Self-directed IRAs

Self-directed IRAs
What is the difference between a regular IRA and a self directed IRA?
A self directed IRA and a regular IRA are similar in many ways. The major difference is that with a self directed IRA, you are allowed to make the investment choices versus a custodian who is in charge of your typical non-self directed IRA.  Often the custodian of a non-self directed IRA may say that you can invest as you wish but impose restrictions when you attempt to make investments that will not benefit the custodian. With a self directed IRA, the only restrictions are the ones you impose on yourself, except for prohibited transactions.  For a discussion of prohibited transactions, see FAQ number 14 below.
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Is it legal to purchase non-traditional assets using my IRA?
Yes. The Employee Retirement Income Security Act (ERISA) of 1974 passed the responsibility of retirement saving from the employer to the employee. Created in 1975, IRAs provide individuals a chance to direct where their retirement funds are invested.

The Internal Revenue Code, instead of distinguishing which investments are allowed, identifies which investments are not permitted under these laws. Under both ERISA and the Internal Revenue Code, there are only two types of investments excluded: life insurance contracts and collectibles such as works of art, rugs, jewelry, etc. Refer to Internal Revenue Code Section 401 (IRC § 408(a) (3)).

To fully maximize your investment options, you need to have a retirement plan that allows you to select your own investments. A truly self-directed retirement plan allows you the freedom to invest in many types of assets -- assets that are not prohibited by the Treasury Department regulations and the Internal Revenue Code.
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How come I haven't known about this?
It’s a common misconception that the only investments allowed in a retirement account are stocks, CD’s, and mutual funds.  The truth is that broader investment options have been available to the public since the inception of the IRA in 1975.

The retirement industry has been dominated by large transaction-driven custodians who have focused on a narrow universe of investments.  While these kinds of accounts may be right for some, they don’t offer the kind of freedom that a self-directed qualified retirement plan offers.
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Are there a lot of people who have accounts?
The self-directed industry is growing at a rapid pace and is expected to see over $2 trillion enter the market in the next couple of years.  There are over 45 million retirement account holders, and less than 4% of those funds are held in nontraditional assets. This number is expected to grow significantly over the next five years as more individuals and their financial advisers become more educated about self directed IRAs.
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My (CPA, attorney, broker, friend, other person) said that buying and selling real estate in my self directed IRA was illegal. Why?
They may be influenced by self interest or they may simply be uninformed.  Attorneys generally stick to their core competencies and rarely deviate from them.  Tax preparers are taught to do just that - prepare taxes.  Your financial advisor’s company or agency may either be disinterested in this type of business or have not been educated regarding this type of investing format.  A stock broker makes money when they sell stocks, bonds and mutual funds - not real estate or other types of investments.
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What types of retirement accounts can I place in my self directed IRA accounts?
There are many different types of retirement accounts that you can place in your self directed IRA accounts.  These accounts include 401(k)s, educational IRAs, qualifiable annuities, Keoghs, traditional IRAs, 403(b)s, money purchase plans and eligible government deferred compensation plans.  If you are uncertain, the tax attorneys at McLaughlin & Quinn, LLC or your self directed IRA custodian can help with additional questions you may have about which other types of retirement accounts you can place in your self directed IRA accounts.  Additionally, to be completely sure whether your funds are eligible for a rollover you will want to contact your current 401(k) provider.
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What are "IRA transfers" and "IRA rollovers"?
A "rollover" occurs when an individual requests a distribution from an IRA/QRP (Qualified Retirement Plan) and then "rolls" the assets into another IRA.  An individual is limited to one rollover per year.  A "transfer" is when IRA assets are moved directly from one financial institution to another without the IRA owner taking possession of the assets. Unlike rollovers, there is no limit on how many transfers can be executed in a year.
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Is there a downside to investing with a self directed IRA? If so, what?
With so many choices available when it comes to investing in a self directed IRA, one might imagine that there isn’t a downside.  Quite the opposite is true.  For some people, a definite downside is the fact that a self directed IRA puts you in charge.  Many people find it frightening to be in charge of their own investments and don’t want the responsibility that goes along with managing and maintaining a self directed IRA.  For these people, a self directed IRA is not right for them.
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Is Real Estate investing an option for my self directed IRA?
Yes.  Real estate is one of the investment options that can truly add value to your investments.  The arena of real estate is expansive when it comes to choices to add to your self directed IRA.  Some of the more popular choices are single family homes, duplex residential rentals, commercial properties, mortgage loans, mortgages, condominiums, raw land in both domestic and foreign countries, manufactured homes, apartment buildings and more.  In 1974, the Employee Retirement Income Security Act (ERISA) gave all self-directed retirement plans this option.  In addition to real estate, you can direct your IRA investments into, among other things, mortgages, notes, tax liens, and private businesses.  There are restrictions on some investments, but the tax attorneys at McLaughlin & Quinn, LLC or your self directed IRA custodian will help you navigate through them.
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Are there different tax rules for self directed IRAs?
The unique thing with IRAs and 401ks are the tax advantages.  Most contributions are either tax deductible as is the case of a traditional IRA or 401k, or the distributions are tax free as in the case of a Roth IRA or Roth 401k.  There are no unique rules for self-directed IRAs.
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How do I make sure I am following the rules?
The IRS does not identify what investments or transactions you can make in your IRA.  They instead state which investments are prohibited and what makes certain transactions prohibited.  Identifying, interpreting and following these rules can be complicated, but not impossible. Utilizing specially trained professionals, such as the tax attorneys at McLaughlin & Quinn, LLC can help you follow Internal Revenue Service and Department of Labor guidelines and steer clear of prohibited transactions.
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I own my own business with no employees. Can I offer self directed IRAs to myself?
If you have no employees, other than yourself, that is those are not spouses, owners or partners, the best plan may be the solo(k) or individual(k), which permits the highest aggregate percentage of contributions and flexibility.  The administration is straightforward and you are the trustee, custodian and administrator, unlike any IRA plans.
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How do I find out what the current contribution limits are for my retirement plan?
You should consult the tax attorneys at McLaughlin & Quinn, LLC or your current retirement plan administrator or trustee.
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What are the different funds I can use I can use to open a self-directed IRA account?
Most employer-sponsored plans, like 401(k) plans do not let you roll your account into a new vehicle while you are still employed.  Some employers, however, do allow you to roll a portion of your funds.  To be certain, contact your current 401(k) provider.

