Even using the most conservative estimates, Americans hold about $152 billion in alternative assets within self-directed IRAs. That’s a sizable amount. Investing in Alternative Assets diversifies your portfolio and reduces overall risk while investing.
Self-directed account holders can acquire a variety of alternative assets such as mortgages, tax liens, franchises, partnerships and private equity. As mentioned previously, they can even purchase property. See “Common Alternative Investments” on page 4 for more information.
Like all IRAs, a qualified provider, typically refer a trustee or custodian, required to administer the account. The custodian will maintain the assets, perform all required record keeping and reporting, issue client statements, assist in helping clients understand the rules and regulations etc.
According to NuWire Investor, the number of self-directed IRA custodians has grown significantly over the past few years. The publisher expects this growth to continue as the self-directed IRA industry matures.
RITA also cites overall longevity and experience as key factors in the industry’s positive outlook. “All of our members have been enabling alternative asset investments as long as they’ve been in existence,” says Anderson, many as far back as 1974, when IRAs were first established under the Employee Retirement Income Security Act (ERISA). “Some of the bigger companies do dozens or even hundreds of these transactions a day.” NuWire maintains a regularly updated list of custodians on its website. RITA also provides a searchable directory of its members.
Avoiding missteps and mistakes
The main benefit of investing within an IRA is that income and appreciation accumulate on a tax-deferred or tax-free basis. This certainly holds true for investing in alternative assets through a self-directed IRA as well.
Self-directed IRAs, however, do come with some extra rules and restrictions. The IRA must be titled as the owner of all assets, and purchase funds must come directly from the IRA. There is one exception to this last rule, explained in “Gaining Checkbook Control” on page 9.
In addition, the IRA must receive all income and pay all expenses related to ongoing ownership of the asset. Investors need to steer clear of any improper use of the IRA, which generally means that only the IRA can benefit from any transactions. To ensure this, investors must avoid “prohibited transactions” with a “disqualified person.” Both of these terms are explained in IRS Publication 590.
Despenas recommends investors read Scott Turransky’s eBook. “Don’t Risk It”, because it provides a good overview of how to comply with the passive investment rules. “But the simplified version is that the IRS considers the investor and most of his or her relatives to be disqualified, and the point is that those people cannot gain any benefit from the investment,” Despenas explains. “Every transaction must be at arm’s length.”
Financing through nonrecourse (or asset based) loans is another important restriction. While an IRA can borrow money to purchase an asset, non recourse financing means that lenders cannot recover more than the value of the asset in the case of default. In contrast, if a borrower defaults on a recourse loan and the asset is worth less than the balance remaining on the loan, the lender can seize the asset and still collect the remaining balance.
And note that Unrelated Business Taxable Income will come into play in most cases if an investor does choose to use leverage. This means that if an investment earns a profit after all typical expenses deducted, the IRA would owe taxes on that income.
It is important to follow them all to maintain the tax-advantaged status of the IRA. If an IRA owner engages in a prohibited transaction, the account balance as a distribution in full. There are also separate penalties applied to each disqualified person involved in the transaction.
Investors also need to be familiar with the rules for the type of IRA involved: a traditional or Roth IRA; a SEP, SAR-SEP or Simple IRA; or a Solo 401(k). Rules regarding contribution limits, early withdrawal penalties and required minimum distributions still apply.
As with any investment, it is important for investors to evaluate potential risks and complete due diligence. Self-directed IRA providers do not have legal obligation to evaluate the quality or legitimacy of an investment and its promoters.
“Custodians and trustees will perform an administrative review of proposed alternative asset investments, but it is not an economic or merit review,” says Mohr. “Investors need to understand they are responsible for choosing/monitoring their investments.” For more information, see “Check Before You Invest”document.
Bottom line: it makes sense for investors to seek expert legal and financial advice at every stage.