Getting in trouble with self-directed IRA?

Question

One of CPAs we work with sent me their client who have gotten themselves in some trouble with their self-directed IRA.

The client opened self-directed IRA with IRA Resources Trust Company. Then he created an LLC with him and his spouse owning 75% of the LLC and his SD IRA owning the remaining 25%. The LLC was a newly created entity at the time. Client personally created the LLC, paid applicable fees with his personal funds, and used generic Operating Agreement. The custodian reviewed and approved this transaction and authorized transfer of funds from his IRA to the LLC. Then he reimbursed himself for the LLC setup fee from the LLC’s checking account.

Next, instead of the LLC purchasing a property using the cash in the bank and getting a non-recourse loan, the client purchased the property in his personal name, got a conventional residential loan, and used money in the LLC for down payment. They are now in the process of quit-claiming the property from their personal names to the LLC.

What do you think?

Sean Walsh · Answer

@Dmitriy Fomichenko I think when it comes to a SDIRA, everyone should think twice about testing the IRS’s tolerance for creativity. I cannot understand why anyone would try to twist the tiger’s tail. And please let’s not give the Feds or Congress any more ‘bad apple’ examples to justify tighter regs and/or more laws that make real estate transactions more difficult. For everyone’s sake, please just know the rules and follow them.

Dmitriy Fomichenko · Answer

Buying real estate in an IRA using leverage is NOT a hassle, it is actually pretty straight forward. But the account holder must know the rules! The account owner, his spouse and immediate family members are considered "disqualified person". The can't guarantee the loan to an IRA, provide any services to an IRA, or receive any benefits from an IRA (directly or indirectly). These are the basics that every self-directed IRA account holder MUST know!

Because personal guarantee is not allowed, conventional loans will not work, must do a non-recourse loan. Most banks don't offer this product, must work with specific lenders, here is the list:

https://www.biggerpockets.com/...

This transaction is in clear violation of the IRS rules, what this person did is equivalent of getting behind the wheel and started driving without any previous driving experience and with fake driver's license. The result: car was wrecked and driver got injured. That's what happened!

The moral of the story: educate yourself on the basic IRS rules, they are not difficult to understand. And if not sure - ask questions and work with knowledgably and experienced professional who can provide property guidance. Unfortunately many reps who work for IRA custodians are uneducated, inexperienced and often mislead their clients by telling them incorrect information...

Taylor L. · Answer

Oh boy.

Speaks to the importance of understanding the rules for yourself and not just relying on the custodian.

Justin Windham · Answer

It is always the responsibility of the account holder to understand and follow the prohibited transaction rules whether a custodian is involved or not. This is just a great example of what can happen if this advice isn't taken seriously. Thanks for posting, Dmitriy.

Justin Windham · Answer

I don't think the main idea expressed in the post is that any of this is a "hassle" but that there is a right way and a (very) wrong way to go about self-directed investing. I think this sentiment can be applied to just about anything, including real estate investing in general. Just because many real estate investors have failed miserably due to a complete lack of knowledge and disregard for basic strategy doesn't mean that real estate investing is not worth the hassle. In either case, taking the time to learn the process before jumping in recklessly is much more likely to yield good results.

Daniel Dietz · Answer

@Mark S. I would have to agree with @Dmitriy Fomichenko is asking what is so funny? I trust his opinion a LOT more than your considering he (an others who have chimed in here) have dealt with thousands of these type of accounts, including mine and my partners. You say "It is not worth the hassle", which I also see others express who have not holistically looked at a persons overall financial situation.

The way I look at it is IF I already have a lot of funds in my retirement accounts, should I NOT invest it in what will make me the best return with the lowest risk? Why settle for 10% returns in a volatile stock market when I can make 15-20% all day long with real estate along with a LOT less risk inside of my Self Directed Accounts?

There is also huge advantages if you qualify for a SOLO401K. Have you ever ran the numbers on what 50k PER YEAR of contributions can turn into over time?

Dmitriy Fomichenko · Answer

This was problematic from the very beginning because client himself filed for the LLC, paid expenses with personal funds, did not use IRS-compliant operating agreement.

While technically it might be possible to partner with one's IRA - because of disqualified person's involvement I would strongly discourage such transaction. I could have been started correctly, but can easily lead to prohibited transaction. Again, bad idea!

Dmitriy Fomichenko · Answer

Agree, they clearly failed to educate themselves and do proper due diligence.

Chris Levarek · Answer

@Dmitriy Fomichenko Thanks for sharing this story. I'm surprised the IRA company wired the funds. Some due diligence was missed on the business plan and entity structure.

Tom Degroodt · Answer

Was the first part (funds added to the LLC) legal?  Then when the client purchased the property with a personal guarantee, is when the train came off the tracks?  Or because the IRA only had a 25% share in the LLC should have been disqualified?

Getting in trouble with self-directed IRA?

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