3 Self-Directed IRA Issues To Understand ... Before You Take the Plunge | Ed Slott and Company, LLC

3 Self-Directed IRA Issues To Understand ... Before You Take the Plunge

By Jeffrey Levine, Director of Retirement Education
Follow Me on Twitter: @IRAGuru4EdSlott

The increase in investment opportunities that are often available in self-directed IRAs can be enticing, but these investments often present unique challenges that should be proactively addressed. The list of challenges is long, but here are three of the most important things to consider before you establish a self-directed IRA accounts.

 

  1. Losing out on Potential Tax Benefits

    Certain tax benefits can be lost that would otherwise be available if the same investment was made in your non-IRA account. For example, real estate is one of the more common holdings in self-directed IRA accounts. If you own real estate (a building) within your IRA account, the ability to deduct depreciation – one of the biggest tax advantages of owning real estate – is lost. In addition, while the sale of real estate with a gain within your IRA would not trigger a tax, when the funds are eventually distributed, tax will be paid at ordinary income tax rates. On the other hand, if the property were purchased outside of a retirement account, as a capital asset, gains on the sale of the property would potentially be taxed at long-term capital gains rates, which would be lower. Of course, gains in a self-directed Roth IRA would be tax-free if distributed as part of a qualified distribution. Furthermore, if the piece of real estate was held outside of your IRA and was not sold during your lifetime, your heirs would generally receive a step-up in basis, completely eliminating any capital gains tax on appreciation that had occurred before your death. In contrast, there is no step-up in basis on property held within your IRA when you pass away.  
     

  2. Financing Issues

    Obtaining financing for investments within self-directed IRAs can be tricky. All transactions must be at “arms-length” and you cannot, in any way, personally guarantee a loan made to your IRA. That would be a prohibited transaction. One solution would be to obtain a non-recourse loan (with no personal guarantee), and there are some companies that do this, but getting a non-recourse loan is often more difficult to obtain than other types of financing that would offer the lender more protection. Even if you’re able to obtain a non-recourse loan, the income generated by your IRA investment that’s attributable to the portion of the investment financed by debt will be subject to a special tax called the Unrelated Debt Financed Income(UDFI) tax. Yep, that’s right. Your IRA or Roth IRA (not you) can actually owe tax and be responsible for filing the appropriate tax returns to report the income.
     

  3. Unrelated Business Income Tax 

    Similar to the UDFI tax discussed above, there is another tax called Unrelated Business Income Tax (UBIT) that is assessed if a tax-exempt entity, such as your IRA, engages in a business activity that is not related to its general purpose. For example, if your self-directed IRA purchases a sandwich shop, the income generated from the business would be subject to UBIT. Though they may be delicious, making sandwiches is definitely not the general purpose of an IRA! This tax was created to keep tax-exempt entities on a level playing field with non-tax-exempt entities. Oh and don’t forget, thanks to the arms-length rules, you generally can’t run the sandwich shop yourself. In fact, you probably shouldn’t even eat there!

 

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