- Image via Wikipedia
I just scrapped the blog I was writing because of a phone call I received. The call was from a man that I met on the east coast while teaching an event a couple of months ago. When I met him he was winding down on an audit that he was going through regarding some real estate transactions done in his Self Directed IRA. He called today to let me know how the audit had shaped up. Unfortunately the audit didn’t go well. His IRA had been disqualified because his custodian had permitted a prohibited transaction in the IRA.
As real estate investors we are familiar with the Latin phrase caveat emptor which is translated as buyer beware. Typically, as investors we think of this phrase in terms of making sure we have done our due diligence prior to acquiring an investment. However, this term must be applied when you are seeking out custodians for your Self Directed IRAs. Please don’t get me wrong, I strongly advocate the use of real estate transactions in retirement plans as a way to increase your retirement nest egg. Unfortunately there have been many unqualified groups pop up over the last several years to jump on the band wagon and cash in on the investors that wish to use retirement funds to acquire real estate, and if you fail to do your due diligence and to properly plan to follow all of the rules for investing in retirement plans you are truly planning to fail.
They Want Your Business
If you go to any search engine on the web and type in “IRA Real Estate” you will truly be amazed at the number of hits. I just found 621,000. The problem is that not all of these groups have your best interest at heart. They may promote strategies that are either blatantly prohibited transactions in an IRA or the transaction walks a very fine line. This is a slippery slope that you want to avoid.
IRS “Dirty Dozen”
For the third year in a row, Abusive Retirement Plans have made the” Dirty Dozen” List published by the IRS. The “Dirty Dozen” is a list of tax scams that the IRS annually publishes. If a taxpayer is found to be involved in one of these transactions not only does the taxpayer, innocent or not, face civil penalties there is also the threat of criminal prosecution. At the very least, you will be sure to have your IRA disqualified resulting in potential adverse tax consequences.
One transaction that the IRS is looking very hard at is when IRAs use limited liability companies to engage in activities that are otherwise considered prohibited. I am not saying that you can’t do many of the transactions Self Directed IRA custodian’s promote but just as no one will look after your retirement funds better than you, it is completely dependent on you, at least in the eyes of the IRS, not to engage in prohibited transactions in your IRA.
Due Diligence
Before you jump into a business relationship with an IRA custodian follow a few simple guidelines:
- Familiarize yourself with IRS Publication 590 (http://www.irs.gov/pub/irs-pdf/p590.pdf)
- Confirm that your custodian is a licensed non-bank custodian.
- Confirm length of time the custodian has been in business.
- Is the custodian licensed to do business in the state you wish the IRA to invest in real estate?
- Find out the value of the custodian’s liability policy.
- Ask for past financial statements from your custodian.
- Check with the Attorney General in the state the custodian is listed to determine whether or not any complaints have been filed against the custodian.
Taking control of your IRA and using your funds to invest in real estate is an excellent opportunity. Just as you wouldn’t jump into an investment without doing your research do not blindly assume that everything you are told by a potential custodian that has a financial interest in having you sign up with them is true. Caveat emptor.
Related posts:
Article Author: Greg BootsGreg has written 8 articles for us.
Visit Greg's Website: http://www.andersonadvisors.com
Greg is a licensed attorney and nationally recognized public speaker focusing on the topics of business formation, estate planning and retirement planning strategies.
Joshua Dorkin
{ 6 comments… read them below or add one }
Greg,
While I agree it is always good advice for people to educate themselves about IRS rules, I am a nonetheless a little rankled by your post.
In my experience, more people are being harmed by incorrect information about what they CAN’T do with their IRAs than what they CAN. In particular, “advisors” who are really sales reps and the big mutual fund companies and brokerages touting “self-directed” IRAs that really aren’t are doing a lot more damage to more people’s financial well-being. These firms perpetuate the incorrect notion that “self-directed” means you can invest in “any public stock or fund WE offer.” This is denying people the right to truly diversify their retirement portfolios — something we now all know all too well is crucial.
It’s also not reasonable for people to expect their custodian to take on liability for investors’ decisions in the first place. Their job is to maintain custody of assets — not provide legal advice. As with any other tax decision — be it deductions, corporate formations, paying your nanny or utilizing IRA funds — American citizens are responsible for knowing the law themselves.
Many people today have the majority of their non-home assets tied up in retirement accounts, so being aware of what is possible and legal — and making sound choices — is absolutely key. I believe more people are being harmed by failing to pursue diversification and the best investment opportunities because they’ve accepted bad/biased information about what is not permitted than are making the kind of mistakes you describe.
Bottom line: we all have a stake in getting the RIGHT information out to everyone, to level the investing playing field. It shouldn’t be the case that only the most wealthy people with the best attorneys and CPAs can tap the benefits of diversification — or investing in real estate (or real estate related vehicles) at a time of unusual bargains.
You dont need a complex answer, here is a very simple one. If you take money our of an IRA to use for a business, that will create a taxable event, and if you are under 59.5 years, you will have to pay a penality, around 10%. You can transfer a 401k into an IRA and you will not own any tax. But if you take that money out of the IRA, the tax man will get his tax for sure.
I agree with Laurie, individual investors should be responsible for their own investment decisions…
As for real estate and IRAs, I too have run across a number of sites touting various strategies. My question has less to do with CAN or CAN’T I buy real estate in my IRA, but WHY buy real estate in your IRA… Can anyone enlighten me?
As I see it, the real advantage of an IRA is tax deductibility and tax-free growth. And while the purchase of a rental property isn’t tax deductible, the income is tax-free if offset by depreciation, and I never pay capital gains if proceeds from the sale are used to buy a new property.
So other than a few thousand dollars in annual tax deductibility, what’s the advantage in buying real estate with an IRA? Wouldn’t an IRA be put to better use investing in assets which are more often subject to taxation?
Laurie,
I appreciate the feedback and I wholeheartedly agree that investors need to have options. However, investors need to be cautious and realize that if they act on incorrect information provided by their paid custodian there is a risk of potential negative tax consequences. Investors must do their own due diligence in order to work with a reputable company.
Michelle,
You are correct, however there is a way around the 10% early withdrawal penalty if you are under 59.5. If you need money out of your IRA prior to age 59.5 you can take a 72(t) election and distribute funds in substantial and equal distributions in order to avoid the 10% penalty.
Greg, your article did not lead me to believe that I should invest my money in one type of market over any other, simply that there are aspects of IRA real estate investing that must be addressed so as to avoid costly penalties. I’ve found that that most Americans with an IRA or 401k are unaware that they have options at all, and so I can see Laurie’s point that showing the different ways they CAN use those hard-earned dollars is key.