If you have set up a self-directed IRA, you have probably done so with the intent to expand your investing options outside of securities and obtain higher returns. However, in pursuit of those returns, you may want to pause and consider whether you crossed any lines subjecting your IRA to taxes, penalties or disqualification.

I bring this to your attention because of findings in the Treasury Inspector General’s Report, wherein it appears the IRS is turning its attention to IRA account owners. This report, coupled with a recent change in one of the annual reporting forms supplied by the IRS to your custodian, leads one to the obvious conclusion that the time for scrutiny of your IRA is now.

The two areas under scrutiny by the IRS are:

1. Non-Traditional Investments (NTIs) held in self-directed IRAs, which could lead to prohibited transaction violations.

2. Unrelated Business Taxable Income (UBTI) or Unrelated Debt Financed Income (UDFI) being generated by investments in IRAs.

The IRS’s quest to find the above missteps by IRA account holders began with the agency sending notices to IRA custodians, followed up by an examination program of specified IRA accounts meeting certain characteristics. The following is a brief summary of the scrutiny and what you should do now to avoid problems in the future.

Non-Traditional Investments

From an investment standpoint, the IRS is concerned over IRAs holding specific types of assets that lend themselves to possible prohibited transactions. Real estate and business entities are of particular concern because IRA account holders are not fully aware of the prohibited transaction rules and have made mistakes with their investing, giving rise to taxes and IRA disqualification.

Here is a partial list of problems I have discovered through my conversations with IRA account holders:

• Loaning money to your IRA or IRA-owned LLC.

• Personally rehabbing real estate held by your IRA or IRA-owned LLC.

• Receiving a management fee for managing your IRA-owned LLC.

• Handling all of the property management duties for IRA-owned real estate.

• Living in one of the units owned by your IRA.

• Assets not properly titled in the name of the IRA or IRA-owned LLC.

• IRA-owned LLC’s revocation by the state of formation for failure to renew.

• Personally guaranteeing a loan to an IRA.

• Personally paying for the setup of an LLC owned by your IRA.

The tax consequences for engaging in a prohibited transaction are extremely costly. Here is an example that many SDIRA account holders can probably relate to:

John attends a real estate convention wherein he listened to a speaker tout the benefits of a SDIRA. Tired of the stock market’s unpredictability, John decides to meet with Susan, a representative of ABC IRA, to discuss how he can roll over his $500,000 401(k) account into an SDIRA and have complete control over the investments. Susan explains how, for $3,000, ABC can set John up an SDIRA with an LLC wherein he will have checkbook control over his money. Enticed by the possibility, John pays ABC $3,000 using his personal credit card to set up his plan.

John unknowingly engaged in a prohibited transaction when he paid ABC $3,000 to establish a SDIRA and an LLC. Under IRC 219(e)(1), cash is the only permissible IRA contribution. When John paid $3,000 to set up the SDIRA, part of his payment was for the creation of an LLC. Thus, John was making an impermissible contribution of an LLC he paid for to his SDIRA. If John’s transgression is discovered by the IRS, John risks disqualification of his entire IRA, resulting in income taxes on his $500,000, plus a 10 percent early withdrawal penalty and a possible 15 percent prohibited transaction penalty.

(Note: If your IRA is disqualified, then you also lose any asset protection benefits afforded your IRA.)

If you are wondering how the IRS might discover John’s mistake, you need only look to John’s IRA custodian, who will report John’s LLC/IRA transaction to the IRS on Form 5498. Form 5498 is required to be submitted to the IRS on an annual basis.

The form requires your custodian to identify if your IRA holds an interest in real estate, LLCs, limited partnerships, trusts, corporations, deeds of trust, promissory notes or any asset not traded on an established exchange. This is a substantial change from the previous version of Form 5498, which did not require identifying any such assets.

Herein lies the concern. If your IRA holds these assets, this information will be provided to the IRS and will possibly fall within its examination program.

If your IRA is invested in nontraditional investments, then it might be in your interest to consider some “spring cleaning” to correct any prior transactions that might result in penalties or disqualification of your IRA if discovered.

Unrelated Business Taxable Income (“UBTI”) 

In addition to prohibited transactions, you must also be aware of possible transactions that subject your SDIRA to taxes. Earnings within an IRA (or IRA/LLC) are exempt from tax. However, certain investments can create taxable income, i.e., UBTI. UBTI is income from a trade or business carried on by the IRA or IRA/LLC. The Internal Revenue Code does not define active trade or business regarding an IRA, but it does provide some statutory “modifications” that specifically exclude certain types of income out of UBTI. These include, but are not limited to:

• Dividends (e.g. paid to the IRA as a result of the IRA-owning C Corporation stock).

• Interest (includes “points”).

• Royalties.

• Rent from real property.

• Sales proceeds from real property.

