One of the most powerful tools you can use in retirement is a Self-Directed IRA. More specifically, a Self-Directed IRA with Checkbook Control takes this strategy even further, allowing you access to any investment you choose without needing approval from a custodian.
But even with access to “any asset you choose”, there are still three sets of IRS rules that you must follow. Keeping these rules in mind when using a Self-Directed IRA with Checkbook Control is even more important, since there isn’t a third party looking over your shoulder to monitor what you’re doing.
The three sets of rules (plus an extra one for Texans) are:
- The Prohibited Transaction Rules
- The UBIT Rules
- The Collectibles/Life Insurance Rules
- The Texas Franchise Tax Rules (in Texas Only)
I’ll address each set of rules in turn. (Quick note: If your self-directed IRA uses a trust instead of an LLC, all the same rules apply. The same rules also all apply to 401(k)s.)
Prohibited Transaction Rules (IRC 4975)
The Prohibited Transaction rules are the first set of rules to keep in mind. There are 6 types of prohibited transactions, all listed in section 4975 of the Internal Revenue Code. All 6 involve transactions between the IRA and a “disqualified person”. We’ll define “disqualified person” later, however for now keep in mind that both you and your family members are “disqualified persons.” You are also considered a “fiduciary” under the rules.
If the prohibited transaction rules prohibit a type of transaction between an IRA and “disqualified person”, then they also prohibit the LLC owned by your IRA from engaging in that transaction with a “disqualified person.”
A “disqualified person” is you, anyone providing services or making decisions for your IRA LLC, your family members, any entity in which you or another disqualified person have greater than 50% ownership (or have control or are an officer or director, even if under 50% ownership), and anyone with which you co own an entity. In the case of a self directed 401(k), the sponsoring employer and any affiliated entities are also disqualified persons. While “family member” does not technically include certain more remote family members like cousins, it is wise to act is if they are disqualified persons regardless as the IRS could rule that transactions with such remote family members provide indirect benefits to you, therefore creating a prohibited transaction.
Here are the 6 prohibited transactions (and don’t worry, as I’ll simplify these into rules of thumb below):
- 4975(c)(1)(A): The direct or indirect sale, exchange, or leasing of property between an IRA and a “disqualified person”. Examples: your IRA LLC sells a piece of real estate to your son, or you sell a piece of real estate you own to your IRA LLC
- 4975(c)(1)(B): The direct or indirect lending of money or other extension of credit between an IRA and a “disqualified person” (including personal guarantees). Examples: Your IRA LLC lends $10,000 to you or a family member, or you personally guarantee a loan taken out by your IRA LLC
- 4975(c)(1)(C): The direct or indirect furnishing of goods, services, or facilities between an IRA and a “disqualified person”. Examples: You buy a piece of real estate with your IRA LLC and you and/or your family members personally fix it up, or your IRA LLC buys a home in Florida and you personally use it for a week’s vacation
- 4975(c)(1)(D): The direct or indirect transfer to a “disqualified person” of income or assets of an IRA. Example: Your IRA LLC hires your friend to manage its investments, and then your friend in return transfers the management fees paid by your IRA LLC back to you
- 4975(c)(1)(E): The direct or indirect act by a “Disqualified Person” who is a fiduciary whereby he/she deals with income or assets of the IRA in his/her own interest or for his/her own account. Examples: You and your IRA LLC purchase a $100,000 piece of property jointly by each contributing $50,000 to the purchase price and each taking 50% ownership of the property, or you are a realtor and you earn a commission when selling a piece of property to your IRA LLC
- 4975(c)(i)(F): Receipt of any consideration by a “Disqualified Person” who is a fiduciary for his/her own account from any party dealing with the IRA in connection with a transaction involving income or assets of the IRA. Example: Your IRA LLC loans money to a lawncare business owned by your friend, and in exchange you receive free lawncare for a year
Despite all of the language above, you can easily avoid accidentally engaging in a prohibited transaction so long as you:
- Never personally enter into any transaction between the IRA LLC and you, a family member, or any entity owned or controlled by you or a family member, or any entity with which you have a financial relationship.
- Never use IRA LLC assets as collateral for a loan.
- Never use IRA LLC assets for personal purposes. For example, never use IRA owned real estate as a residence.
- Never allow the IRA LLC to take out a loan (which includes not shorting any stock or other assets). The LLC can, however, act as a lender so long as the borrower isn’t a “disqualified person.”
- Never use personal funds to pay expenses of the IRA LLC, and never have the IRA LLC pay your personal expenses.
