Last fall, Kiplinger's Personal Finance ran a story that featured a professional home remodeler who bought a fixer-upper with cash inside his Individual Retirement Account and then turned a quick profit after sprucing it up and reselling it. What's remarkable about this story? The fact that the investor seemed oblivious to the legal and financial troubles he might encounter if a copy of the magazine piece ever hit an auditor's in-basket at the Internal Revenue Service.
Even if the enterprising investor had only sawed a few two-by-fours, installed a sink or merely swept the floor, he faced potential legal problems. "The guy's got tax evasion issues," suggests CPA Ed Slott, principal at E. Slott & Company in Rockville Centre, N.Y. and the author of Parlay Your IRA Into a Family Fortune (Penguin). And that's hardly the only tax problems this investor could face. The various violations, if proven, would entitle the IRS to take a claw hammer and smash his IRA to bits.
Anecdotes like this understandably turn many investment advisors, CPAs and attorneys into hard-bitten skeptics when someone periodically asks them about self-directed IRAs. These IRAs, which allow individuals to sink money into property, private equity, trust deeds and other types of investments that traditional IRA custodians won't touch can seem as fragile as Faberg? eggs. And yet custodians in this niche field report soaring interest in self-directed IRAs, which make up roughly 2 percent of the estimated $3.6 to $3.8 trillion IRA market.
Clinging to your own prejudices against this IRA oddity may not always be in your clients' interest or your own. Disenchantment with the stock market and a keen interest in real estate and other nontraditional investments has propelled more investors into exploring alternatives. Also fueling this interest are wealthy clients with hefty IRA account balances who not only understand real estate, but also may have made some of their fortune with property. It's these investors who have chafed at their inability to use retirement cash to build more wealth in land. Try talking this type of client out of investing tax-deferred money in a condo in Scottsdale, Ariz., or a strip mall in Ithaca, N.Y., and they may walk out the door to find someone more openminded.
For all the potential hassles, Natalie Choate, an attorney at Bingham McCutchen LLP in Boston and the author of Life and Death Planning for Retirement Benefits (Ataxplan), believes that for the appropriate client, a self-directed IRA can be worthwhile. "If you have a sophisticated IRA owner who is willing to pay professional fees to make sure it's done right and not simply rely on promoters' statements, some valuable deals [will] get done."
In fact, a small but increasing number of advisors, CPAs, brokers and attorneys are concluding that self-directed IRAs are worth learning about and incorporating into their practices. Franklin H. Federmann, CPA, MST, principal at Federmann Financial Advisors Inc. in Ronkonkoma, N.Y., has helped a couple of his sophisticated clients invest a small portion of their retirement portfolios in residential waterfront property on Long Island [N.Y.]. "I'm not actively marketing this," he says, "but my clients came to me and said, 'I want to do this or that.'" Federmann, who chairs the personal financial planning committee of the New York State Society of CPAs, says he doesn't include the value of the properties when calculating his clients' annual fees, but it certainly would be allowable.
Other professionals have chosen different payment models. In Washington state, advisor Eric Wickstrom, CFP, CPA, says he charges a consulting fee for people who want to add real estate to an IRA. Wickstrom, who worked in the real estate investment field 20 years ago, educates interested clients about the rules, assists in locating a real estate agent and, ultimately, helps with the documentation. If investors become financial planning clients, he charges either a flat annual fee for overseeing the self-directed IRA or assesses an annual 15 or 20 basis points on the property's value.
If you're intrigued with self-directed IRAs, it's not hard to get yourself noticed. There are approximately 20 self-directed IRA custodians in this country and many--if not all of them--would be quite interested in making your acquaintance. Denver-based Fiserv ISS--which custodies both traditional and alternative IRA investments--is the leader in the field, with a purported 60 percent of the market and a current campaign to bring real estate investments in particular to the attention of its advisor clients. Others--such as Pensco Trust Company in San Francisco, Equity Trust Company in Elyria, Ohio, and Entrust Administration in Oakland, Calif.--are also actively forming alliances with professionals willing to learn the considerable minutiae of rules governing self-directed IRAs. It's a natural fit, since custodians are strictly IRA administrators, which means they don't provide financial advice or due diligence on any investments. "When an individual calls us," says Richard Desich, Equity Trust's VP, marketing, "we provide general education about how, generically, you can make a transaction, but we don't look at an investment and say that it's good or [bad]."