If you can roll your funds into a new account, here is a list of the types of accounts that are eligible:

Traditional IRA
Roth IRA
SEP IRA
SIMPLE IRA
Solo(k) or Individual(k)
401(k)
Health Savings Account
Coverdell Education Savings Account
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Can I use my 401(k) funds with my current employer to purchase non-standard assets?
Possibly.  If the company has a self-directed 401(k), you may have the ability to self-direct your 401(k) into these types of investments.  To be certain, contact your current 401(k) administrator or the tax attorneys at McLaughlin & Quinn, LLC.  We can work with your Plan Administrator regarding these plans.
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What is the deadline to contribute to an IRA or Qualified Plan?
Qualified plans must be established by the last day of your fiscal year if contributions are to be made for that year.  If you have a calendar year end, you need to establish the plan on or before the last day to contribute for that year.  The contributions may be made until your company tax year deadline including extensions.  401(k) deferrals must be made no later than 30 days after which the contributions are received.

SEP IRA and SIMPLE IRA contributions may be made by the company tax deadline plus extensions, except for defaults, which follow the above rules.

IRA contributions must be made by April 15 with no extensions.
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What kinds of investments can I make?
You may purchase real estate, secured or unsecured notes, options, private placement, accounts receivable, timber deeds, crops, cattle, stock, bonds, tax lien certificates, mutual funds, certificates of deposit, anything which is not prohibited or collectible as defined by the Internal Revenue Code.

Many other types of investments are permitted, and thus the range of possible investment choices is nearly unlimited.  Consequently, an IRA can purchase any form of real estate.

Real estate IRA investing opens up a huge range of alternative investments for individuals who are knowledgeable about real estate investing or who work with knowledgeable advisors, sponsors, or brokers.  Investing in real estate for your retirement may serve as a means to diversify your retirement portfolio to hedge against the cyclical changes in the stock market, economy and bank and government-based investments.

For many who are experienced with real estate investing, real estate investments hold the potential to protect against the loss of principal while generating better than market rate returns through income production and capital gains. When real estate investments are not leveraged, both income and capital gains can flow back to IRAs tax-deferred (or tax-free if the IRA is a Roth IRA).

If you have your IRA purchase real estate from an unrelated party and pay cash for it, and you do not use the real estate for personal reasons while it is in your IRA (i.e., you treat it strictly as an investment), there are no special issues.
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What are the limits to the investments I can make?
You cannot invest in life insurance contracts or collectibles.  Collectibles include gems, antiques or rugs, stamps or coins, works of art or alcoholic beverages.

There are also certain transactions in which you cannot participate when using IRA funds.  These transactions are referred to as “prohibited transactions”.  Prohibited Transactions are defined in IRC § 4975(c)(1) and IRS Publication 590.  These transactions were established to maintain that everything the IRA engages in is for the exclusive benefit of the retirement plan.  Sometimes professionals refer to these as “self-dealing” transactions.  Self-dealing happens when an IRA owner uses their individual retirement funds for their personal benefit instead of benefiting the IRA.  If you violate these rules, your entire IRA could loose its tax-deferred or tax-free status.  It is important that you work with one of the tax attorneys at McLaughlin & Quinn, LLC or other competent tax professional to avoid violating these rules.

Lastly, a self directed IRA cannot own share of stock in an S corporation.
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What is a prohibited transaction?
There are some transactions that are prohibited by the IRS and the Department of Labor. There are basic requirements and procedures needed to apply for exemptions from the prohibited transaction rules (includes ERISA and non-ERISA plans and Individual Retirement Arrangements). If you are considering this, please contact one of the tax attorneys at McLaughlin & Quinn, LLC.

IRA transactions must be for the exclusive benefit of the retirement plan and must not directly or indirectly benefit the IRA owner.  For example, the owner cannot:
a. Borrow money from his IRA
b. Buy property for personal use with his IRA funds
c. Use IRA assets to secure a loan
d. Sell property to his IRA
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Can my self directed IRA purchase real estate already owned by me or my spouse?
No. The not so simple details are associated with Internal Revenue Code Section 4975, which indicates that you cannot purchase property from yourself or other disqualified individuals.  Disqualified individuals includes yourself, your spouse, your lineal descendants and their spouses, your investment manager, and any corporate or other such partnership where you have 50% or more of ownership interest.
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What you can't do in an IRA with real estate?
Your IRA cannot directly or indirectly buy real estate from a "disqualified person".

You cannot have your IRA enable an investment for yourself or another disqualified person.  In other words, if the IRA's investment is deemed essential to accomplishing a transaction in which both you and your IRA invest, then the transaction would be considered a prohibited transaction.