- Do not open a brokerage account in the name of your IRA LLC for publicly traded stocks, bonds and mutual funds; instead use a plain, vanilla IRA offered by the brokerage itself for those traditional investments. (Note that if you are using a self-employed 401(k) instead of an IRA, it is ok to open a special “investment only” brokerage account for the 401(k), however.)
- Never perform any maintenance or repairs on any IRA LLC real estate yourself; always hire an unrelated third party for those services.
- Never get cute by trying to skirt the bullet points above on a technicality, because indirect transactions violate the rules just like direct transactions.
If you are contemplating an investment that you think could be a problem under the rules, check with a lawyer first. The penalty for violating the rules is disqualification of the entire IRA.
UBIT (IRC 512)
One of the major advantages of any IRA is that income earned by the IRA is not taxed. However, there are certain types of income that an IRA must avoid, as earning these types of income generates Unrelated Business Income Tax (UBIT).
Interest, dividends, capital gains, and royalties never create a UBIT problem. Passthrough income from an active business (which could include Bitcoin mining), on the other hand, may create UBIT issues. [A good rule of thumb is that an investment that generates a Form 1099 DIV or 1099 INT for tax purposes creates no UBIT issues, while investments that generate a Form K1 for tax purposes (or direct business income in the case of an investment in a disregarded entity single member LLC) do potentially create UBIT issues.]
Rental income earned from real estate owned by your IRA LLC also does not generate UBIT, so long as two requirements are met:
- The amount of rent you charge is not based on the amount of profits earned by the tenant.
- No “substantial services” are provided in exchange for the rent. For example, you should not provide linen, laundry, or maid services as part of the rent paid.
Gains on selling real estate typically also do not generate UBIT, so long as the property sold was a property previously rented out by your IRA LLC. On the other hand, if your IRA LLC is engaging in frequent “fix and flips” on properties that have never been used as rentals, you do have a potential UBIT issue that will be require further discussion with an attorney.
Lastly, even if an investment does not normally generate UBIT, if your IRA LLC takes out any sort of loan to make the investment, UBIT pops up. This is easy to avoid by simply not having your IRA LLC take out any loans (including margin/shorting loans and mortgages).
Collectibles and Life Insurance (IRC 408)
The Collectibles and Life Insurance Rules are easy to understand.
Section 408(a)(3) of the Internal Revenue Code prohibits your IRA (or IRA LLC) from owning life insurance. This section is clear and easy to understand.
Section 408(m) prohibits your IRA (or IRA LLC) from owning “collectibles.” A “collectible” is:
(A) any work of art,
(B) any rug or antique,
(C) any metal or gem,
(D) any stamp or coin,
(E) any alcoholic beverage, or
(F) any other tangible personal property specified by the Secretary [of the Treasury]
This is pretty self explanatory. “Tangible personal property” is any type of property which you can touch and move: furniture, comic books, an automobile, etc. Real estate is not tangible personal property, nor are bank accounts, ownership interests in corporations, or debt interests.
Subsection (C) prohibits ownership of any “metal,” however there is a special exception in section 408(m) that allows your IRA LLC to own gold and other precious metals so long as said metals are either:
- Bullion meeting the Treasury Department’s purity standards, or
- Coins of the type on the Treasury Department’s approved list (typically American Eagles)
Most investors will want to hold bullion. Bullion has a special requirement under the Code that’s inapplicable to other assets, namely it must be held in “physical possession” of a licensed financial institution. This means it can not be held in possession of you or your LLC. Delaware Depository is an example of a storage method for bullion that is properly licensed to hold precious metals in a retirement account.
If you’re holding American Eagles or other approved coins, it’s unclear under the statute as to whether you’re required to have a financial institution take physical possession, or whether your LLC can hold the coins. The requirements for physical possession apply only to “bullion”, however the statute isn’t clear as to whether coins fall under the definition of “bullion” for this purpose. It’s therefore safest to arrange for financial institution possession.
Before Closing… A Quick Note About Texas Franchise Tax
If your IRA-LLC or other entity owns any Texas real estate (or any other physical assets located within Texas), operates a business within Texas, or if you are a Texas resident and your IRA setup has any nonpassive income of any type, you may be creating a Texas franchise tax liability. Be sure to contact a trusted advisor to discuss this issue as you may need to divide your assets into separate entities to minimize the impact.
Following these three sets of rules is critical with a Self-Directed IRA. If you have questions or would like my assistance in setting up a Self-Directed IRA with LLC Checkbook Control, contact me.
Disclaimer: Information provided is for educational purposes only. Nothing herein constitutes legal advice or investment advice. Readers are responsible for their own due diligence in selection of investments, exchanges, and technology platforms.