Warning: Investing in Real Estate with a Self-Directed IRA

Tax, SDIRAs & Cost Segregation
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Warning: Investing in Real Estate with a Self-Directed IRA

Dmitriy Fomichenko
Solo 401k Expert · Anaheim Hills, CA · Member since 2012 · 18k+ posts · 6k+ votes

I just had a consultation with someone who has the following story. Classic example of a prohibited transaction. Sometimes I hear arguments against "checkbook control" that custodian is there to protect your IRA and prevent a prohibited transaction. Well, the truth is: custodian will not protect you; you are 100% responsible for violating the rules and you better understand the rules before engaging in a transaction. Here is the story, what do you think?

My wife and I each have a Self-Directed IRA that we would like to roll over into Solo 401k. However, we have a current situation with the investment.

We each opened a Self-Directed IRA with Equity trust last fall. My wife funded hers with $5,000 from a previous employer 401k and mine $50,000 from a traditional IRA.

We used that total $55,000 to loan money to a company “ABC LLC” with the owner being a friend of ours. “ABC LLC” purchased an investment property for $55,000 with a promissory note and a trust deed to our IRAs for monthly payments with interest. “ABC LLC” was supposed to fix the property up and then flip for sale and pay us back the original investment plus any final interest.

We soon found out that “ABC LLC” didn’t have the funds to fix the property up and never paid us the monthly payments. My wife personally got a loan from a private lender to begin remodeling and getting the property ready for sale.

We are currently trying to sell the property in order to pay off the private lender and then put the original investment back into our Equity Trust Accounts. We don’t think that we’ll make any gains on the sale but if we do,I assume the net gain will go 90% to my Equity Trust account and 10% to my wife’s Equity Trust account?

We hope to clean up this situation in order to get the Equity Trust IRA accounts made whole again with the original investments so that we can close these accounts and roll the funds into the solo 401k plan.

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Brian EastmanPro Member
Self Directed IRA & 401k Advisor · Wenatchee, WA · Member since 2014 · 2k+ posts · 2k+ votes
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@Dmitriy Fomichenko

Thank you for sharing this.  It is unfortunate but true that too many folks think "self-directed" also means "do it yourself", and want to steam ahead without consulting with the proper tax and legal expertise.

That personal loan the wife took and then injected into the deal is a very clear prohibited transaction and there really is no solution for that. They will need to work with a CPA to declare the IRA accounts as having been distributed. In all fairness to Equity Trust, they likely never heard of this and were not consulted by the client. They certainly would not have advised such a transaction.

It is critical to understand that a trust company serving as custodian is simply a processor and record keeper.  They have no responsibility to vett your investment strategy, and explicitly state so much on their contracts (not always so explicitly in their marketing, however).  When it comes to following the IRS rules, the only one who "has your back" is you.

A self directed IRA or Solo 401k is a very powerful and flexible tool. As with any sophisticated instrument, however, one must commit to understanding the proper usage. If you setup an account with a trust company as custodian, be sure to separately engage a tax attorney or CPA to educate you on the proper usage of your plan relative to your specific investment goals.

If you choose to establish a "checkbook control" plan with an advisory firm, and you identify a firm that actually provides meaningful support as opposed to a discounted "document mill", you will have a good bit better access to education than with a custodian, but you will still want to be sure to have your own independent counsel.

I would add that this unfortunate story should not discourage folks from considering a self-directed IRA. Yes, there are rules that go along with retaining the tax-sheltered status of such a plan. It is not that hard with access to quality advisement to understand and follow those rules. In doing so, one has the opportunity to diversify their hard-earned retirement savings into solid, performing assets such a real estate, notes, etc. You can do a lot of good wealth building with such a plan if used properly.

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  • Brian EastmanPro Member
    Self Directed IRA & 401k Advisor · Wenatchee, WA · Member since 2014 · 2k+ posts · 2k+ votes
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    @Dmitriy Fomichenko

    Thank you for sharing this.  It is unfortunate but true that too many folks think "self-directed" also means "do it yourself", and want to steam ahead without consulting with the proper tax and legal expertise.