Your IRA cannot purchase a real estate asset and then have a disqualified person use it while it is in the IRA.  For example, you cannot buy a vacation home and use it partly for personal use, even though you might rent it to unrelated persons the rest of the year.
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Who is a disqualified person?
The IRA owner; the IRA owner's spouse, descendant (e.g., son), or ascendant (e.g., mother); spouse of a descendant of the IRA holder; a fiduciary of the IRA or person providing services to the IRA (e.g., the trustee or custodian); an entity at least 50% of which is owned (or at least 50% of the beneficial interests are held) by a combination of the above (e.g., if you and your spouse own 50% of an LLC, that LLC is a disqualified person with respect to your IRA); or a 10% owner, officer, or director or highly compensated employee of such an entity.
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Who makes the self directed IRA’s investment decisions?
You do.  Your account is truly "self-directed," which means that you make the investment decisions for your retirement assets in much the same way as you invest outside of your retirement plan.  But you don’t invest alone. The tax attorneys at McLaughlin & Quinn, LLC will help you navigate the complex rules that govern prohibited transactions so you can focus on making the best investment decisions.
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How are my assets managed?
Your assets are co-managed by you and your self directed IRA custodian.  You make all investment decisions, and the custodian generally takes care of all of the paperwork and reporting details.  Once you make an investment, the custodian generally keeps your books and records, coordinates the custodianship of your assets, oversees the annual asset valuation, and files all required annual reports.
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How do I open a self directed IRA?
You can open a self directed IRA by contacting a custodian or by speaking with on of the tax attorneys at McLaughlin & Quinn, LLC.  You are generally asked a few questions regarding the type of account that you would like to open.  Then, you are provided with the account application form. Simply fill out the form, sign it, and mail it to the custodian or work with one of the tax attorneys at McLaughlin & Quinn, LLC.
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How much should I have in my account to get started?
While there is generally no minimum amount, the amount you should start with depends on the nature of the deal or investment you plan to make.  Keep in mind that if you make a cash contribution to your account, check the contribution limits for that account type.
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Can I transfer my current retirement funds to the custodian of my self directed IRA?
Yes, most application kits contain documents that assists you in transferring or rolling over your funds to your custodian.  To obtain an application kit, contact your custodian.
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Can I consolidate my IRAs?
Yes.  You can consolidate:

Your traditional IRA and SEP IRA into a single traditional IRA

A SIMPLE IRA to a traditional IRA after two years

Multiple Roth IRAs to a single Roth IRA
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I have a 401(k) plan with my former employer. How can I self-direct the funds?
You can self-direct the funds by rolling over your account into a traditional IRA or a qualified plan (if you are eligible to have a qualified plan) that permits complete self-direction.  Contact your former employer's plan administrator or benefits department to determine what, if any, special procedures may be required. Use your custodian's funding form to carry out the rollover from your former employer's plan, as well as any other special forms required.

You may roll over the assets you have in your old plan to your self directed IRA "in kind." "In kind" means that the assets you held in your old qualified plan, 401(k), or other plan are rolled "as is" into your self directed IRA.  There may be restrictions from the fund provider, broker, or annuity company about "in kind" rollovers or transfers. Your former employer will advise you about any restrictions.

If you are still employed, check with your current plan administrator to determine if self-direction is currently allowed within your plan or if this option can be added.
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How do I determine which retirement plan is best for me?

The factors to consider are:

  1. Your age
  2. Your contribution and deferral capability
  3. Whether you have common-law employees
  4. When you wish to retire
  5. Your tax situation

Most people seek to make the highest contribution to their retirement plan that they can. Then they choose the plan that gives them the most flexibility.

In any event, you should also seek the services of one of the tax attorneys at McLaughlin & Quinn, LLC or other tax professional to assist you in the proper selection of the plan best suited for you.

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How do I fund my new self directed IRA?
You may initially fund your self directed IRA in one of several ways.  At the same time you submit your application , you should indicate how you plan on funding your new IRA.  Because the time it takes for your custodian to receive funds can vary greatly, take this waiting period into consideration when planning your investment timeline.  Your self directed IRA cannot make a purchase before funds reach the custodian and have cleared the banking system.

Funding Via Transfer.  If you have decided to transfer other IRA funds into your new self directed IRA, you generally will complete a transfer request form and your custodian will forward the completed transfer request form(s) to your current custodian(s) to initiate the transfer(s). You should expect this method to take anywhere between a week and a month, depending on your current custodian.  Most take approximately 3-4 weeks to process this request.

Funding Via Direct Rollover.  If you have decided to roll over funds from a previous 401(k) or other qualified plan, you will typically submit an application to your custodian in order to open your new self directed IRA, and contact your current plan administrator. Ask them what you need to do to initiate a "Direct Rollover" to an IRA.  Once you have requested this "direct rollover", you should expect this method to take anywhere between a week and a month, depending on your current retirement plan administrator.  Most take approximately 3-4 weeks to process your request.  In some rare cases, they will want your new custodian to send a "letter of acceptance."

Funding Via Cash Rollover.  Another way to move IRA funds from your current custodian to your new self directed IRA custodian is a cash rollover.  If you are in a hurry, this is most likely the fastest method of moving cash between accounts.  You will need to request a taxable distribution from your current custodian.  If possible, ask them not to withhold taxes (because you are going to cancel out the taxable event).  You will then endorse that check over to your new IRA account by signing the back and making it payable to "ABC Trust Company Custodian F.B.O. "Your Full Name" IRA".  To avoid tax and/or penalty, you must deposit this check into your new self directed IRA within 60 days.  Note: You are only allowed to use this method once every 12 calendar months per IRA.  This method takes only as long as it takes you to get a distribution and mail it in with the necessary paperwork.
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Once I have decided to open a self directed IRA account to invest directly in real estate and have chosen a custodian, what are the practical steps that happen?
A.    Open and fund your self directed IRA with your chosen custodian and make sure the IRA will have cash in it in time to make your investment.  Before looking around for your investment, if you haven't already established and funded your self directed IRA, you will want to begin there. Before moving any further, you will at the very least, need to open an account so that you have your IRA's "name" to work with.  Always remember, it is your IRA that is making the investment - not you.

Generally, once the custodian receives your application for a self directed IRA, the application is processed and you receive your new account number.  The form of your self directed IRA's legal "name" is generally "ABC Trust Company Custodian F.B.O. 'Your Full Name' 'IRA' (or SEP IRA, Roth IRA, etc.)'Account #' ".  For example: “ABC Trust Company F.B.O. Jane M. Investor, IRA, Acct. MQ148”. With this new name, you may begin to search for your real estate investment.

B.    You must draw up all offers and/or contracts so that the buyer is listed as your IRA, not you.  Your self directed IRA should be treated as an investor separate from you, and the name of your IRA - not yours - should be used anywhere on the offer that describes the portion it is buying. Whether it is the sole buyer, or buying as a tenant in common, the documents should be vested correctly.  Your IRA's title is usually "ABC Trust Company Custodian F.B.O. 'IRA Owner's Full Name' IRA 'Account Number'". You are not allowed to transfer a contract drawn up in your name into your IRA's name.

