Self Directed IRA Tax Implications
Many investors are turning to self-directed IRAs (SDIRAs) in order to diversify their investments and seek higher returns through alternative assets such as real estate and private equity investments, yet these types of accounts typically offer limited financial information and lack liquidity.
Additionally, IRA owners may need to set up complex legal structures like limited liability companies or partnerships in order to hold alternative investments within their IRA accounts, which could create additional complexities that cause errors in reporting and regulatory compliance issues.
Taxes on Distributions
Self-directed IRAs may provide more freedom and choice when investing, but they do come with tax implications that must be carefully considered before any investments are made. Therefore, it is crucial that IRA owners become familiar with these tax regulations prior to making any investments.
For example, if your IRA invests in real estate, profits associated with debt-financed property are considered income from “trade or business.” Under UBIT rules, any such profits must be reported and taxed accordingly.
UBTI typically arises only when an IRA purchases real estate using indebtedness loans, or investments which generate passive income such as rental, royalty and dividend payments. When this occurs, you will likely need to file IRS Form 990-T and pay all applicable taxes due.
Owners of individual retirement accounts (IRAs) should ensure all rental, maintenance and management expenses are covered from within their IRA funds to avoid engaging in prohibited transactions with disqualified persons and protecting their retirement assets. Any time an IRA engages in an unlawful transaction all assets in its account may become immediately taxable with additional penalties being assessed immediately as well.
Unrelated Business Income Tax (UBIT)
UBIT (Unrelated Business Income Tax) is a tax on income earned from carrying on certain trades or businesses by non-profit organizations and government entities, such as IRAs or qualified retirement plans. A business is considered active if it generates revenue with the intent to turn a profit, and must be regularly undertaken rather than being occasional or one-off activities.
The IRS defines trade or business as any activity conducted for the production of income. An art museum that sells educational books on art development would qualify as conducting a trade or business, while selling T-shirts does not.
UBIT includes certain payments received by a controlled organization from its subsidiary such as interest, annuities, royalties or rents. Though experts have discussed reforming it in recent years, its presence remains undiminished and remains an expensive expense for nonprofits as well as an issue between IRS officials and charity advocates.
Prohibited Transactions
Though self-directed IRAs may seem open to almost any investment type, the IRS does regulate and place restrictions on them. Of particular note are their prohibited transactions rules which can result in penalties from 15% of any amount involved up to 100% of its value; prohibited transaction rules for an IRA include these:
Self-dealing investments include investing in real estate that you own or investing in a company that you own (unless the IRA owner can demonstrate that their transaction took place arm’s length). Furthermore, property purchased or sold to disqualified people – which includes yourself and certain family members – are prohibited.
This rule may not always be straightforward when investing in start-ups and closely held companies, such as investments that use start-up capital to establish or fund three businesses that were organized and funded with help from a private equity firm that also managed Mr. Swanson’s funds. As evidenced in Swanson v. Commissioner (Tax Court Memo 2004-260) indirect self-dealing was present during initial capitalization and funding of three businesses organized and funded with private equity firm assistance by Mr. Swanson himself.
Requirements for Custodians
IRS law mandates that your IRA assets must be stored with an authorized custodian, making selecting one essential to ensuring your investment strategy’s success.
Questions to pose when looking for an individual retirement account (IRA) custodian include:
Are they capable of supporting investments in alternative assets, such as real estate and private equity?
Have they a firm grasp on the regulations pertaining to your chosen investment class?
Are they aware of prohibited transactions?
Your chosen company must offer an opinion as to whether your investment constitutes an illegal transaction, in order to safeguard yourself against being penalized by the IRS and face fines or taxes due to breaking their rules.
Consider customer testimonials, security protocols, fees and any other variables that could have an effect on your IRA account. It should also be easy for you to communicate with their service team; the top companies have staff with extensive knowledge regarding self-directed retirement accounts.
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