    That personal loan the wife took and then injected into the deal is a very clear prohibited transaction and there really is no solution for that. They will need to work with a CPA to declare the IRA accounts as having been distributed. In all fairness to Equity Trust, they likely never heard of this and were not consulted by the client. They certainly would not have advised such a transaction.

    It is critical to understand that a trust company serving as custodian is simply a processor and record keeper.  They have no responsibility to vett your investment strategy, and explicitly state so much on their contracts (not always so explicitly in their marketing, however).  When it comes to following the IRS rules, the only one who "has your back" is you.

    A self directed IRA or Solo 401k is a very powerful and flexible tool. As with any sophisticated instrument, however, one must commit to understanding the proper usage. If you setup an account with a trust company as custodian, be sure to separately engage a tax attorney or CPA to educate you on the proper usage of your plan relative to your specific investment goals.

    If you choose to establish a "checkbook control" plan with an advisory firm, and you identify a firm that actually provides meaningful support as opposed to a discounted "document mill", you will have a good bit better access to education than with a custodian, but you will still want to be sure to have your own independent counsel.

    I would add that this unfortunate story should not discourage folks from considering a self-directed IRA. Yes, there are rules that go along with retaining the tax-sheltered status of such a plan. It is not that hard with access to quality advisement to understand and follow those rules. In doing so, one has the opportunity to diversify their hard-earned retirement savings into solid, performing assets such a real estate, notes, etc. You can do a lot of good wealth building with such a plan if used properly.

    7Reply
  • Dmitriy Fomichenko
    OP
    Solo 401k Expert · Anaheim Hills, CA · Member since 2012 · 18k+ posts · 6k+ votes
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    @Brian Eastman, thanks for your comments. I agree with you and the purpose of this post is not to discourage folks from using SD IRA but to encourage them to invest a little time to educate themselves. It is clear that the people in the story have very foggy idea of how SD IRA works and should they take the initiative to contact their custodian, or another professional this prohibited transaction could have been avoided.

    I always tell my clients: if you are unsure about what you are doing - please ask (and ask before you do it not after the fact).

    5Reply
  • Daniel DietzPro Member
    Rental Property Investor · Reedsburg, WI · Member since 2011 · 1k+ posts · 857 votes
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    Great example of how a well intended investor with no intent on 'skirting the rules' screwed up. Absolutely education is the #1 thing before using a Self Directed IRA or 401.

    Dan Dietz

    [email protected]608-524-4899
    1Reply
  • Justin WindhamPro Member
    Banker · Nationwide · Member since 2015 · 4k+ posts · 1k+ votes
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    @Dmitriy Fomichenko Thanks for posting this. 

    Unfortunately, this is what can happen when people take action without the proper knowledge and guidance. Similar situations have come up on some of our calls throughout the years.

    I agree with the other posters, education and verification BEFORE the transaction is key.

    0Reply
  • Ryan Luthi
    Real Estate Broker · Edina, MN · Member since 2015 · 56 posts · 37 votes
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    Great stuff gentlemen!  Lots of confusion around this concept but when done right, its truly incredible what you can do with SDIRA's!  

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  • Dmitriy Fomichenko
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    Solo 401k Expert · Anaheim Hills, CA · Member since 2012 · 18k+ posts · 6k+ votes
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    Originally posted by @Daniel Dietz:

    Great example of how a well intended investor with no intent on 'skirting the rules' screwed up. Absolutely education is the #1 thing before using a Self Directed IRA or 401k.

    Daniel, I am not sure what the intention was, but it looks to me that making all possible efforts to follow the rules was not the intent (otherwise they would seek the guidance prior to making those moves).

    0Reply
  • Eddy Dumire
    Investor · Stafford, VA · Member since 2014 · 246 posts · 83 votes
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    I'm new to the SDIRA.  I've been looking into it a little bit in anticipation of setting up my own.  My understanding is that the only actions they could have taken are as follows:

    1. Have the IRA foreclose on the property.

    2. Contract with someone to fix up the property but only if there were sufficient funds in the IRA.

    3. Get a non-recourse loan in the IRA's name to finish the rehab.

    Can someone chime in and let me know if I understand this correctly?

    My general impressions are that the SDIRA has to be self-sufficient.  You can make decisions for it, but it has to fund all those decisions on it's own.

