This year’s bear market, and the prospects for continued volatility for the near future, have motivated many retirement investors to pay more attention to financial pundits extolling non-traditional investment options for self-directed IRAs. Unregistered hedge funds, managed futures and even cryptocurrencies have all been hyped as alternative IRA investments, primarily by commission-earning salespeople.
Some commentators are also hyping two strategies that, on the surface, seem tailor made for these times:
- investing IRA assets directly in income-generating real estate; and
- using IRA assets to fund a startup business.
While these options may seem attractive on the surface, they are also subject to strict IRS rules that, if broken, could subject you to costly penalties and potentially remove the tax-exempt status of your self-directed IRA.
These rules generally fall into two categories:
- Disqualified persons. You can’t use your IRA assets to engage in transactions with your spouse, children and grandchildren; any corporate entity or trust where a disqualified person has more than 50% ownership; or your IRA’s custodian or designated fiduciary (such as a financial advisor)
- Prohibited transactions. The IRS prohibits IRA owners from using these assets to generate immediate personal financial benefits for themselves or any disqualified persons or entities.
1. Using an IRA to invest directly in real estate
With sky-high real estate values falling in value as interest rates rise, many investors are exploring the option of purchasing reasonably priced income-producing property within their self-directed IRA.
Although the potential to generate income from rent and capital gains on the property is an attractive lure, numerous prohibited transactions could be part of the package. If you are considering such an investment, be aware that:
- The property cannot be used by disqualified people, including you and direct family members.
- Expenses directly related to the real estate must be paid for by the IRA itself.
- Management and maintenance of the real estate (e.g., collecting rent, paying taxes) must be handled only by the account’s custodian.
- IRA assets must be valued and reported to the IRS annually. Because real estate investments are generally illiquid, their value can’t readily be assessed, which could lead to inaccurate reporting to the IRS.
Unless you fully understand the rules and have the wherewithal to abide by them, directly purchasing real estate in an IRA may not be worth the trouble. It could result in the disqualification of your IRA, meaning that it could even lose tax-exempt status.
As an alternative, you may want to consider adding shares of real estate investment trusts (REITs) or mutual funds that invest in them. REITs purchase and manage income-producing properties, offering you many of the benefits of investing in real estate without the hassles of direct ownership.
2. Funding a startup with an IRA
With high interest rates raising the cost of borrowing and more privately owned companies competing for a shrinking pool of venture capital, some entrepreneurs want to use their IRA assets to provide funding for their startup company. This strategy is formally known as a “rollover as business start-up” (ROBS).
To fund a startup, an individual establishes a C corporation. The corporation then sets up a retirement plan, which offers employees the option to purchase company stock. The owner rolls his or her IRA or 401(k) from a previous employer into the new retirement plan and uses these assets to purchase the startup’s stock. The business now has the capital to operate.
Although each step described is generally acceptable, ROBSs have been garnering increased IRS scrutiny and has the potential to be viewed as a prohibited transaction. Why?
- Some business owners pay themselves a salary from ROBS assets, even though they are among the disqualified persons whom the IRS says cannot benefit from a ROBS in specific ways.
- The IRS may see the salary as a transfer of plan assets for the employer’s benefit, which is prohibited.
- The employer limits the purchase of company stock to themself. This is prohibited, because with a C corporation, all employees must have the option to purchase company stock.
- The valuation of the employer’s IRA assets at the time of purchase is inaccurate. This could affect individuals who are taking required minimum distributions (RMDs). An inaccurate valuation of the purchase could lead to taking less than the correct RMD amount.
Some entrepreneurs, particularly franchisors, try to convince other friends, family members to use their own ROBSs to invest in their business venture. Some hire professional promoters to find additional ROBS candidates. If the promoter is a fiduciary, the payment of promoter fees from plan assets could be considered a prohibited transaction.
If you’re thinking of using a ROBS to fund your startup, seriously re-consider this strategy. The violations listed could lead to hefty IRS taxes and penalties. More important, the strategy could significantly deplete your retirement assets—and the assets of other investors who use ROBSs to fund your business.
Consider other alternative options
If you are still considering either of these options, it’s important to consult with a qualified tax advisor, attorney and your IRA custodian to ensure that you understand the risks before you implement them.
If you decide not to move forward but are still dissatisfied with your IRA’s investment returns, a financial advisor can work with you to adjust your current portfolio and help you explore other alternative investment options that may pose fewer legal and tax risks.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice nor should be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. If you have a financial advisor, talk to them before making any investing decisions. Past performance is not indicative of future results. Investments are subject to risk, including the loss of principal.
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David Jaeger is a financial advisor at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 508.598.1082 or djaeger@canbyfinancial.com
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