Individual retirement arrangement or IRA’s are very common and well-known. Normally when someone owns an IRA they invest in stocks, bonds, and mutual funds, but did you know that there is alternative arrangement, called a self-directed IRA?
A self-directed IRA allows an individual to invest in a wide array of assets, including real estate, private equity, and to make private loans. There are prohibited transactions though, such as living in a property owned by the self-directed IRA, so you must be careful to comply with the rules.
Why Use a Self-Directed IRA? Because of the ability to invest in non-traditional assets, you have the ability to earn a higher rate of return and to diversify your investments from traditional stock and bond portfolios.
Traps to Be Aware of: The easiest mistake to make is to not be aware of the tax traps of investing in private equity or real estate. For example, if you invest in a restaurant that is formed as an LLC, then the income from the LLC will be “passed-through” to the IRA. Although this is allowed, the income is considered “unrelated business taxable income” and would trigger tax on the income. A way of getting around this is to invest in a company organized as a c-corporation and receive dividend income.
Other Traps: These traps are called prohibited transactions and if you engage in them then the IRS will tax all of your IRA assets as a distribution as ordinary income plus penalties, when applicable. A sample of prohibited transactions includes borrowing money from your IRA, selling property to it, using it as security for a loan, and many other self-dealing transactions.
Despite the traps that need to be avoided, a self-directed IRA may be appropriate for your portfolio. As with any investments you need to perform your due diligence to choose the right investments, IRA custodian, and advisors.