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  • Dmitriy Fomichenko
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    Solo 401k Expert · Anaheim Hills, CA · Member since 2012 · 18k+ posts · 6k+ votes
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    @Eddy Dumire

    your understanding is correct. Perhaps there could be other options, they reason they screwed up is by getting personally engaged in the transaction making it prohibited. 

    0Reply
  • Rajeev Kotyan
    Professional · Lexington, MA · Member since 2016 · 136 posts · 43 votes
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    @Dmitriy Fomichenko: Thanks for the good post of what many a times we have come across, and @Brian Eastman for the advice for folks to do (i.e. work with people who are knowledgeable, qualified and can provide correct guidance).

    @Eddy Dumire: You have hit the nail on the head. Good luck in your endeavors.

    0Reply
  • Jacqueline Pelzer
    Mount Vernon, NY · Member since 2016 · 86 posts · 16 votes
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    @Dmitriy Fomichenko and @Brian Eastman

    Thanks so much for the original post and for the response. It really helped. I have become very interested in a SD IRA. My plan is to set one up in a SD IRA LLC and make it a parent LLC and then to open a separate LLC as a sub. The purpose is to purchase several investment properties and have the IRA LLC as a 50% owner in the sub LLC. That way I can put profits back into the IRA and I can also put profits into my own account. And I'd also split expenses 50/50 between the IRA and myself. I don't think this is a prohibited transaction since the IRA is not the one purchasing the property but has a 50/50 ownership of and all properties I properties I purchase. Also I plan on buying out of state properties and set up another LLC in that state for a 50/50 split as well. Not sure if that is clear. Anyway, I plan on getting in contact and setting up this through a company that specifically deals with SD IRA LLC and then I can just set up any sub LLC's on the side I guess. Of course, I plan on running this through a tax attorney, real estate attorney, CPA type of people. Any thoughts? Sorry for the eye full (versus the mouth full) :-)

    1Reply
  • Brian EastmanPro Member
    Self Directed IRA & 401k Advisor · Wenatchee, WA · Member since 2014 · 2k+ posts · 2k+ votes
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    @Jacqueline Pelzer

    What you propose as joint ventures between your IRA and yourself is doable, but does create risk exposure. Find an ERISA tax attorney to discuss this with, then find a provider to establish the plan structure if your discussion with the attorney leaves you still wanting to pursue such a strategy.

    1Reply
  • Dmitriy Fomichenko
    OP
    Solo 401k Expert · Anaheim Hills, CA · Member since 2012 · 18k+ posts · 6k+ votes
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    @Jacqueline Pelzer

    without digging into details of your transaction further I can't tell you for sure if what you are describing is prohibited or not, but you are in the grey area for sure.

    Under certain circumstances your IRA could partner up with a 'disqualified person', but such transaction could easily become prohibited down the road.

    1Reply
  • Daniel DietzPro Member
    Rental Property Investor · Reedsburg, WI · Member since 2011 · 1k+ posts · 857 votes
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    @Dmitriy Fomichenko,

    It is hard to say what their thoughts were :-)

    What I had in mind when I wrote that was that is it seems like occasionally I see people post things like "how can we 'get around' all these silly rules" - meaning having the intent from the start of things. Hopefully most of them figure out that that is not the best idea before they start.

    Dan Dietz

    [email protected]608-524-4899
    0Reply
  • Edward Synicky
    Rental Property Investor · Yorba Linda, CA · Member since 2012 · 336 posts · 69 votes
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    @Jacqueline Pelzer

    Jacqueline, I'm not an expert in the solo 401K plan as Dmitriy certainly seems to  be. But I am a long time real estate investor with many properties all over the US and my family is very comfortable as a result. My mantra in all aspect of life has been keep it simple and avoid the pitfalls of a complicated approach to something that does not need to be complicated. What you are proposing, in my humble opinion, is way to complicated than necessary to gain wealth by investing in real estate. I suspect the expense of establishing what you have proposed and the cost of upkeep will not be worth the effort. And that does not even consider the legality of such a proposal. I 100% believe in self directing your retirement account but before you make a move talk with someone like Dmitriy. 

    Good luck and safe investing.

