Expanding the IRA Investment Universe

The investment universe is expanding for many IRA owners. Some uses of the accounts that are becoming more frequent are: investing in a small business, either your own or that of a friend or relative; becoming a mortgage lender; buying real estate; and investing in gold, among many other investment options.

Your IRA doesn’t have to be invested in publicly-traded stocks, bonds, or mutual funds. Most IRA sponsors restrict you to these options, because that is what they are geared up to hold. But the law allows many other investments in IRAs.

For your IRA to own any of these other investments, you have to find an IRA custodian or trustee that allows a true self-directed IRA, one that allows you to invest in any asset permitted by law. (In fact, some let you invest in assets not permitted by the law. It’s up to you to know the rules and be responsible for any penalties the IRS imposes.) You can find these custodians and trustees by going to your favorite Internet search engine and searching for “self-directed IRA.” The firm that appears to have done this the longest is The Entrust Group, though I haven’t dealt with it.

A true self-directed IRA has higher fees than a conventional IRA. The trustee has to do more work, and there are fewer IRAs of this type so the custodian doesn’t have the scale and efficiencies of traditional IRAs.

One way to make a true self-directed IRA more efficient and reduce some of the costs is to form a limited liability company and have it be wholly-owned by the IRA. That way, you can conduct transactions through the LLC and not have to pay the IRA custodian’s fee for each transaction. Even so, the LLC can engage only in transactions allowed for an IRA directly, and it also must file an annual tax return. It probably also has to pay an annual fee and file a form under state law.

Having the LLC isn’t essential to make nontraditional investments through an IRA. If you plan to use the self-directed IRA to make only a few purchases that you hold for the long-term, you might not want to bother with the LLC. It might cost less to avoid the LLC and pay the custodian’s fees.

Once you set up the self-directed IRA, either with or without an LLC, the next step is to invest the IRA the way you want without violating the rules against prohibited investments and transactions.

The list of prohibited investments for IRAs is short. It consists of life insurance and collectibles. Collectibles include art, antiques, rugs, stamps, coins, metals, gems, and alcoholic beverages. The IRS can add to the list but hasn’t. There are some exceptions, such as U.S.-minted gold coins that are legal tender. Those are allowed in IRAs.

The longer and more significant list is of prohibited transactions. It’s easy to make a mistake and stumble into a prohibited transaction and its penalty. You want to avoid prohibited transactions, because the penalty is that the entire IRA will be treated as fully distributed when the prohibited transaction was made. The IRA owner must include its full value in gross income, regardless of the amount of the prohibited transaction. If the owner has multiple IRAs, only the IRA that engaged in the prohibited transaction is penalized.

Basically, a prohibited transaction is an IRA investment or deal with a related or disqualified person. It doesn’t matter if the transactions are at fair market value. They are prohibited at any price.

There are six prohibited transactions between IRAs and related parties. The first four are specific, and the last two are general.

The specific prohibited transactions are:

* A sale, exchange, or lease of property;

* A loan of money;

* Furnishing goods, services, or facilities; and

* A transfer or the use of the income or assets of the IRA;

The general prohibitions are: an act in which the related party deals with the IRA income or assets as his or her own; and the receipt of any benefit for the related party’s personal account in connection with a transaction involving the IRA’s income or assets.

Stated in clear, plain English the prohibited transactions can be summarized as: No deals are allowed involving the IRA and the owner or a person related to the IRA or its owner.

A related person for an IRA is the IRA owner; anyone who makes decisions for the IRA; anyone providing services to the IRA; an ancestor, spouse, or descendant of the IRA owner, of the owner’s spouse, of a decision maker for the IRA, or of anyone providing services to the IRA; a corporation, trust, partnership, or estate that is 50% or more owned by any of the above persons; an officer, director, highly compensated employee, or 10% or greater owner of any of the above; and a partner of any of the above.

That sounds comprehensive, but it isn’t when you look at the details. Not included as related persons are brothers, sisters, step relatives, nieces, and nephews of the IRA owner. Also not included are friends and neighbors of the owner. A “significant other” to whom the IRA owner is not married also is not a related person.

Roth IRAs don’t escape these rules. A Roth IRA is subject to the same rules as traditional IRAs and other qualified retirement plans unless specifically exempted. There isn’t an exemption to the prohibited investment and transaction rules for Roth IRAs. In addition, the IRS appears to have gone a step further for Roth IRAs. It issued a notice stating that any transaction between a Roth IRA and a “related party” would be considered a tax shelter or an abusive transaction required to be registered with the IRS. For this notice, the IRS considered brothers and sisters as related parties. (IRS Notice 2004-8)

The good news is the Department of Labor is allowed to grant exemptions from the prohibited transaction rules for specific taxpayers with specific transactions. Under the procedure for granting exemptions, the DOL grants a number of exemptions each year. Here is a sample of exemptions granted in the past:

• An IRA owner sold real estate to his IRA.

• An IRA owner sold stock to his IRA.

• An IRA owner purchased stock from his IRA.

• An IRA owner purchased real estate from his IRA.

• An IRA lent money to a corporation of which the IRA owner was the sole owner. That means when loan payments were made, the corporation deducted interest it paid to the IRA.

The DOL also grants “class exemptions” so that everyone engaging in that type of transaction does not have to apply for an individual exemption. Anyone meeting the qualifications stated in the class exemption qualifies. Class exemptions cover many transactions that IRA owners typically want to engage in.

The possibility of an exemption widens an IRA’s investment options. For example, an IRA might be able to write the mortgage on the owner’s next home or vacation home. Instead of writing mortgage checks and paying interest to a bank or other lender, the owner will be making the payments to his or her IRA. And the interest payments likely will be deductible. That’s a pretty good deal.

Another possibility is that the IRA can invest in the owner’s business or the business of someone close to the owner.

Exemptions are granted through the Employee Benefits Security Administration of the Department of Labor. You can find more about them at this web site address: http://www.dol.gov/ebsa/regs/technical_guidance.html#exemptions. But I don’t recommend proceeding down this road on your own. The rules are technical, and you have to comply with them completely. You should consult with an accountant or attorney who is well-versed in the rules for IRAs and retirement plans. As mentioned earlier, the penalty for mistakes is steep and should be avoided.

You can find more details about these and other rules in my report, IRA Investment Guide: A Road Map for Avoiding the Traps and Penalties for IRA Investments, available through the “Bob’s Library” tab on the web site at www.RetirementWatch.com.