C.    When your IRA purchases property, your IRA must fund any deposit or earnest funds necessary.  To authorize your custodian to put down a deposit from your self directed IRA, you typically complete an investment authorization form and provide a copy of the purchase contract.

D.    At closing, you, the IRA owner, must read, approve and sign all documents before sending them to your custodian for the final custodial signature.  After checking for your signature of approval, an officer of your custodian will finalize the sale by signing the documents on your IRA's behalf.  The signed documents will then be returned to the closing agent, along with funds, for processing.  All documents must be vested correctly.
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What happens to the money that isn't invested in assets?
Because all plans are self-directed, you may direct your money anywhere you wish.  Most custodians hold all your uninvested money is for your benefit in FDIC-insured accounts.  Or you can direct your custodian to deposit the funds in any financial institution.
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How fast will my custodian respond to an investment opportunity?
Once you send most custodians documentation regarding your proposed transaction and the persons to whom funds are to be sent, the custodian will send checks overnight or wire funds for you within hours of your call.  Check with your custodian for their particular requirements.
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Is Real Estate investing an option for my self directed IRA?
Yes.  Real estate is one of the investment options that can truly add value to your investments.  The arena of real estate is expansive when it comes to choices to add to your self directed IRA.  Some of the more popular choices are single family homes, duplex residential rentals, commercial properties, mortgage loans, mortgages, condominiums, raw land in both domestic and foreign countries, manufactured homes, apartment buildings and more.
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What you can do in an IRA with real estate?
Buying real estate from an unrelated party (i.e., one who is not a disqualified person) with cash is the simplest way of investing in real estate with your IRA.  Your IRA can buy raw land, commercial property, residential (e.g., rental) property, real estate options, as well as extend loans (e.g., first and second mortgages), secured by real estate with your IRA, to unrelated parties.

As discussed below, your IRA can also buy property through leveraging, provided the loan is not guaranteed by the IRA owner (or any other disqualified person) and that the IRA has enough liquidity to support the mortgage and expenses.  Most custodians have limits on the amount of leverage they will permit.  Also, as mentioned below, leveraging can result in income taxes on unrelated debt-financed income (UDFI) that must be paid by the IRA.  Generally, these taxes are higher than would be paid on income generated from a property that you buy and finance personally.  In addition, the UDFI taxes must be paid from funds from the IRA and, therefore, there has to be enough liquidity in the IRA to cover these taxes.  See IRS Form 990T and its accompanying instructions for details.

There are a variety of ways, however, that an IRA can participate in a real estate investment without a full cash capital investment.  For example, your IRA can co-invest with other parties. You could also have your IRA, and other parties participate in real estate investing by becoming members of an LLC that buys and sells property.
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Are there restrictions on where my IRA can purchase real estate?
No.  Your IRA can purchase real estate anywhere.
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What is the difference between a self directed IRA and a self directed IRA LLC?
A self directed IRA and self directed LLC are both self directed accounts.  The difference is that with a self directed IRA LLC, managing the account and balancing the checkbook as well as writing checks from the IRA are all your responsibility as manager of the LLC, which is owned solely or partially by your self directed IRA.
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How does the IRS feel about self directed IRA investments in real estate, limited partnerships, limited liability companies, joint ventures, and C Corporations?
The IRS makes a clear statement on their website about real estate investing with a self directed or regular IRA which says, “…many IRA trustees do not allow IRA owners to invest IRA funds in real estate.  IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option.”
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What is an LLC?

A limited liability company (LLC) is a form of doing business.  Unlike more common “C” and “S” corporations, investors or owners of LLCs are called members and not stockholders or partners (partnerships), and their investments are called membership interests and not shares (stock) or units (partnerships).

LLCs are rapidly gaining favor for their following important features:

  1. They are pass-through entities like partnerships so that profits and losses pass-through them without tax to the underlying members who are taxed at their appropriate tax rates;
  2. They provide a “limit to liability” as no member is liable for the debts of the LLC and the member’s liability, therefore, is limited to the amount of their investment in the LLC;
  3. "S" Corporations are not permitted to have IRAs as shareholders. LLCs have more flexibility than “S” corporations (e.g., LLCs can have two types of memberships unlike “S” corporations which can only have one type of stock). In addition, there are some of the legal formalities (such as required meetings and minutes) that apply to “S” and “C” corporations that do not apply to LLCs. However, although all 50 states have LLC structures, there currently is no uniform LLC legal definition, and it is therefore important to check the requirements for your state’s LLC structure;
  4. Dividends are not taxed twice as with “C” corporations;
  5. With the exceptions of the District of Columbus and Massachusetts, there is not a limit or minimum number of investors;
  6. Unlike “S” corporations, you can have individuals and other entities (including an IRA) as members;
  7. They offer flexibility in the distribution of profits and losses unlike "S" and “C” corporations.

The first LLC agreement was created by the State of Wyoming in 1977, and when partnership tax status was granted by the IRS in 1988, all states created them. By 1998, LLCs were universal. They can be formed quickly and inexpensively, and are not taxed as entities in most states. It is important to be sure that the LLC operating agreement contains the language necessary for the LLC to receive pass-through tax status like a partnership, and for that reason alone, the operating agreement should be formulated by an attorney familiar with state and federal law regarding LLCs.

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Why would you want to form an LLC?

When you are:

  1. Concerned with tax liability and are not running a business with your IRA;
  2. Interested in reducing otherwise legally required documentation of ongoing corporate activities such as minutes;
  3. Desiring flexibility in the number and type of potential members including individuals, other corporations, trusts, pensions, IRAs, and foreigners;
  4. Interested in limiting the exposure to liability claims to the amount of your investment.

