Entrust Learning Center > 1. Self-Directed IRA Basics > Separating Fact from Fiction with Self-Directed IRAs

Separating Fact from Fiction with Self-Directed IRAs

By: Scott Maurer

IRA Insights

Investing in alternate assets with a self-directed IRA can be a fairly simple process, but it can also become more intricate and complex depending on the nature of the investment and the individuals involved. When I attend networking events or meet with potential clients, I often hear pieces of misinformation mixed with accurate information, regarding self-directed IRAs. What starts out as one person’s supposition, may eventually become another man’s truth. In this article, I will explore some thoughts and ideas I have heard repeated over the years, and attempt to separate fact from fiction.

MYTH #1: If I use a neutral third-party between myself and my IRA, I can get around the rules regarding prohibited transactions. 

The IRS has very stiff penalties for engaging in prohibited transactions with an IRA account. (prohibited transactions are defined in IRC Section 4975). As many IRA investors know, an IRA cannot purchase an asset that is already owned by the IRA owner personally (or if the asset is owned by a disqualified person). So many individuals have surmised that this rule would be negated if they were to first transfer the asset out of their name to someone who is not a disqualified person (like a close friend or business associate) and then have that individual transfer the asset back to their IRA.

When you look at the two steps separately, the transfer of an asset from the IRA owner to the non-disqualified person is certainly not a prohibited transaction because there is no IRA involved. Further, the transfer of the asset from a non-disqualified person to the IRA is not prohibited. However, the IRS will most likely view the totality of the events as a “step transaction.” The Step Transaction Doctrine most often applies in corporate or partnership restructuring, but can also apply to many other scenarios as well.

When looking for a “step transaction,” the IRS will review a series of separate steps (as in the example above) and potentially treat the separate series of steps as one transaction. So a transfer of property from yourself to another individual, who subsequently transfers it to your IRA, may be viewed by the IRS as a transfer of property from you to your IRA. If the process is determined to be a step transaction, this would result in a clear violation of the Prohibited Transaction Rules of IRC Section 4975. The intent of the IRA owner at the time of the first transfer is typically the main determining factor the IRS would use to identify a step transaction. There would also be a consideration of the intervals of time in between each step. However, there is no safe harbor period, and it is likely that the IRA owner’s apparent intent would be the more compelling factor.

MYTH #2: If I invest in real estate using an IRA, then my IRA cannot be sued since an IRA is creditor-protected from a judgment.

While it is a true statement that in many states an IRA enjoys protection from the creditors of the IRA owner, this does not mean that an IRA is immune from litigation relating to assets that the IRA owns. To illustrate the difference in the above statements, consider these two examples:

1)    The IRA owner, Jim, is involved in a car accident for which it is legally determined that Jim is at fault. The other person involved in the accident, Bob, sues Jim and is successful in obtaining a judgment against Jim personally for the automobile accident. Since Jim lives in a state that deems IRAs to be protected from creditors, Bob cannot attach his judgment to the IRA or its assets, and must obtain satisfaction of his judgment from other assets that Jim owns. In this example, the IRA is creditor-protected because Bob is not allowed to satisfy his personal judgment against Jim by pursuing the assets of Jim’s IRA.

2)    Jim’s IRA owns a rental property that is currently leased out to a family. Despite some repair efforts, the stairs leading into the house are in a state of disrepair. During a family event, a visiting relative trips and falls down the stairs, sustaining injury. The relative sues the owner of the home, which in this case the IRA account, for failure to maintain a safe premises and neglecting to warn of the possible danger. Putting aside the merits of the lawsuit, Jim cannot simply claim to the court that the case must be dismissed since his IRA is creditor-protected. If a liability arises from within the IRA (i.e., the liability arises from an asset that the IRA has ownership in), then the IRA may be liable and forced to pay any damages awarded. So, if the visiting relative were to prevail in the lawsuit, then the IRA would have to pay the damages.

What these two examples delineate is that while an IRA may be protected from claims against the IRA owner individually, on separate matters that are unrelated to assets owned by the IRA, the IRA is not immune from a lawsuit due to a cause of action arising from an asset owned by the IRA itself. It is important that IRA owners understand this critical distinction so that they can adequately protect the IRA by purchasing insurance and/or employing the use of LLCs or other entities.

MYTH #3: If my IRA owns real estate, it is okay for me to perform a lot of the maintenance functions or fix-up work so long as I don’t get paid for the work.

This myth also has a corollary that it is okay for an individual to perform work on their IRA-owned properties, so long as the individual is paid a reasonable wage for the work. Neither of these two scenarios is possible with a self-directed IRA. Looking again at IRC Section 4975 dealing with prohibited transactions, the IRA owner is forbidden to provide services to the IRA account.  Whether or not the IRA owner is paid is irrelevant. If an IRA owns property and there is repair or maintenance work to be done, the IRA owner is required to hire an independent third-party to complete the work and the IRA would need to pay for that service.

Too often, one hears something repeated over and over by various individuals and assumes that it is true. It may often be, but it is always wise to write down what you hear and then do your own research to determine the validity. There can be substantial penalties for failing to comply with IRS guidelines, when it comes to your self-directed IRA. It would be unfortunate to be penalized for acting on advice that had been passed along as the truth, only to find out that it was merely an often-repeated fiction.

Scott Maurer is an attorney and the director of education andmarketing for Entrust of Tampa Bay, LLC. He can be reached at smaurer@theentrustgroup.com or 800-425-0653 ext 1123.