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

[Dmitriy Fomichenko]

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.

[Brian Eastman]

@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.