A popular asset protection strategy has a few “chinks in the armor.”
If you have real estate in a self-directed individual retirement account (IRA), then you likely have at least considered setting up an LLC, called an IRA LLC, within that self-directed IRA in order to further insulate those investments. It’s a common form of asset protection, and a lot of providers recommend that account-holders take this step once or even many times to add layers of protection to individual investments. The theory is that since the account holder is the beneficiary of the IRA, they indirectly own the IRA LLC and the assets within it. Most account holders and asset protection strategists also believe that the assets are fully protected from the IRA custodian’s or trustee’s actions since these individuals cannot act on the contents of the IRA without the beneficiary’s permission.
Unfortunately, that entire premise has some major flaws. Failing to understand where the conventional wisdom regarding IRA LLCs falls flat is crucial to understanding if and how your self-directed investment portfolio is protected.
The best way to explain the “chinks in the armor” of this strategy is with a case study:
A while back, an IRA custodian who headed up a firm that held multiple self-directed IRA accounts started running a Ponzi scheme on the side. By the time he was caught, his investors (not necessarily his account holders) had lost millions of dollars. This demonstrated pretty clearly that he might not have been the best guy for the job of custodian or trustee of anyone’s IRA.
However, the twist in the story (and where your IRA LLC’s “Achille’s heel” becomes evident) happened after that custodian got caught and eventually was instructed by the federal government to compensate his victims for their losses. The feds decided to hit all of the self-directed IRA accounts held by the scammer’s company for a 10-percent fee to cover this compensation. A number of account beneficiaries opted not to pay the fee, believing that their IRA LLCs would protect their portfolios.
Unfortunately, the receiver for the custodian, the guy in charge of collecting the compensation funds, simply filed a motion to force the dissolution of the IRA LLCs so that the 10-percent fee could be forcibly withdrawn. He argued that the custodian was the sole member of the LLCs and that under various state statutes, LLC members have the right to dissolve LLCs. He won. The LLCs were dissolved and their assets sold at auction in order to recover the 10-percent fees from each account, and there was nothing that the beneficiaries could do about it.
Are you scared now? If not, let me sum up what we just learned:
The courts set a precedent that your self-directed IRA custodian can do whatever they want with your IRA LLC.
Now, will your custodian do that? Probably not. But if he or she does, you could be in serious trouble.
Does this mean that self-directed IRAs are not a good way to invest? Of course not! They are among the most flexible and widely available options for real estate investors in particular to effectively build wealth for retirement. However, if you have the option of using a self-directed 401(k) instead, you should explore that option. Investors holding this type of account maintain near-complete control of their investments and are less vulnerable to this scary situation.
Sidebar: Why Do Real Estate Investors Self-Direct Their Retirement?
Self-directed IRAs are tax-advantaged accounts that allow you to save for retirement and invest those savings in just about any type of asset you like – anything the law allows. Since conventional IRAs are usually restricted stocks, mutual funds, or CD’s, investors with special knowledge or expertise in other areas, like real estate or precious metals, tend to find self-directed IRAs particularly attractive.
Real estate investors use their self-directed IRAs to do deals in a variety of ways, including:
- Private Money Loans
- Private Mortgage Notes
- Turnkey Rental Investments
- Tax Lien Certificates
All of these deals can be done, when structured correctly, inside your IRA in such a way as to provide a degree of asset protection to your investment and to create a beneficial tax scenario for your ROI.