Does the IRS Audit Self Directed IRAs?
Self-directed IRAs allow investors to expand their investment options beyond stocks and bonds by exploring real estate, private placements and other alternative assets.
However, investing in these assets requires strict observance of tax and compliance rules; otherwise the IRA could be disqualified and lose any associated tax advantages.
Self-directed IRAs follow their own set of regulations in addition to those standard to all retirement accounts, such as prohibited transactions, UDIC/UBTI taxes, fair market value (FMV) reporting etc.
Know the rules to prevent yourself from infringing them, which can have costly repercussions both taxation-wise and reputationally.
The IRS prohibits you from purchasing property owned by your SDIRA that also serves as your residence, nor from directly benefitting from what the SDIRA owns, such as renting it out or receiving income from it.
Common mistakes include failing to follow up properly on K-1s from project entities, not reading K-1s from an IRA custodian and not being aware of potential red flags for fraudulent investments; such as new investment companies without track records or offering unreasonable high rates of return as indicators of fraudulent behavior.
2. Due Diligence
Due diligence refers to the process of researching an investment or transaction before entering into it. The phrase is commonly used in business settings when investigating potential partners before entering into contracts together.
Self-directed IRAs require additional rules for due diligence to operate properly. For instance, the IRS prohibits using assets owned by an IRA to benefit disqualified people or rent real estate owned by it as tenants or renters. Furthermore, IRA funds cannot be loaned directly or personally guaranteed loans in its name.
Since alternative investments aren’t vetted by your custodian, it’s up to you and your advisors to verify whether they are legitimate – this includes verifying whether an IRA reports its fair market value to the IRS every year. Mismatched fair market values could result in prohibited transactions with potentially severe tax implications; to protect yourself against this happening it’s vitally important that a due diligence process with clearly defined individual responsibilities, tasks and project deadlines as well as a list of questions is established prior to investing.
Self-directed IRAs allow investors to diversify their retirement investments with alternative assets such as promissory notes, private placements, tax liens and real estate investments that may lack transparency or liquidity compared to publicly traded stocks or may not be audited annually by an external auditor. Each year the custodian of an IRA must report investment information back to the IRS using Form 5498 which serves only as an informational filing and does not require taxes or penalties be paid from within their IRA account.
SDIRA investors must also understand the rules and regulations surrounding their asset purchases and sales, in addition to avoiding prohibited transactions. Reputable dealers should be used as advisors when buying or selling investments to ensure compliance and avoid run-ins with the IRS; additionally they can assist the IRA owner in conducting due diligence on each investment – steps which help avoid UBTI (Unrelated Business Taxable Income) or UDFI (Unrelated Debt Financing Income), both of which can cause taxable events with reporting requirements attached.
Self-directed IRAs allow more freedom when it comes to investing in alternative assets than a traditional IRA; however, their own set of regulations must be observed in order to avoid penalties and taxes.
Under law, any activity with an SDIRA that constitutes illegal transactions and receiving indirect benefits is unlawful, such as living in property owned by your IRA, using it to pay personal expenses incurred through self-directed investments, lending money or borrowing against self-directed IRA investments and lending money back out again against yourself or borrowing against an SDIRA investment.
SDIRAs must file Form 990-T with the IRS as well, similar to how charitable organizations file this tax return. While Form 990-T typically applies only to organizations earning unrelated business income (UBI), an SDIRA/LLC that invests in real estate could find itself subject to IRS auditing that could result in major tax adjustments that undermine its original purpose.