The Self-Directed IRA—Gateway to Alternative Investments

By Gregg D. Killoren, J.D., State Banking Law Reporter and Individual Retirement Plans Guide.

Self-directed IRAs enable their owners to pursue a variety of investments beyond the more customary mutual funds, stocks and bonds to which traditional IRAs are limited. The goal is to achieve a return on investment that betters the returns generally provided by more traditional investment vehicles. While self-directed IRAs account for less than 2 percent of the country’s $4.2 trillion in IRA funds, four of the largest custodians of self-directed IRAs—Fiserv, Sterling Trust, Equity Trust, and Entrust Administration— report that the volume has soared in the last five years.

Recently, both the Wall Street Journal and New York Times have published articles featuring the advantages of self-directed IRAs and highlighting some of the more exotic investment choices made by certain IRA holders, such as musical instrument rentals. Other examples of investments made by individuals through self-directed IRAs include real estate, mortgage loans, startup businesses, foreign businesses, private jets and even racehorses. However, while the universe of possible investments is seemingly limitless, the IRS has imposed a few prohibitions and requirements. A self-directed IRA owner's failure to heed the IRS rules may have serious tax consequences for the plan's assets.

Prohibited Transactions

Under Code Sec. 408(e)(2), the assets of an IRA plan must be invested to benefit only the IRA plan itself. Thus, the IRA owner may not use the assets in a self-serving or self-dealing manner. In general, Code Sec. 4975 prohibits IRA plans from selling, leasing or lending property and from providing goods and services to disqualified persons. The definition of a disqualified person includes: the IRA owner, the IRA owner's spouse, the IRA owner's ancestors and lineal descendants (for example, parents and children), spouses of the IRA owner's lineal descendants (that is, son- or daughter-in-law), investment managers and advisors, anyone providing services to the IRA (such as the IRA trustee or custodian) and any corporation, partnership, trust or estate in which the IRA owner has a 50-percent or greater interest. A determination of self-dealing is made based on the facts and circumstances of each case and thus may be highly subjective.

Engaging in a prohibited transaction results in a loss of the IRA's tax-exempt status, and the IRA owner is deemed to have received a total distribution on the first day of the tax year in which the prohibited transaction occurred. This constructive distribution must be included in the individual's income for the year and is subject to a 10-percent penalty on premature distributions for individuals, except those who have reached age 59 ½ or are disabled. Any income earned by the account is also taxed to the individual.

Prohibited Investments

In addition to prohibiting certain transactions, the IRS has also banned IRA plans from investing in certain assets. No part of an IRA plan's assets may be invested in life insurance, under Code Sec. 408(a). Also, in a private letter ruling, the IRS has prohibited an IRA from investing in S corporation stock.

Further, Code Sec. 408(m) generally bars an IRA plan from investing in collectibles. The term "collectible" includes any work of art, rug, antique, metal, gem, stamp, coin, alcoholic beverage or other item of tangible personal property specified by the IRS. The term “collectible” does not include certain gold, silver or platinum coins or any gold, silver, platinum or palladium bullion of a fineness equal to or exceeding the minimum fineness that a contract market requires for metals that may be delivered in satisfaction of a regulated futures contract, if such bullion is in the physical possession of a trustee.

If an IRA does invest in collectibles, the IRA is considered to have made a distribution in an amount equal to their cost. However, the IRA plan would not otherwise lose its tax-exempt status.

Unrelated Business Taxable Income

Finally, the owner of a self-directed IRA must be aware of unrelated business taxable income (UBTI). IRAs are taxed on UBTI, which is defined as income less allowable deductions from any regularly carried trade or business that is not substantially related to the IRA's purpose of providing retirement income for the IRA owner. An unrelated business is defined as any trade or business that is not substantially related to the purpose or function of the trust and is regularly carried on by such trust, for example an IRA, or by a partnership of which it is a member. Sources of UBTI are business operations, partnerships and debt-financed property.

Income derived from UBTI is not tax-deferred, and consequently the IRA plan must pay current taxes, usually quarterly, on such income. Any UBTI tax due must be paid from self-directed IRA assets, not by the IRA owner. If the IRA owner pays the tax, it is considered an IRA contribution, subject to the contribution limits.

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