Rules & Restrictions

A properly structured Self-Directed IRA is considered the by IRS to be no different from what most of us think of as a "standard IRA". The IRS does not distinguish between a Self-Directed IRA and a "standard IRA", but instead provides guidelines and enforces rules on all IRAs. The main difference between a Self-Directed IRA and a "standard IRA" is the investment flexibility provided by the Self-Directed IRA as compared to the typically limited investment options in the "standard IRA".

While Self-Directed IRAs can potentially provide an IRA owner with significant economic benefits, it is very important to understand the limitations and risks of Self-Directed IRAs. Please remember that a Self-Directed IRA is actually just an IRA, so the risks will generally be the same for both IRA structures. Each investment in each IRA will carry their own benefits and risks. Some of the risks associated with Self-Directed IRAs include but are not limited to:

• Prohibited Transactions: It is very important to avoid prohibited IRA transactions. This can lead to unnecessary taxation and potential penalties. Examples include borrowing money from the IRA, selling property to the IRA, receiving unreasonable compensation for managing the IRA, using the IRA as security for a loan, and, buying property for personal use (present or future) with IRA funds.
• Investing in Collectibles: IRA funds cannot be invested in collectibles such as artwork, rugs, antiques, metals, gems, stamps, coins, alcoholic beverages, and certain other tangible personal property.
• An IRA Cannot Buy Life Insurance: Life insurance cannot be purchased or held in an IRA.
• No S-Corporations: S-Corporations cannot be held in an IRA. Other asset ownership forms are acceptable.
• Making Excess Contributions: An individual may not make excess contributions to an IRA account.
• Taking Early Distributions: Unless strict rules are followed and/or unless specific events occur, premature distributions will be taxed and potentially penalized.
• Allowing Excess Amounts to Accumulate (failing to take required distributions): One of the potentially largest penalties an IRA owner faces is caused by not adhering to the minimum IRA distribution rules as set forth by the IRS. Such excess accumulations can be subject to a 50% federal excise tax.
• Lack of Liquidity: Investments in an IRA might be partially or fully illiquid because there is no established secondary market for reselling the asset. These types of assets in an IRA should be viewed as long term investments.
• Timing of Real Estate Investment Exit is Unknown: Because there is no set date, nor preset sales price, to sell a real estate investment, there is uncertainty to when an asset will be sold and how much the asset will ultimately be sold for. IRA assets are primarily used for retirement savings. If an asset in an IRA is not liquidated at the time the asset, or income from the asset is needed, retirement goals might not be achieved.
• Capital Expenditures: Real estate or other types of assets purchased in the IRA could require additional cash in the future for capital expenditures, repairs, legal costs, and other miscellaneous costs. The IRA cannot pay these costs, the IRA must pay the costs. If the IRA does not have sufficient funds to pay these expenses, additional deposits or transfers might have to be made into the Self-Directed IRA account. IRA owners must make sure to avoid making excess contributions.
• Cash Distributions: Cash distributed from IRAs, other than from Roth IRAs qualifying for tax-free status, will be taxed fully for ordinary income tax purposes.
• Lack of Exposure Among Professionals: Many professionals from the financial, real estate, accounting and legal industries may not fully understand the potential tax and investment risks of Self-Directed IRA accounts.
• Projected Cash Flow May Not "Flow" as Planned: The net cash flow from the assets in an IRA can be affected by many things. Therefore, current and future cash flow from the assets can fluctuate tremendously and can be lower than what was originally anticipated. For example, if real estate is the asset in the IRA, net rental cash flow issues can be attributable to many things such as:
  • Tenants being delinquent with lease payments
  • Tenants moving out and having to make concessions, pay costs to acquire new tenants
  • Extra expenses not planned for
  • Soft leasing market
• Projected Appreciation May Not Occur as Planned: Every IRA owner wants his/her IRA to increase in value. It is important to understand that typically there is no guarantee that the IRA assets will appreciate in value, nor that the IRA assets will provide a better rate of return than other non-IRA investments, nor that the IRA won’t ultimately decrease in value. There is no guarantee that the IRA will make any money at all.
• Co-Owners: If IRA assets are invested in an asset that has multiple, or co-owners, the IRA owner is locked into a long-term relationship with other people, who may not have known each other previously.
• Income Tax Risks: Every IRA has the potential to be affected by a tremendous number of income tax risks. In addition to non-compliance with IRS rules, a major income tax risk is higher tax rates when IRA distributions are made to the IRA owner as compared to the income tax rates at the time the IRA contribution was made.
• The IRS Could Change the Laws Regarding IRAs: The IRS has provided significant technical guidance in regards to IRAs. But at any time the rules for IRAs can be changed.
• Costs and Fees: Typically there are costs and fees involved with investing in any IRA asset. Some of these fees include sales commissions and compensation to the registered representative and syndication fees paid to the sponsor and others involved in the acquisition, packaging, distribution and sales process. Additionally, these fees include offering and organizational fees incurred by the sponsor to establish and promote the asset to the public. These fees ultimately decrease the net realized rate of return for the IRA assets.
• Estate Taxes: Assets remaining in an IRA at the time of an IRA owner’s death will typically be includable in the deceased IRA owner’s estate, and thus subject to potential estate taxation. This is true for all types of IRAs including Roth IRAs. This statement might confuse many Roth IRA owners because Roth IRAs can provide income that is tax-free for income tax purposes. But ALL IRAs are includable in the estate, including Roth IRAs.
• No Basis Step-up: IRAs, other than Roth IRAs and the non-deductible portion of traditional IRAs, have an effective tax cost basis equal to $0. This simply means that every dollar distributed will be subjected to ordinary income taxation. Many assets that are held outside of IRAs receive a "stepped up basis" when the owner passes away which effectively eliminates any taxable capital gain and accompanying income taxes. IRA assets do not afford this same benefit. $500,000 in a taxable IRA account will remain as a fully taxable $500,000 account for beneficiaries.
• Another Significant Consideration Is The Management Of The Assets: By definition a Self-Directed IRA will require management participation of the IRA owner. When to buy assets, when to sell assets, day-to-day management, and basically all decisions will be a responsibility of the IRA owner.
• Long Term Commitment: More than any other structure, IRA assets typically require the mindset of "long-term commitment". IRAs are meant for retirement which is long-term. IRAs are typically taxable so lump sum distributions are infrequent which also points to long-term.
• Current Liquidity: It is imperative to retain enough liquidity in an IRA, especially a Self-Directed IRA, to meet the ongoing expenses associated with an investment (e.g., taxes, mortgage payments, minimum distribution payouts, capital calls, etc.). A lack of liquidity could cause an IRA owner to sell off holdings in order to meet obligations. The prospect of liquidating IRA holdings in order to satisfy cash flow demands could lead to highly unfavorable investment decisions.
• Unrelated Business Taxable Income: Income in an IRA might create Unrelated Business Taxable Income, causing taxation in an otherwise tax-deferred account. Please see the next section titled "Unrelated Business Taxable Income – UBTI" for more details.