    1Reply
  • Bryan DruryPro Member
    Investor · Owensboro, KY · Member since 2008 · 130 posts · 65 votes
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    @Edward Synicky, I subscribe to your philosophy. We call it the KISS principal.Keep it simple stupid.@Jacqueline Pelzer seems to want to make it entirely to complicated.Most of us don't need extra headaches,there's already enough to go around without making things more complicated.Especially when it comes to the IRS.A phone call or email about mixing personal money with SDIRA money could eliminate some headaches and the possibility of triggering a taxable event.Educate yourself and ask the professionals for advice concerning self directed retirement  money before you take action.

    0Reply
  • Jacqueline Pelzer
    Mount Vernon, NY · Member since 2016 · 86 posts · 16 votes
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    @Bryan Drury not only was your comment condescending it was completely unnecessary. Since when does asking experts in a field an indication that one WANTS to complicate anything?!  And I asked some professionals a question BEFORE I took ANY action as you so "smartly" suggested. And since clearly it wasn't you who I asked you could have just breezed on by. 

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  • Bryan DruryPro Member
    Investor · Owensboro, KY · Member since 2008 · 130 posts · 65 votes
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    @Jacqueline Pelzer  I apologize for offending you.

    3Reply
  • Jacqueline Pelzer
    Mount Vernon, NY · Member since 2016 · 86 posts · 16 votes
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    @Bryan Drury thank you.

    @Edward Synicky and @Dmitriy Fomichenko gentlemen, let me explain my thinking behind it.  Sincerely and truly my intention is NOT to complicate anything, not to do anything prohibited and NOT to do anything illegal. 

    Let me be more clear and specific. I am a law enforcement professional. In approximately 7 years I will be eligible to retire with my pension, which will provide income each month for the rest of my life. My intention is to set up a SD IRA because I want to purchase property and have income put away for when I am eligible for normal IRA withdrawal. But at the same time, I really didn't want to be forced to put it ALL away for age 59 1/2 (or whatever it will be by the time I get there) so I was looking things over and came across the SD IRA LLC which seemed awesome. And I became curious if I made THAT IRA LLC a parent company and opened a subsidiary LLC I could purchase property under the subsidiary, making the SD IRA LLC a 50% owner. That way I could put money away and also have money for NOW. I understand and do intend to get a CPA or some sort of professional local to me to break it all down. But I wanted to explain my rationale which is to put money toward my future but also to have money in the now as well. Hope that makes things more clear. In addition, eventually I'd want to purchase property in more than one state and would set up individual LLC's for those states to separate things. But ultimately have that SD IRA LL be a 50% ownership in all properties. If that's too much and too complicated then I won't do it, but it was an idea that I was attempting to run past you both since that was, indeed, the topic. Thanks for your time.

    1Reply
  • Rajeev Kotyan
    Professional · Lexington, MA · Member since 2016 · 136 posts · 43 votes
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    @Jacqueline Pelzer: What you have suggested in your expanded posting is walking a very fine line. 

    There are numerous hurdles to overcome:

    (1) A 50% rule, i.e. once an IRA (directly or indirectly) participates with a disqualified party (in this case you), then you cannot have additional capital contribution in the child LLC's that you mention.

    (2) An "enabling" rule. i.e. Is the IRA (directly or indirectly) be able to complete the transaction without the participation of a disqualified party, and vice versa: Is the disqualified party able to complete the transaction without the participation of the IRA (directly or indirectly)?

    (3) Based on your posting, you may also get into issues surrounding "operating entity" versus "venture capital holding" as the SDIRA, LLC (your parent LLC), which is a legal structural issue and general operating issue that you may have to overcome.

    Please note that these hurdles I mention here is over and above the list provided by @Dmitriy Fomichenko and @Brian Eastman in earlier posts, and generally the second one is a very high hurdle to overcome (i.e. a lot of documentation required to be maintained for an audit). This applies to 401k's too.

    As you also mention, work with a knowledgeable and qualified professional who understands these nuances and can guide you appropriately.