For all of the above reasons, LLCs are becoming very popular as investment vehicles for people who have self directed IRAs and who want to obtain more flexibility and control with their IRA investments.  The attorneys at McLaughlin & Quinn, LLC help individuals establish and operate LLCs for their investments within self-directed IRAs.  Frequently, these proprietors refer to the LLC’s ability to provide so-called “checkbook control” to the IRA investor.  This is meant to describe the IRA investor’s ability to write a check from the LLC’s checkbook when buying investments within the LLC.  This not only gives complete control to the investor, but eliminates the need to have to go through the IRA custodian for processing, which can result in extra time and costs.

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What are the risks associated with using an LLC in a self directed IRA?
The biggest risk is the potential to create a prohibited transaction.  There are certain rules and regulations regarding IRA transactions that, if violated, can invalidate the IRA, resulting in taxes and penalties.  Most IRA custodians are familiar with these rules and will inform their clients when they see them about to commit a violation.  Although, by contract, a self directed IRA owner is solely responsible for avoiding a prohibited transaction, custodians will try to offer their input if they see the potential for a prohibited transaction.  When an investor, therefore, takes the transaction processing away from the custodian, through the creation and funding of an LLC, they reduce the level of scrutiny that could help avoid an inadvertent violation of the rules.  They would be advised to seek the counsel of one of the tax attorneys at McLaughlin & Quinn, LLC, who can assist them and help them to avoid potential problems.
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Can using an LLC simplify investing and provide asset protection?
Yes.  Many investors using self-directed IRAs to purchase real estate, use LLCs to simplify their investing and to provide asset protection.  For example, if an investor(s) is investing in a commercial or industrial property, they may want to protect their personal assets from lawsuits. The LLC protects its members from personal liability regardless of the type and magnitude of the suit.  In terms of simplification, LLCs consisting of multiple members can appoint one member to process all of the required documentation associated with a real estate purchase as opposed to have a dozen or so handling the paperwork, as would be the case if they invested directly into the property as co-tenants.

As assets such as real estate are purchased they are acquired in the name of the LLC and not the IRA, just as if your IRA were a stockholder in IBM.  The IRA IBM shareholder owns shares but does not participate in IBM’s business affairs, but shares in its success through stock appreciation and dividends, if any.

The same is true of the IRA that is a member in an LLC.  It does not participate in the affairs of the LLC, once the initial funding is completed.  Like the IRA that invests in IBM, it will share in the profits and losses of the LLC which are passed along to it and any other members.
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What legal issues are particular to IRAs investing in an LLC?
Some legal issues that are particular to IRAs have to be known and understood by the LLC investor and/or their professional advisors.

An IRA cannot invest in an LLC in which the IRA owner and/or any other “disqualified persons” already own 50% or more of.  Disqualified persons include the IRA owner, the spouse of the IRA owner, the IRA owner’s descendants, ascendants and spouses of descendants.  For example, if you and your wife and kids have an existing LLC in which you are the only owners (e.g., 100% ownership by disqualified persons), then your IRA cannot invest in that LLC.  You could, however, create a new LLC and have both your IRA and the existing LLC invest into it as founding members at the same time.

A notice issued by the IRS in early 2004 called "2004-8", sets out guidelines related to avoiding a penalty associated with a prohibited transaction involving a Roth IRA. However, many attorneys will advise that similar triggering transactions involving traditional IRAs be avoided as well.  Essentially, what 2004-8 says is that any Roth IRA owner that has a “controlling” interest in an entity (e.g., an LLC), has to avoid a transaction between that entity and any disqualified person. In addition, even if the IRA owner doesn’t have a “controlling” interest in the entity, certain transactions, that are not necessarily prohibited, still have to be "listed" (e.g., filed) with the IRS. Failure to do so can result in a penalty of up to $100,000.  For example, let’s assume that you and your Roth IRA each own a part of an entity or that just your Roth owns a part (in both cases, let’s assume the ownership interest is 15%).  If you are the managing member, or if the operating agreement or by-laws of the entity stipulate that you alone can make decisions for the entity (hence “control” the entity), and the entity conducts a transaction between itself and a disqualified person such as your wife, or another entity that you own, you could be considered creating a prohibited transaction (even though you are not violating the letter of the rules of any existing IRA prohibited transaction provision).

A 2004 U.S. Tax Court case contradicted previous case law when it ruled that a prohibited transaction was created when an entity that was owned partially by an IRA made a loan to another entity that was owned (33%) by the IRA owner.  So, you can see that this area of the IRS regulations is changing and current knowledge is necessary if an LLC's transactions involve anyone but third parties in relation to the IRA owner.

The tax attorneys at McLaughlin & Quinn, LLC stay abreast of these changes, and we publish informational material, conduct seminars, send e-mail alerts and newsletters, post to our blog and otherwise educate investors and their professionals so they become knowledgeable of potential violations and stay informed of legal changes affecting IRA transactions.

In summary, an LLC can be a good way to take control of your IRA investing, but remember, they are not a license to ignore the rules. Be sure to maintain a current knowledge of the rules, and to include a competent attorney or accountant on your team to help you avoid costly violations.
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What does 'private placement' mean?
"Private placement" is the term used in the securities world to define a non-public offering of an investment vehicle.  Securities regulations allow exemption for selected types of private placements.  The primary classifications for these exemptions are Rules 501-506 D.  Smaller private offerings can be done where there are less than 35 investors and when the public is not solicited (e.g., friends and family rounds of financing).  The most common types of private placements are those involving closely-held private companies.  It is estimated that 75% of new businesses formed in the United States are funded through such private placements.
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What are the procedures for investing IRA funds in closely-held enterprises?
IRA owners are often presented with opportunities to invest IRA funds in an existing or new closely-held enterprise, such as an operating business, a real estate venture or an investment partnership.  Significant tax consequences can occur if such an investment is a "prohibited transaction" or generates "unrelated business taxable income."  However, in appropriate circumstances, an IRA's investment in a closely-held enterprise can be structured to eliminate or reduce the risk of adverse tax consequences.
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What are the prohibited transaction considerations with private placements?
When IRA funds are invested in an enterprise in which the IRA owner has, or will have, some other relationship - current owner, co-investor, employee, creditor, director or officer - there is often an issue of whether the investment will constitute a "prohibited transaction" under the tax laws.  A prohibited transaction between the IRA and IRA owner will result in immediate taxation to the owner of the IRA's entire value.  Prohibited transaction issues may also arise after the IRA investment is made, usually in connection with a transaction or service between the IRA and the enterprise or the IRA owner (or related person) and the enterprise.

