Self-Directed IRA and Self Dealing

[Tanner Gish]

Hey Friends,

  There is probably some seminole BP thread that asnwers this already, but I haven't found it yet.

My account just put a damper on my plans to fund a Self Directed IRA this month with a 2015 max contribution, and a 2016 max contribution in early Jan, and to take those $13,000 to invest in a flip project I'm working on. I was told my plan has two shortcomings:

1) You cannot use proceeds from a self directed IRA to finance (purchase or rehab) any part of a deal you manage (even it the property is owned by an LLC, I still own the LLC)- this is "Self-dealing." True?

2) You cannot do this, and let's say, this $13k was all that was needed for rehab (let's say property was purchased with another loan) as equity ownership in the property, and after the flip, the profit share for that borrowed $13k was, say, $20 k (a 153% return), that this also not allowed- the rate of return cannot exceed what typical equity market return would be. I find this "counsel" I received pretty unbelievable, as I'm pretty sure Uncle Sam won't stop you from making this kind of return had you bought Netflix stock with your IRA years ago and made that kind of return.

  Humbly looking for your wisdom and advice. Thanks!

-Tanner

[Brian Eastman]

@Tanner Gish

I guess my earlier post was not entirely clear.  I was rushing out the door to run a shift at the scouts tree lot.

There is no limitation on the rate of return that an IRA may receive. A self directed IRA is no different from any other IRA when it comes to tax rules. You just have a different type of vehicle that may invest differently.

There are, however, two taxes that get in the way of the scenario you mention - assuming perhaps that the IRA capital was an equity stake in someone else's flip property for example.

When a tax exempt entity such as as IRA, church, etc., engages in a trade or business activity on a regular or repeated basis, there is a trust tax known as UBIT that applies. This tax pre-dates IRA plans and was enacted by congress to prevent tax-exempt entities from driving tax-paying businesses out of business.

When an IRA uses leverage, there is another trust tax known as UDFI that applies to the profits derived from the non-IRA capital.

The two taxes do not double up, and UBIT tax precedence of UDFI, but on a highly leveraged flip one could have exposure to both.

If you want to go into tax-land, check out IRS publication 598.

With that background aside, you could successfully put IRA money to work in real estate. You just need to do the homework to understand the rules and strategize accordingly. It is tough to justify setting up a self directed IRA and potentially engaging tax counsel if you want to engage in the tax-implicated transactions indicated above for a $13K account. It is also difficult though certainly not impossible to put a smaller amount of capital such as that to work in real estate.

Investing in discounted notes, tax liens, or hard money lending are generally the types of avenues that work well with a newer account with less capital, as these strategies do not have tax implications and can be done with lesser funding.