Typical self-directed IRA candidates are between the ages of 40 and 65 and are knowledgeable about a particular type of investment. Often, their expertise involves real estate, but other professional skills come into play as well. One of Pensco's clients, for instance, is a bankruptcy attorney who used his IRA to buy bankruptcy claims. Another is a longtime Alaskan fisherman who acquired fishing rights in her state and then subleased them to other fishermen for a source of steady income.
And saltwater fish are hardly the oddest investment. There is, in fact, a great deal of freedom on what investors can tuck inside a self-directed IRA. Esoteric investments such as trees, farms, earth-moving equipment and franchises have found their way into the savings instruments. Only four investments are actually considered forbidden fruit: collectibles, S corporation stock, life insurance and loans to the IRA owner. Real estate is the most popular choice, however, while private equity is considered the runner-up. What's also unusual about self-directed IRAs is that individuals can band together to boost their buying power. Leveraging is also permitted and growing in popularity, but borrowing inside an IRA comes with its own caveats.
The freedom to invest in areas that brokerage firms would spurn has created both fortunes and financial debacles. "The bottom line is that we have had hundreds, if not thousands, of clients who have become millionaires through real estate," says Tom Anderson, Pensco's president. When problems do occur, it's usually because the investments were inappropriate or investors trampled on tax rules. Plenty of do-it-yourselfers don't evaluate an investment's suitability and overlook the potential challenges down the road. For example, what happens if an IRA is tied up in a vacant piece of land, and the IRA owner has to start taking required minimum distributions? Such situations are why advisors suggest that letting investors set up self-directed IRAs on their own is far too perilous.
Beyond evaluating investment opportunities, the self-directed IRA landscape is littered with legal booby traps for novices. One of the best ways to sidestep them is to avoid prohibited transactions, which the IRS considers to be any improper use of an IRA by the owner or a so-called "disqualified" person. The list of disqualified persons includes the IRA owner, and his or her parents, spouse and children. Someone who owns a house inside an IRA, for instance, could not rent it to his parents. And the IRA owner couldn't inhabit the residence either.
An investor, however, isn't necessarily safe even if the IRA confines its dealings to those who aren't off limits, such as siblings, friends, in-laws and stepchildren. A 2004 U.S. Tax Court case (Tax Court Memo 2004-260) which involved a CPA and the profit-sharing plan of his wholly owned CPA firm, made clear that the rules are not so cut and dry. The court concluded that an IRA owner would be in trouble if he benefited indirectly from a transaction involving his IRA, even if no disqualified person was involved. Choate provides this example to illustrate the tax court's logic: Suppose an IRA owner rents an apartment to his mother-in-law. On the surface, this might seem legitimate, but thanks to the Tax Court ruling, you need to determine if the IRA investor would benefit indirectly from the rental. If the mother-in-law would have had to move in with the investor and his wife if the rental wasn't available, for example, this could be construed as an indirect benefit.
Commingling outside cash with IRA assets is also a potential danger. Suppose the property tax on an IRA-owned vacation home needs to be paid, but the rental check hasn't cleared so there isn't enough cash in the IRA to pay the bill. It's a temporary cash-flow problem that some might assume could be solved by paying the tax out of a personal account until the IRA money is freed up. However, if the owner does this, the IRS could penalize him for making an excessive contribution to his IRA.
The penalty for engaging in a prohibited transaction--whether intentional or not--is brutal: The IRA is considered dead dating back to the first day of the year the prohibited transaction occurred. The entire IRA must be dismantled, and taxes and a 10 percent early withdrawal penalty, if applicable, paid. The punishment is the reason why experts say no one should have all their retirement assets tied up in a solitary, self-directed IRA.
