know that some alternative IRA investments can generate this tax. While more standard IRA investments are exempt from UBTI and will not be taxed until they are distributed, the more atypical ventures could create a tax liability now. 

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Even if the investment and earnings remain in the IRA, this tax could still be applicable. (See IRS Publication 598, Tax on Unrelated Business Income of Exempt Organizations, for a list of items subject to UBTI.) UBTI must be reported on IRS Form 990-T by the custodian when the income exceeds $1,000. For an IRA, UBTI is calculated at trust income tax rates.

Valuation issues and UBTI aside, if an IRA owner violates any of the IRA investment rules, a prohibited transaction could occur. This means the IRA loses its qualified status, and the entire IRA is deemed distributed. Taxes and any penalties would then apply. “Creative” investments within self-directed IRAs can bring the possibility of a prohibited transaction much closer into view.

Example: Roy purchases a barbecue restaurant within his self-directed IRA. The income generated from the barbecue joint will be subject to UBTI. The tax on this income is not deferred and must be paid by the IRA. The tax is paid with the IRA assets. If Roy pays the tax with non-IRA dollars, it is considered a contribution to his IRA.

Roy is not allowed to work at the barbecue restaurant, nor should he ever eat there. (In fact, based on the prohibited transaction rules, neither should his spouse, children, or any lineal descendants.)

The rules against self-dealing with IRA investments are clear. Any violation, and Roy could be staring at a prohibited transaction. A pulled pork sandwich with a side of mac n’ cheese and sweet tea could cost Roy the qualified status on his IRA dollars. The entire account could be deemed to have been distributed, and all taxes would be due.

Know that the IRS is peering over your shoulder. Box 15a on IRS Form 5498 (“FMV of certain specified assets”) is for reporting the fair market value of hard-to-value assets within the IRA (like a racehorse or a BBQ restaurant). Box 15b shows the type of hard-to-value asset. Codes in this box cover such investments as “stock or other ownership interest in a corporation that is not readily tradable on an established securities market,” ownership interest in an LLC or similar entity, real estate, option contracts, and other assets that do not have a readily available fair market value. (My guess is a racehorse would garner a Code G, which in itself would be a great name for said horse.)

An IRA is no place to recklessly experiment with a new investment recipe. Before purchasing items at an exotic grocery store, you must understand how to prepare the ingredients. Before diving headfirst into a self-directed IRA, IRA owners must know the risks, potential pitfalls and tax ramifications of certain investments. A knowledgeable financial adviser can provide valuable guidance prior to a self-directed IRA shopping spree.

About the author: Andy Ives, CFP, AIF, is an IRA Analyst with Ed Slott and Company, LLC with over 20 years of experience with IRAs, retirement plans and investments. Andy has worked directly with financial advisers, third party administrators, mutual fund companies and end-user clients, both corporate and individual.

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