Thinking of a Self-Directed IRA (part 2)

2. IRA custodians and IRA LLC facilitators often miss legal and tax problems. It never ceases to amaze me when IRA account owners tell me that what they have done with their IRA (or IRA LLC) – or what they plan to do in the future – is okay “because their custodian said so.” There are numerous problems with this statement. First, IRA custodians and IRA LLC facilitation companies are not in the business of advising IRA owners on the subtleties of IRA legal and tax issues. These companies do not practice law, provide financial advice, or otherwise provide their clients with investment or tax advice. In fact, all IRA custodians and IRA LLC facilitators have language in their contracts that say things like “you are solely responsible for the success or failure of your account” or “we are not advising you on legal or tax issues.”

Second, although IRA custodians do their best to train their representatives to recognize obvious legal and tax problems, the ultimate motivation of IRA custodian and IRA LLC facilitator employees is to establish as many accounts as possible (i.e. more commissions). The result is that these representatives often glaze over the legal parameters and/or ignore key facts that might cause legal and tax problems. After all, it is not the employee’s problem if the IRA account holder violates the IRA rules.

The third potential problem with relying on the advice provided by an IRA custodian or IRA LLC facilitation company is that not all IRA legal and tax issues are “black and white.” For example, the “prohibited transaction” rules (which, if violated, can result in an IRA being treated as fully distributed to the IRA owner in one lump sum = terrible tax consequences) state that a “disqualified person” includes an IRA account holder’s spouse – in other words, no financial interactions can occur between the IRA and the IRA account holder’s spouse. However, this does not mean that a loan from IRA to the IRA account holder’s girlfriend is legally proper. In fact, the IRS has the ability to scrutinize any IRA investment that creates a “conflict of interest.” This is a simple example of the intricacies involved in the federal law that IRA custodians and IRA LLC facilitators either are not aware of or choose to ignore.

3. IRA tax returns – the tax compliance black hole. Many self-directed IRA (and IRA LLC) account owners are completely unaware that there are certain situations where the income earned by their self-directed IRA is not exempt from current tax (i.e. their IRA must file a tax return and pay a tax). Generically speaking, these situations occur when the IRA earns income that is “debt-financed” for from an “operating business.” However, the devil is in the tax details when it comes to these situations. In addition, because the IRA custodians and IRA LLC facilitators take a completely hands-off approach, many of these situations are entirely unreported to the IRS, and thus lead to a potential ticking time bomb (think: IRS audit).

For example, consider a situation in which a self-directed IRA (or IRA LLC) invests into a real estate partnership that has four other owners (which might or might not be other IRAs). The partnership then uses the initial investors’ funds along with a bank loan to purchase a piece of vacant land. The partnership then builds several houses on the property and sells all of them for a substantial profit. At the end of the tax year, the partnership will issue tax forms to the investors showing each investors’ share of the partnership’s gain. For the IRA investor, the forms will go to the self-directed IRA account holder (or IRA LLC’s Manager). This situation will definitely trigger a tax filing requirement for the IRA (due to development being considered an operating business and/or due to the debt-financing), but unfortunately the IRA custodian might never realize that this situation has occurred. Further, if the IRA account holder is unaware of the rules, a “tax compliance black hole” will emerge.

Summary: The issues above demonstrate the importance of IRA account holders speaking with experienced legal and/or tax professionals before moving forward with a self-directed IRA (or IRA LLC) formation and investment. If there is one thing that my experience with self-directed IRA investors has taught me, it is that up front education is critical in order to prevent both immediate and long term legal and tax compliance violations.