Introduction to Self-Directed IRAs

An individual retirement account (IRA) is a tax advantaged, custodial account set up for the exclusive benefit of the owner. The account must meet the following requirements: First, the custodian must be a bank, a federally insured credit union, a savings and loan association, or another entity approved by the IRS to act as custodian. The custodian is responsible for receiving and holding IRA assets, maintaining accurate records, making distributions, and providing annual statements to the IRA owner.

Second, the custodian generally cannot accept contributions that exceed the IRA contribution limits, with the exception of rollover contributions. Contributions, except for rollovers, must be in cash. Third, the owner must have a nonforfeitable right to the account at all times. Fourth, assets in the account cannot be combined with other property, except in a common trust fund or common investment fund, and fifth, the rules on distributions must be followed.

Most IRA custodians only allow IRAs to select from investments that their company offers, such as stocks and bond portfolios. However, the Internal Revenue Code (IRC) only prohibits investing in life insurance contracts or collectibles under IRC § 408. Collectibles include works of art, rugs or antiques, any metal or gem, any stamp or coin, or any alcoholic beverage.

In other words, the only restrictions on using an IRA to invest in real estate, notes, or any asset other than those listed above would come from the IRA custodians themselves, not any law or regulation. The IRS website states that IRA custodians “are permitted to impose additional restrictions on investments. For example, because of administrative burdens, many IRA trustees do not permit IRA owners to invest IRA funds in real estate. IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option.”

The alternative is a self-directed IRA. A self-directed IRA is simply an IRA account in which the custodian agrees to allow the owner to exercise greater control over investment decisions. However, because there is so much more flexibility over a self-directed IRA, the owner must be aware of the rules regarding prohibited transactions with related parties. The IRS imposes significant tax penalties if any “disqualified person” engages in a “prohibited transaction” with a retirement plan. A “disqualified person” according to IRC § 4975 includes any of the following people or entities:

      The owner of the plan;
      A family member such as a spouse, ancestor, lineal descendant, and their spouses;
      The administrator of the plan;
      Any person providing services to the plan;
      Any corporation, partnership, trust, or estate in which the IRA owner owns, either directly or indirectly, 50% or more; or
      An officer, director, 10% or more shareholder, or highly compensated employee of any entity described above.

A prohibited transaction according to IRC § 4975 is any direct or indirect:

      Sale or exchange, or leasing of any property between a plan and a disqualified person; or a transfer of real or personal property by a disqualified person to a plan where the property is subject to a mortgage or similar lien placed on the property by the disqualified person within 10 years prior to the transfer, or the property transferred is subject to a mortgage or similar lien which the plan assumes;
      Lending of money or other extension of credit between a plan and a disqualified person;
      Furnishing of goods, services, or facilities between a plan and a disqualified person;
      Transfer to, or use by or for the benefit of, a disqualified person of income or assets of a plan;
      Act by a disqualified person who is a fiduciary whereby he or she deals with the income or assets of a plan in his or her own interest or account; or
      Receipt of any consideration for his or her own personal account by any disqualified person who is a fiduciary from any party dealing with the plan connected with a transaction involving the income or assets of the plan.

In short, a prohibited transaction is one that violates the purpose of IRA law, which is to benefit the owner in the future after retirement, when distributions are permitted. The owner has a fiduciary relationship with his or her self-directed IRA, and with these rules in mind, they can take use their IRA funds to make a wide range of of the investments.