The government and the courts have provided only limited guidance regarding when an IRA investment in a closely-held enterprise may give rise to a prohibited transaction. Nevertheless, some general observations can be made:

In an advisory opinion, the Department of Labor (which interprets the prohibited transaction rules) concluded that investment by both an IRA and the IRA owner in a partnership was not a prohibited transaction where the IRA owner and his family owned less than 50% of the partnership, and the IRA owner derived no (or only an incidental) benefit from the IRA's investment. Note: In all examples, the terms 'family' or 'related persons' does NOT include siblings (brothers and sisters) of the IRA owner.

Thus, co-investment by an IRA and IRA owner in the same enterprise should be permissible under some circumstances, as long as certain caveats noted in that opinion are heeded.

An IRA's investment in an enterprise of which the IRA owner and related persons already own 50% or more (in value or voting power) is a prohibited transaction. However, many believe that a simultaneous co-investment by an IRA and the IRA owner in the enterprise's initial capitalization, resulting in their joint ownership of a majority interest in the enterprise, is not a prohibited transaction.

An IRA investment should not be made to facilitate or protect the IRA owner's investment or interest. For example, an IRA's investment for the purpose of ensuring the IRA owner's employment with the enterprise, or preserving the IRA owner's investment in the enterprise, is likely to be viewed as a prohibited transaction.

The IRS appears to take the position that if a transaction between an IRA and a "disqualified person" would be a prohibited transaction, then a transaction between that person and an entity in which the IRA has an ownership interest would also be a prohibited transaction if the IRA, alone or together with certain other "disqualified persons," can require the corporation to enter into the transaction.

If an IRA owner wishes to invest only some IRA funds in the enterprise, it is advisable to first transfer the amount to be invested to a separate IRA. Such separation may ensure that, if a prohibited transaction does occur, any adverse tax consequences would impact only the separate IRA making the investment.
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What are the Unrelated Business Taxable Income (UBTI) consequences of a private placement?
If the enterprise is a pass-through entity (a partnership or a limited liability company) which produces or sells goods or provides services, the IRA's share of the enterprise's ongoing net income likely will be unrelated business taxable income.  An IRA is required to pay income tax on UBTI at the trust income tax rate.  Also, if the business is a pass-through entity which acquires any assets through loans or on margin, a portion of the IRA's share of the income may constitute UBTI.

The IRA generally will not have UBTI on the sale of its equity interest in the pass-through entity (except to the extent that interest was acquired through debt which was still outstanding within twelve months of the sale).

Structuring the enterprise as a C corporation can avoid UBTI, although the enterprise then will be subject to income tax in accordance with applicable corporate taxation rules.
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What Special Considerations for Roth IRAs must be considered?
Transactions between a business of which a Roth IRA (or Roth IRAs of related persons) owns substantially all the interests and the IRA holder or related persons may be "listed transactions" which may need to be reported to the IRS.  The fact that the transaction is "listed" or must be reported does not mean it is prohibited.  Please see IRS Notice 2004-8 or consult one of the tax attorneys at McLaughlin & Quinn, LLC for further details.
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May an IRA own S Corporation stock?
An IRA may not be an S corporation shareholder.
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May a self directed IRA make secured and unsecured loans?
A note is an extension of credit from one or more individuals or entities (lender(s)) to another individual(s)or entity(ies)(borrowers). An IRA is able to extend credit to any party (including corporations) as long as the party is not considered a “disqualified person”.  Such notes can be either secured or unsecured.  If they are secured, it means that in the event the borrower defaults on the loan from the lender, the borrower agrees to supply the lender with the “collateral” or “security” in lieu of the principal balance of the loan.
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What is a secured loan?
The most common example of a secured loan is the mortgage you may have on your primary residence. In this case, you get a loan from your bank, after supplying an agreed upon amount of equity or down payment.  The bank will extend the loan only if you pledge the deed to your property as “collateral”.  Thus, if you fail to make your mortgage payments to them, they have the right to “foreclose” and take the property from you. And to make matters worse, you will lose your equity or the amount you originally invested and any appreciation since buying the property.

In many states, these loans are called mortgages.  In some states, they are called “”trust deeds” or “deeds of trust”.  In any case, they are secured loans (notes), usually with property as collateral.  The collateral can be real estate (of any kind), gems, mineral rights, a car, plane or virtually anything else of value as agreed upon between the borrower and lender.

Many IRA investors have invested in nothing more than such “trust deeds.”  These investments generally result in monthly income (principal and/or interest payments against the loan), which makes them suitable for someone who requires a steady income (distribution) from their IRA.  One of the keys to the success of these investments is the quality of the “underwriting”.  This entails, briefly, evaluating the creditworthiness of the borrower, and the value and the condition of the property itself (so that the lender or IRA owner can be assured in the event of default, that his or her IRA will be able to receive at least the amount of his or her investment in the event of foreclosure).  If the note is secured by a deed (hence “trust deed”) to a property with a low loan to value (e.g., amount of debt/value of property), there is a good chance, if a default occurs, that the lender will not only get their entire investment back, but also a good part of the equity buildup, including the borrower’s down payment.

