by: Thomas Fafinski
IRA ownership of investments that are nonmarketable securities is perfectly legal. Todd Grill, owner of Nexus Direct IRA in Plymouth, Minn., says, “Why wouldn’t you invest in things you know? If you are a real estate investor, why wouldn’t you want your money in real estate? If you are interested in lending money, why wouldn’t you want to lend money using tax-favored funds? The types of investments you can make with your IRA are nearly unlimited. You can invest in metals, livestock, promissory notes and private placements.”
That said, you should never:
- Commingle IRA and personal funds
- Allow the IRA to transact with any lineal descendant relative or related entity
- Perform services for the IRA owned investment beyond investment management
“This strategy is not for everyone or for every investment,” says Paul Miller, recently selected a FIVE STAR Wealth Manager by a 2010 independent consumer survey and owner of Edina-based Business by Design, an entrepreneur coaching and tax preparation firm that offers assistance with establishing accounts. “For instance, if you invest in real estate with your IRA, it is not as powerful if you have mortgage financing. Financing real estate with your IRA can lead to unrelated business taxable income that is taxed at the highest rate. That said, for a sophisticated entrepreneur, this strategy certainly has its benefits.”
There are some legal limitations to what you can invest in with your IRA, too. IRAs are not allowed to invest in:
- Life insurance
- Collectibles
- Loans to disqualified persons
- “S corporation” stock (this actually being a requirement of the S corp regulations rather than a function of the IRA rules)
Even though S corporation stock is off limits, you certainly can invest in regular C corporations or limited liability companies, or LLCs. Extreme care should be given when forming an LLC as the risk of commingling personal and IRA funds is exacerbated. There is a danger that the IRA owner actively manages the LLC by managing the property. Some IRA custodians are unwilling to hold an unconventional IRA investment in an LLC. Others will allow you to take ownership of the investment through an LLC if you are working with experienced professionals.
Melissa Twaddle, president of Entrust Midwest, LLC, says that real estate investors need to be careful “not to perform personal services to improve the value of the IRA-owned real estate. If the IRA owner or beneficiary engages in a prohibited transaction with respect to the IRA, the IRA stops being an IRA as of the first day of the year. The income then becomes taxable on the entire IRA value, plus 10 percent if you are under 59½.”
So who is a disqualified person? People related as lineal descendants, e.g., grandparents, parents, children, spouses and anyone that qualifies as a grandparent, parent or child of your spouse. Additionally, if any of these persons are in a fiduciary capacity in an entity that is controlled by them, the entity becomes a disqualified person.
There is more to the disqualified person rules than meets the eye. Prohibited persons include any other person (including those not otherwise disqualified) involved in a transaction or series of transactions that would lead to a benefit (any type of benefit, including anything indirectly benefiting an employer) to any disqualified person listed above, e.g., parents, grandparents, etc. In the interest of fair disclosure, I have personally invested in real estate through my own IRA and through my children’s educational IRAs.
On a final note, Paul Miller states, “If you don’t look at converting to a Roth IRA this year, then you are making a big mistake. If your financial advisor does not suggest that you consider investigating a conversion to a Roth IRA, you should have other things to consider too.” By combining the Roth conversion with self-direction in non-traditional investments, you may also be able to obtain discounted values for the tax on your Roth conversion.