For investors, one of the greatest perils is the natural temptation to roll up their sleeves and pitch in to boost an IRA's value. But self-dealing is another no-no. "People always pick investments that they can do themselves, but it leads to...getting into trouble," Slott says. The home remodeler, for instance, was forbidden to perform any work on the house he bought. An architect, who obtains a piece of property for his IRA, can't draw up plans for a new house. What an investor can do, though, is make managerial decisions. An IRA owner could select a tenant for his condo and decide what rent to charge. He could also pick a landscaper to draw up plans for the backyard, or find a plumber to replace a bathtub. But he could not do the work himself.
Self-directed IRA enthusiasts also have to be aware of another bogyman--the unrelated business taxable income tax. If an IRA investor borrows when buying property, attorney Choate says, some of the generated revenue will be considered income from debt-financed property, which is classified as Unrelated Business Taxable Income Tax (UBTI). But even before jumping that hurdle, investors must borrow without setting up any red flags. Personally guaranteeing loans to their individual IRAs is considered a prohibited transaction. To sidestep this, investors can obtain a non-recourse loan, which does not require collateral. While few banks are willing to give these loans, a notable exception is North American Savings Bank in Grandview, Mo. which participated in a "Real Estate in IRAs" workshop for advisors attending Fiserv's annual summer conference in Denver. But Anderson expects a new player on the scene soon: One of the major wirehouses is on the verge of announcing that it will issue a $500 million line of credit to a venture which intends to break into the IRA lending business. This Wall Street commitment, Anderson suggests, shows the growing financial promise of self-directed IRAs.
What seems clear to the professionals in this emerging field is that the IRS has been snoozing while countless investors knowingly or mistakenly break the rules. "At this point, the IRS is not looking," acknowledges Patrick W. Rice, the author of IRA Wealth, Revolutionary IRA Strategies for Real Estate Investment (Square One) and president of IRA Resource Associates, Inc. in Camas, Wash., a firm that works with individual investors and advisors to find properties for IRAs. "At some point, though, the IRS will look hard, and if you're doing things improperly, you will get caught," Rice warns.
Custodians do not consider themselves policemen, but they can intercede in extreme cases. Hugh Bromma, CEO of Entrust Group, says his company will alert clients when they spot problems and ask them to correct them. In rare cases where a client steadfastly flaunts the rules, Entrust will send IRA distributions to the individual and notify the IRS. One of Entrust's busted IRAs involved a woman who refused to stop renting her Virginia condo to her daughter.
If you do help a client establish a self-directed IRA, cover your own back, Slott urges. He suggests crafting a letter to your client that carries the kind of warnings you hear squeezed into 60-second television commercial hawking prescription drugs. The due diligence letter should include potential problems as well as how they can be avoided.
To educate yourself, take advantage of free materials from custodians. In addition to its other available presentations, Fiserv ISS's Investment Administration Services will offer a CE course on the topic through RegEd in the fourth quarter of the year, according to Vice President Joan Owens. The conference workshop carried two CE credits, she notes. You might also examine section 4975 of the IRS Code, which lays out the prohibited transactions for IRAs. What you may find infuriating about this section is that it was principally written for pension-plan trustees and was intended to ensure that these fiduciaries did not steal from employees. Choate also suggests reading prohibited transaction rulings located on the Web site of the U.S. Department of Labor's Employee Benefits Security Administration (www.dol.gov/ebsa). In some cases, you might advise a client to seek a prohibited transaction exemption from the DOL.
Educating yourself, Choate says, is critical. "It's like minimum required distributions. You can't just dabble in it; you have to become an expert. If you study the rules, you will know more than 90 percent of the people."
Lynn O'Shaughnessy (email@example.com) is a financial journalist and former reporter for the Los Angeles Times. She is the author of the Retirement Bible and the Investment Bible (both Wiley).