However, the objective of most of these loans (sometimes referred to as “hard-money loans” because of their generally higher rates of interest) is not to have the borrower default.  Most of these loans are given to people in the midst of some financial crisis, such as the loss of their job, or a medical crisis, where they need short time financing that would otherwise not be available through traditional lenders such as banks. Banks, who are not in the business of foreclosing and taking physical possession of properties when their debtors default, will generally require a borrower to have a regular source of income before they will lend to him or her.  Hard money lenders, who specialize in these so-called “B” or “C” paper loans, will usually not lend more than 70% of the value of the property, to be sure that their risk of loss is mitigated.  In addition, the more equity a borrower has in their property, the more likely they will do everything they can to ensure that they don’t go into default, thus, losing their equity investment in the property.  The balance between the needs of the supplier (lender), and the demander (borrower), is usually determined by a mortgage broker that specializes in “hard-money loans”.  The broker generally finds borrowers and then “brokers” or sells the loans to investors (the lenders, including self-directed IRAs).  The broker charges 1-2% and the balance of the yield on the loan goes to the investor.  Most of these brokers also offer to “service” these loans, for an additional fee, which can range from $10/month to .5-1% of the loan value per year. Servicing means collecting the loan payments and processing them, as well as going after delinquent borrowers. Some states will have licensing and regulatory requirements for such firms.  California, for example, one of the top hard-money mortgage lending states, has supervision over all such “hard-money” lending firms through its Department of Real Estate.  It is important to understand the rules in your state regarding these type of loans and the brokers who provide them, to be sure that you enter into a sound and legal investment.  But, done correctly, with good underwriting, these loans can be a good source of consistent and above-market-rate returns. Of course, when these compound tax-deferred in an IRA over many years, the results can be dramatic.
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What is an unsecured loan?
An unsecured loan is an extension of credit or a promise to pay between one or more parties and another or other parties. Unlike a secured loan, there is no collateral supporting the obligation in the event of default by the borrower.
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What types of loans can be made by a self directed IRA?
  1. Unsecured Loan between an IRA and an Individual
    When an unsecured loan is between an IRA and an individual, it is only the reputation and creditworthiness of the borrower (individual) that the lender (IRA) is relying on for repayment.  As a result, unsecured loans are much higher risk than secured loans and for this reason they are most common between family and friends.  With IRAs, however, there are restrictions for certain intra-family transactions (click here for prohibited transactions).
  2. Unsecured Loan between an IRA and an entity (LLC, C-Corp, etc.)
    Unsecured loans between an IRA (as the lender) and a corporation (as the borrower) are even rarer than personal loans, because an entity doesn’t have to stake its personal reputation on the line.  However, such loans are more vulnerable to lawsuits in the event of default.  In addition, care must be taken to avoid lending to a company that is owned 50% or more by "disqualified persons" (e.g. direct relatives and the spouse of the IRA owner and including the IRA owner's personal stake in the entity at the time of the IRA's investment).
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What are 'public investments'?
"Public Investments" are investments offered over public exchanges such as the New York Stock Exchange, Chicago Board of Options, American Stock Exchange, NASDAQ and the over-the-counter markets, etc.  In addition, Federal, State and Municipal offerings such as Treasury Bills, bank certificates of deposit, mutual funds, municipal bonds and bills ("munis") are generally considered public investments. All such investments are registered with the Securities Exchange Commission (SEC) as public investments.
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How do they become public?
Common stock of companies goes "public" when it files for listing and registration on one of the public exchanges. In order is to be accepted for listing on an exchange, a company has to have its offering registered with the SEC and must submit information about its financial and other corporate history. Once a company is listed on an exchange, its stock may be purchased or sold through that exchange.
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Who buys/sells them?
Securities broker firms work with all the exchanges, either directly or through agents, to acquire or sell securities for their clients.  Most brokers also will acquire certificates of deposit and U.S. and municipal bonds for their clients and these investments can also be acquired directly form their sponsors (e.g., Federal Reserve, state and national banks, credit unions, etc.).
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How are they regulated?
All of the exchanges and financial institutions that offer public investments are regulated either by the U.S. Treasury Department (I.R.S. or S.E.C.) or state or Federal Bank regulators. While this does not guarantee that all transactions will be performed legally and efficiently, there is a high degree of assurance that such will be the case.
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Are most custodians also securities brokers/dealers?
No, but check with your own custodian.
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Do most custodians allow their clients to trade public investments?
Yes.  Most custodians allow clients to invest in public investments through a broker/dealer of their choice.
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How does this work?
Most custodians work with a number of broker/dealers, whereby the custodian establishes brokerage accounts on behalf of its clients at the clients' broker/dealer of choice.  These brokerage accounts are then held as an asset within the clients' self directed IRA accounts.  The registration on the account reads "ABC Trust Company, custodian for "client name", IRA, Acct. no. ____". In this way, the brokerage account is part of the overall self directed IRA client account.
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Why hold a brokerage account in a self directed IRA?
  • Ease of management. Holding a brokerage account in your self directed IRA allows you to view your entire retirement portfolio at once, and to receive consolidated statements.
  • Speed of transfer. With the trading account inside the self directed IRA, funds can be moved quickly and easily between traded (or public) investments and non-traded investments such as real estate or private placements.
  • Cost Effectiveness. Because the need to transfer funds between institutions is eliminated, certain fees may be avoided.

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What do I do if I don’t have enough money to buy real estate in my IRA?
You may partner with yourself or others; you make allowable contributions; you may obtain debt financing through private sources or financial institutions on a non-recourse basis; you may arrange a seller carry back loan; you may sell other assets in your IRA to raise cash to make the purchase; you may transfer funds from other IRAs or rollover funds from qualified plans, such as 401(k), 403(b) or government 457 plans you may have had at employers where you no longer work; if you have a profit sharing or 401(k) plan where you currently work, you may be able to make in-service withdrawals and roll those to the IRA within 60 days.
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Where can I get a loan for real estate purchases using my IRA?
Normally private lenders, seller carry backs, and mortgage companies may lend to your IRA on a non-recourse basis.  Sometimes banks and credit unions may make non-recourse portfolio loans to IRAs.
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Can my IRA take a loan to enhance the purchasing power of the IRA?
Yes.  However the loan must be a non-recourse loan. Non-recourse against the IRA and the IRA holder.
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What are some of the significant issues when a self directed IRA invests in real estate through a down payment and leveraging?
  1. You cannot personally guarantee a loan for your IRA;
  2. It may be difficult to get a bank to allow an IRA to be the debtor without a personal guarantee.  However, there are now some banks that specialize in loans to IRAs.  Currently, the typical minimum IRA down payment for such loans is 30%, although the exact amount is up to the lender;
  3. Your IRA will pay tax on UDFI (Unrelated Debt Financed Income), which is the income and/or capital gains attributable to the leveraged portion. (UDFI is taxed at the trust tax rate because an IRA is treated as a trust for this purpose.)
As a consequence, although it is perfectly legal, it may not be desirable to have an IRA carry debt in a real estate investment transaction if there is any significant risk that the IRA will be unable to pay the mortgage payments.
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What is Unrelated Business Income Tax?
UBIT comes in two forms. Unrelated Business Income Tax (UBIT) and Unrelated Debt Financed Income Tax (UDFI).

