By Adam Beaty

Isn't there so much more you could be doing with your IRA instead of investing it in mutual funds, stocks, and bonds?

It seems that by putting "better" investments into your IRA, you could gain a better return and, thus, a better retirement.

Most custodians that are going to hold your IRA account are going to limit your investment choices to those mutual funds, stocks, and bonds. There are a few custodians out there that will open a self-directed IRA on your behalf.

With a self-directed IRA you are given many more investment options. Options to invest into businesses, limited partnerships, and even directly into real estate.

Now, just because you are given these options doesn't mean you should rush out and make those investments. There are a few caveats that you need to be aware of before making alternative investments with your IRA. The IRS has set very strict rules that are incredibly easy to break.

What is a Self-Directed IRA?

Most custodians will allow you to open a traditional IRA that holds very simple and easy-to-own investments. These investments can be in stocks, bonds, mutual funds, and exchange-traded funds. For the investor and the custodian this is an easy process that doesn't require a lot of oversight. In fact, rarely are any of these transactions prohibited, so the chance of messing up is slim.

Big-box custodians don't want to take on the extra work of managing investments outside of these more standard investments, nor do they need to. This, in turn, has opened the door for companies to come in and specialize in IRAs with alternative investments.

Companies such as Equity Trust, Pensco, and Entrust Group all offer the option of a self-directed IRA.

The self-directed IRA is still a traditional IRA. The account is funded with pre-tax money and the money withdrawn will be taxed as ordinary income. If you withdraw money before the age of 59½, there will be penalties.

These companies allow you to invest your IRA funds into alternative investments which include limited partnerships, small businesses, and directly into real estate.

Investing in real estate with an IRA became very popular in the 2000s real estate boom.

There are some investments that are still prohibited. Investments such as life insurance, collectibles (minus some precious metals), and S corporations are all still prohibited from being owned by any IRA account.

The real trap for using a self-directed IRA is that it is up to you, the account owner, to make sure you don't break any rules. Most people believe that the IRA custodian would stop them from breaking the law and place their IRA in jeopardy but that is not true. An IRA custodian may stop some of the bigger rule breaks, such as letting you invest in life insurance, but they will not monitor what you do with your money outside of that. There are multiple ways to break the rules by making alternative investments with your IRA.

Beware Disqualified Persons

The first thing you must understand when making alternative investments with your IRA is who you can and cannot do business with. If you are investing in normal mutual funds, stocks, and bonds, you do not need to worry about this.

The IRS stipulates that your IRA can not benefit you or any related parties outside of the IRA. A disqualified person includes the fiduciary to the account, which includes the IRA owner, any member of the family, a corporation, partnership, trust, or estate where 50% or more interest is owned by you or a related person, or an officer, director or 10% or more shareholder of any entity described above.

Basically, if you or your family will benefit at all from your IRA investment, it is prohibited. You cannot use your IRA to invest in your brother's business. Your brother would gain from that transaction, so it is prohibited. You cannot invest in a business that you own, because you will have gained from it.

If you are investing in real estate, you cannot rent, sell, or give away for free any part of the property to yourself or anyone related.

What happens when you do break the rule and transact with a disqualified person?

The IRS will levy a penalty on the amount involved in the transaction. The initial penalty is 15% of the amount involved for each year. If the transaction is not corrected within the taxable year that it was discovered, the penalty jumps to 100% of the amount involved. If more than one person was involved in the transaction, all parties could face the penalty. As you can see, the penalty is steep for doing transactions with a disqualified person. If you go down this route, it is best to make sure that nobody you know will be on the other end of your IRA transaction. The worst news is that this penalty is not as severe as the IRS gets with IRA transactions.

Beware Disqualified Transactions

Now that you know you cannot make investments with your IRA that are related to you or someone you know, there are transactions that you must be careful of, too.

You cannot sell, exchange, or lease property to a disqualified person. It doesn't matter if the sale, exchange, or lease is done for a profit, loss, or at fair-market value. If you sell a house to yourself, rent a room to your child, or give your mother a piece of land that is owned by your IRA, this is a prohibited transaction.

You cannot lend money or extend credit to or from your IRA with any disqualified person. Again, it doesn't matter if this ends up being a gain, loss, or wash transaction.

You cannot furnish goods, services, or facilities with any disqualified person, nor can you transfer, use, benefit, or deal assets from your IRA that benefit a disqualified person.

The penalty for this type of transaction is a lot more severe. The IRS will treat the complete IRA as disqualified. The entire IRA is treated as a distribution, and normal penalties and tax will be assessed on the distribution.

Here's an example: You have a $1 million IRA, and with it, you use $200,000 to invest in a house. You decide to rent that house to your brother at fair market value. Once the IRS finds out, they will deem this a prohibited transaction with a disqualified person. They will tell you that the entire $1 million IRA is being treated as a distribution. If you are under the age of 59 ½ you will be assessed a 10% penalty ($100,000), and you will have to include the $1 million as income and pay ordinary income tax on it. That is a steep penalty.

Why You Never Invest in Real Estate in an IRA

You may be thinking that you could take this chance and just not let your IRA benefit a disqualified person. After all, how difficult could it be to not rent, sell, or lease to a family member?

It seems easy enough.

Don't forget that a disqualified person also includes yourself, and a prohibited transaction includes rendering of goods, services, transfer or use of the asset. That means, if you walk into your rental house and change out the burned-out light bulb, you have rendered a service to that property. This has now become a disqualified transaction benefiting a disqualified person.

If you own a piece of land that has a pond on it, and your family wants to go fish in the pond, you just committed a prohibited transaction.

Basically, if you want your IRA to own real estate, you or anyone related cannot set foot on the land, ever.

You must hire everything to be done and you must pay for the expenses from the IRA. You cannot pay the expenses out of your own pocket. Any income received from the property must be paid directly to the IRA. If you were to place the income in your own bank account before moving it to the IRA you have commingled funds, and this is prohibited.

It is very easy to break one of the IRS rules against prohibited persons or prohibited transactions. This becomes especially true if your IRA is involved in real estate.

If you do decide to own real estate with your IRA, you and related parties should expect to never set foot on the property. Doing very little to benefit yourself or the property can immediately deem it a prohibited transaction and the penalty can be fierce.

It is not up to the IRA custodian to tell you what you are doing is wrong. They will simply allow you to purchase the asset in the IRA. What you do after that is beyond their scope. Most traditional IRAs will never even have to worry about these rules. You or a related party would have to own a large portion of a public company to be considered a disqualified person.

About the author: Adam Beaty is a Certified Financial Planner, specializing in pre-retirees/retirees, at Bullogic Wealth Management.