Self Directed IRA
What is an a "SELF DIRECTED IRA"?
- An SDIRA is an IRA (Traditional or Roth) established with a custodian* (special broker) that facilitates investments into any qualified* investments
- Created by rolling over existing IRA/401k OR can also establish a new IRA with a SDIRA custodian and has same contribution limits as typical IRA
- YOU choose the investments, the broker facilitates the investment and paperwork!
Why establish an SDIRA? Why invest through an SDIRA?
- Gives you the ability to invest money outside of the stock market
- Provides you access to a diverse set of investments
- Grants you more flexibility with your investments to maximize retirement account returns
What can an SDIRA invest in?
- Real estate
- Promissory notes
- Precious metals
- Private company stock
How do you create a SDIRA?
- Set up an account with a SDIRA custodian (takes less than 15 minutes)
- Fund the account with new funds or rollover from IRA / previous employer 401k
- Custodian will initiate transfer from existing IRA / 401k
- Send broker the investment opportunity and documents
- Custodian reviews documentation to check for prohibited transaction
- Custodian releases funds
- As investment earns money, funds are sent to your retirement accoun
SDIRA Investment Limitations
- SDIRA accounts are allowed to invest with any person or company that is not a "disqualified person"
- SDIRA accounts are not allowed to invest with a "disqualified person"
- Example: Your IRA is not permitted to invest in a company that is fully owned by you and or your spouse
- Disqualified person is implied if the person owns 50% or more of the company
- Investing with a "disqualified person" is a "prohibited transaction"
3 Types of prohibited transactions: per se, personal extension of credit, self-dealing
- Per Se - when an IRA engages in a transaction with a disqualified person
- Personal guarantee or extension of credit - IRA owner cannot guarantee a loan or obtain a loan personally on behalf of SDIRA.
- Must use non-recourse debt or have someone that’s not disqualified take on recourse. IRA cannot lend or take credit to/from disqualified person.
- IRA can participate as a cash investor and have other partners that are not disqualified guarantee the loan
3. Self-Dealing - when the IRA owner or other disqualified person benefits from IRA’s investments
Consequences of prohibited transaction (can vary, but typical)
- Creates a tax event
- Entire IRA becomes disqualified - entire account is distributed based on fair market value
- Amounts distributed are subject to ordinary income tax and early withdrawal penalty of 10% on gross distribution
- Not a legality issue, just loss of tax advantaged status for the IRA
- One strategy implemented is to create multiple IRA so that if one IRA somehow is deemed to have engaged in a prohibited transaction, only that single IRA is impacted
SDIRA investing, UBIT and UDFI
UBIT- Unrelated Business Income Tax is a form of tax that is required to be paid on certain IRA investments. The tax is based on ordinary income received by an IRA and is taxed at 39.5% for income earned over $11,950 per year. UBIT CAN BE avoided through choosing correct SDIRA investment vehicles!
Common investments that cause UBIT:
UDFI- Unrelated Debt Financed Income is income that is received by an IRA account that is attributable to an investment that has debt. Common example of this is your IRA owning a rental house that has a bank mortgage. Income that is generated under UDFI is subject to UBIT.
UDFI Overview
- UDF Income is paid at the UBIT tax rate
- Applies to both operating income each year and capital gains at sale of business or property
- Includes all debt financing on business or property
- Requires a separate tax ID from IRS for the IRA to report and pay 990-T taxes
How is UDFI calculated?
- Determine ratio of debt (average for the year) vs basis of the property (cost minus any depreciation); debt/basis
- Ratio is multiplied by income from property - this is subject to UDFI
- Simple Example
- Average Debt $50,000
- Property Basis $100,000
- Ratio = 50%
- Income = $20,000
- Subject to UDFI = $10,000