UBIT applies to IRAs invested in entities that do not pay taxes (such as many LLCs) that are an operating entity of a business that produces in excess of $1,000 per year in income.

UDFI relates to an individual retirement account that is debt financed provided that the net gain is more than $1,000 in a year.

UBIT is applied to profits made on the sale of a debt financed property.

Preparation of the 990-T tax forms is performed by you. The trustee or custodian or appropriate agent will file such taxes and sign the tax forms on behalf of your plan.

In 1950, the IRS code was amended to include a provision called unrelated business taxable income or UBTI. The tax on such income is called unrelated business income tax (UBIT).

Essentially, if a tax exempt entity (e.g., non-profit) engages in a business that is unrelated to its primary purpose, any income derived from such business will be subject to UBIT. IRAs are also subject to UBIT if they conduct unrelated businesses that produce profits.

For example, if an IRA forms an LLC to buy and operate a dry cleaner or gas station, businesses obviously unrelated to the primary purpose of an IRA, the net income will be taxed as UBIT (at the trust tax rate because an IRA is considered a trust under the tax code in this purpose). The change in the code was intended to level the playing field between tax-exempt organizations and for-profit organizations conducting the same businesses.
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What is Unrelated Debt-Financed Income and how is it taxed?

Whenever debt is used by a tax-deferred or tax-exempt entity (with some exceptions), tax is applied to that portion of the gain that is debt-financed.  This income is called unrelated debt financed income or UDFI, which is a subset of UBTI.  Taxes on both are calculated and reported on IRS form 990-T.

Any property held to produce income is debt-financed property if at any time during the tax year there was acquisition indebtedness outstanding for the property.  When any property held for the production of income by a tax-exempt organization or IRA or Roth IRA is disposed of at a gain during the tax year, and there was acquisition indebtedness outstanding for that property at any time during the 12-month period before the date of disposition, the property is debt-financed property.  In general, average acquisition indebtedness for any tax year is the average amount of the outstanding principal debt during the part of the tax year the property is held by the entity or IRA.

To calculate the average amount of acquisition debt, determine the amount of the outstanding principal debt on the first day of each calendar month during that part of the tax year that the organization holds the property. Add these amounts together, and divide the result by the total number of months during the tax year that the organization held the property.

The amount of gain or income taxable as UDFI for any tax year is the total income, multiplied by a fraction. The numerator is the average amount of acquisition debt, and the denominator is the average of the adjusted bases at the beginning and at the end of the year.

Before calculating the net income, certain deductions can be taken into consideration, just as they are when you purchase property outside of an IRA.  To be directly connected with debt-financed property or income derived from it, the deduction must be clearly related to the property and its income.

Securities purchased on margin are considered debt-financed property.

Acquisition indebtedness is the outstanding amount of principal debt incurred by the organization to acquire or improve the property:

  1. Before the property was acquired or improved, if the debt was incurred because of the acquisition or improvement of the property; or

  2. After the property was acquired or improved, if the debt was incurred because of the acquisition or improvement, and the organization could reasonably foresee the need to incur the debt at the time the property was acquired or improved.

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What are required minimum distributions?
Required minimum distributions are the minimum amounts that must be distributed to you from your retirement account(s) after you reach age 70 ½ (with the exception of the Roth IRA).
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When an investment is sold by my IRA, can I keep the profit that is above my initial investment?
All money generated from an investment owned in an IRA must be deposited back into the IRA.  Of course there is no income tax on this profit until the IRA begins its annual distributions.  However, investors may incur unrelated business income tax (UBIT) on a portion of their investment income if the investment was made using borrowed funds.
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What is a self directed IRA custodian?
The Custodian is a bank or savings and loan association, as defined in IRC 408(n), or any other entity that has the approval of the IRS to act as custodian.  In order to have a self-directed IRA, it needs to be held with a custodian who will allow investments into non-traditional investments.
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Why are there not more of these custodians across the country?
There are very few non-traditional IRA custodians simply because the business is not as profitable as it is for the brokerage houses.  It requires many more hours to complete a real estate transaction than to purchase stocks over an electronic system.  Traditional banks do not compete because it does not fit within their business objectives.  They make money by leveraging the dollars you have sitting in their accounts.
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Are my funds safe with one of these custodians?
A custodian must be a registered trust company.  For one to register as a trust company the institution must meet stringent state requirements and have adequate reserves.  Your money is kept in a separate account for your benefit and not subject to creditors of the custodian.  Further, if your funds have been placed into an LLC or C Corporation, the custodian never has control of your money.
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What type of services do most custodians provide?
Custodians act as a retirement plan record keeper for self-directed IRAs and generally offer the same retirement plans as other plan administrators.  As your account administrator, they don’t tell you what to invest in, rather, they guide you in your transaction purchases.
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What are the fees and costs involved?
Each custodian has its own fee schedules.  You should confirm the fees prior to establishing the account.
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Why do I need an administrator or custodian?
The Internal Revenue Service requires a custodian to hold the IRA assets and the custodian is required to report transactions on the account.  Due to some of the nuances with self-directed accounts, a majority of custodians do not accept these types of assets.
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Can my IRA be sued?
Your IRA may be subject to legal action.  Individual retirement accounts are not always exempt from creditor claims, and are never exempt from federal or state taxing authorities; however, some states do not permit creditors to collect from IRAs.
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