    3Reply
  • Bryan DruryPro Member
    Investor · Owensboro, KY · Member since 2008 · 130 posts · 65 votes
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    @Jacqueline Pelzer,Thank you for your civil service.I have some experience with self directed retirement investing.I worked with @Dmitriy Fomichenko at Sense Financial Services to set up a Solo 401 K account.Very professional,prompt,and knowledgeable.Ive learned that you can get tripped up by the regulations via the IRS very easily.There are a lot of details that have to be correct or their are consequences that usually cost you you money.Thats why I like simple.I will admit I've been out of my comfort zone  during this process.It sounds like your comfort zone is much broader than mine,thus your more comfortable with complicated matters.Good for you.I considered buying rental properties thru my Solo 401K but it was more complicated than the way we are use to purchasing,renovating,and refinancing them.We discovered private lending and that's what we are doing thru the Solo 401K.Maybe less complicated?We have had success their.Good luck to you.Keep it simple,LOL

    0Reply
  • Jacqueline Pelzer
    Mount Vernon, NY · Member since 2016 · 86 posts · 16 votes
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    @Rajeev Kotyan Yes, I do not think I am comfortable walking any fine lines.  That brings stress to one's life and I don't need any more stress.  Thank you so much for your response.  I see your point about the disqualified party (me) and I wouldn't want to run into complications.  So I think I will go back to the drawing board.

    @Bryan Drury Thank you so much for your thoughtful and informative response. Like you, I really do not want to run into issues and I definitely do not want to cost myself any more money. I pay enough. Do you prefer the Solo 401K than the SD IRA? What made you go with one and not the other. And yes....keeping it simple is really what I prefer. :-)

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  • Dmitriy Fomichenko
    OP
    Solo 401k Expert · Anaheim Hills, CA · Member since 2012 · 18k+ posts · 6k+ votes
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    @Jacqueline Pelzer

    I understand that you wish to be able to 'self-directed' your retirement dollars into real estate and other alternative investments, while at the same time you wish to create some cash flow from your personal investments. Nothing wrong with that.

    However, there is no need for you to create the structures that you described with the LLC and sub-LLC. As @Bryan Drury suggested: keep things simple. That is my philosophy also. Start self-directed IRA (or Solo 401k if you qualify for it) and be in control of how you retirement funds are invested. But at the same time use your personal savings to invest and start building passive income that you can enjoy now. I don't see any reason for pulling the funds together and partnering with your IRA. IRA investments CAN NOT provide you with the cash flow that you can use now. Keep them separate.

    2Reply
  • Jacqueline Pelzer
    Mount Vernon, NY · Member since 2016 · 86 posts · 16 votes
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    @Dmitriy Fomichenko thank you for your help. I will keep it separate. Especially now that I understand how complicated it would make my life. Thank you. 

    1Reply
  • Bryan DruryPro Member
    Investor · Owensboro, KY · Member since 2008 · 130 posts · 65 votes
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    @Jacqueline Pelzer

    Do you prefer the Solo 401K than the SD IRA? What made you go with one and not the other.                    Jacqueline, the Solo 401K has many things going for it that may make it a better option for some people depending upon their circumstances.It is designed for small business owners that do not have any W-2 employees.It has very high contribution limits allowing the account holder to quickly build a nest egg.You don't have to deal with a 3rd party custodian.You have checkbook control over the account.There is a Roth sub account component.Solo 401K is UBTI exempt, you also may borrow funds from the account. Rollover ability from other retirement plans is also allowed.

    For my circumstances the Solo401K was a better option.I had a conventional 401K at my employers but when we were bought out by another corporation we had the option of converting the 401 to a conventional IRA.And that is what we did. At that point in time I was not aware of Solo401K.After reading about them we soon figured out they were a good fit.So we converted conventional IRA to Solo401K.@Dmitriy Fomichenko has a web site at Sense Financial.com that can explain in much more detail what I just summarized.You need to spend some time educating yourself on your options before retirement about self directed retirement plans.Good luck

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  • Dmitriy Fomichenko
    OP
    Solo 401k Expert · Anaheim Hills, CA · Member since 2012 · 18k+ posts · 6k+ votes
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    Good summary of the benefits @Bryan Drury. Just wanted to add that one doesn't necessarily have to 'own a small business'. Any sole-proprietor or someone with 1099 income (even part time) can adopt a Solo 401k plan.

    The UBIT (Unrelated Business Income Tax) exemption only applies on leveraged real estate, whereas in IRA it would be subject to taxes. However, income from any other unrelated business activity would still be subject to UBIT with Solo 401k also.

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