The issue for some IRA account holders is certain passive activities can rise to the level of a trade or business. Such an example is flipping or developing real estate inside an IRA. It is well recognized by the IRS that an individual can be a “dealer” of real estate (i.e., purchases property with the intent to resell. A dealer is actively engaged in the trade or business of real estate.) This same test can be applied to an IRA. If the IRS determines your IRA is engaging in a trade or business, then the gains will be subject to trust tax rates:

$0 – $2,500 = 15%

$2,500 – $5,900 = $375 + 25%

$5,900 – $9,050 = $1,225 + 28%

$9,050 – $12,300 = $2,107 + 33%

Over $12,300 = $3,179 + 39.6%

Other activities that, taken independently, would not be considered a trade or business inside your IRA, could rise to this level if the IRA account holder actively engages in such activity outside of the IRA as a trade or business. An example would be private lending. If a person actively pursues private lending as a private business venture utilizing his IRA for the same activity could give rise to UBTI. The IRS might argue the same activity is taking place in the IRA that is carried on outside by the account holder.

If UBTI wasn’t enough of a concern, you also need to be up to speed on “unrelated debt-financed income” (UDFI). UDFI occurs when your IRA receives (either directly or indirectly through a “flow-through” entity, like an LLC) income from “debt-financed” property.

Consider Kevin, who set up a self-directed Roth IRA and rolled over $80,000 from his traditional Roth. Kevin wanted to use his funds to purchase a rental house. With the help of a fellow investor and his IRA custodian, Kevin bought a rental property in Las Vegas for $200,000. Kevin was able to make the purchase with the assistance of an unrelated lender who loaned Kevin’s IRA $120,000 on a nonrecourse basis. (A nonrecourse loan is one where the lender can only look to the asset itself for recovery in the event of default, i.e., no personal guarantee.) Kevin’s first-year rental income, after expenses, was $20,000. Kevin was ecstatic with his tax-free return until he spoke with his CPA, who informed Kevin his Roth IRA must pay $2,000 in tax on the income. Kevin was confused; he thought Roth IRAs were supposed to be tax-free. Unfortunately for Kevin, his IRA custodian did not explain the rules to him; the use of debt inside of an IRA is a taxable event.

Kevin’s situation is not unlike those of many real estate investors who have used their self-directed IRAs to purchase real estate using nonrecourse financing. When an IRA uses debt for a purchase, the debt-financed portion of the investment is taxable to the IRA at the trust tax rates mentioned earlier. In Kevin’s situation, he borrowed $120,000 to make a $200,000 purchase. Therefore, 60 percent of the acquisition cost was attributed to debt. Thus, $12,000 of the $20,000 in annual income is taxable to Kevin’s IRA. Further, when Kevin later sells the property, his IRA will pay tax on the debt-financed portion of the gain.

Using debt inside an IRA will allow you to make more and larger deals, but it comes at a cost: high taxes. Also, consider that if your self-directed IRA is not a Roth, then you will be taxed a second time on your money when it is withdrawn. Often, real estate investors using debt inside their IRAs end up paying over 45 percent in taxes on their income. (Note that expenses attributed to the property, e.g., depreciation, management fees, etc., are deducted against your income in calculating the taxable amount.)

IRA Tax Filing

If you think you have engaged in a transaction resulting in possible UBTI or UDFI, it is important you bring your tax filing into compliance sooner rather than later. IRAs with taxable income must file Form 990-T by April 15 and pay any tax due (depending on the amount of the tax you may be required to make quarterly payments). Failure to timely file and pay the tax will result in the following penalties:

Interest // This includes interest charged on taxes not paid by the due date and interest charged on penalties imposed for failure to file, negligence, fraud, substantial valuation misstatements and substantial understatements of tax from the due date (including extensions) to the date of payment.

Late filing of return // Failure to file Form 990-T for other than reasonable cause may subject your IRA to a penalty of 5 percent per month of the net amount due, up to a maximum of 25 percent. The minimum penalty for a return that is more than 60 days late is the smaller of the tax due or $135.

Late payment of tax // A penalty for late payment of taxes is usually half of 1 percent of the unpaid tax for each month or part of a month the tax is unpaid. The penalty cannot exceed 25 percent of the unpaid tax.

Penalty for not filing quarterly // A penalty is assessed against IRAs that do not file quarterly estimated tax payments in the same manner as a corporation. In other words, after the first 990-T is filed, the IRA must make payments every three months.

To file a 990-T, your IRA must obtain a federal tax ID number (“EIN”). Not only will you need this number for tax reporting, you will also need it if you plan to invest in a partnership, LLC or other entity required to file a tax return, purchase promissory notes, engage in private lending, or issue or receive 1099s, 1098s or K-1s.

Most self-directed IRA investors are unaware of their responsibility to file. Some operate under the assumption their custodian is responsible for handling all reporting. I must disabuse them of their belief because their custodian is not in the position to have all the information necessary to file the 990-T. Most self-directed IRAs are set up with an LLC to give the account holder “checkbook control,” and as a result, all investment paperwork is sent to the IRA account holder.

The good news is these problems can be easily addressed and corrected with the right support and front-end advice

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  • Clint Coons

    Clint Coons is a founding partner of Anderson Law Group and current manager of the Washington state office of Anderson Advisors, a legal, business and tax specialty company. Real estate investing is a major focus of his practice. A noted author and presenter on asset protection and tax reductions, Coons has gained national recognition as an expert in his field and is noted for his ability to take a complicated law or structure and explain it in clearly understandable terms. For more information, visit www.andersonadvisors.com.

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