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Self-directed IRAs offer limitless options

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08-06-2006

PERSONAL INVESTMENT by Tara Siegel Bernard, Dow Jones News Service, Miami Hearald

Investors are pushing the limits when it comes to IRA investing: They've stashed everything inside from bowling alleys and racehorses to acreage in New Zealand. They've even lent IRA money to startup banks and cash-strapped individuals, in exchange for an attractive return.

In fact, it's actually easier to describe what you can't do with an investment retirement account. Collectibles -- such as artwork, antiques, gems or wine -- are prohibited, as are insurance policies. Beyond that, as long as you strictly adhere to certain IRS rules, you can squeeze just about anything inside. And more investors -- notably baby boomers with sizable rollover IRAs -- have been doing exactly that. Disenchanted with stock market returns, they're increasingly turning, at least in part, to more exotic investments.

''In the past five years, investors started to look at real estate, private placements, mortgage notes [and other alternatives] because they weren't happy with the stock market. So they decided to get out or get into other investments,'' says Hugh Bromma, chief executive of the Entrust Group in Oakland, Calif., which oversees $2.2 billion in self-directed IRA assets, of which about 80 percent is invested in real estate.

Nontraditional assets are best kept in what's known as a ''self-directed'' IRA. While some of the major brokerage houses might offer them to their wealthier clients, several custodial firms specialize in setting them up and are well-versed in the rules governing them. IRA assets -- which account for slightly more than one-quarter of U.S. retirement assets -- totaled $3.7 trillion in 2005, according to the Investment Company Institute. Self-directed IRA providers estimate that about 2 percent of that is held in self-directed IRAs.

''That segment of the market is growing faster than the overall IRA market itself,'' says Tom W. Anderson, founder and chief executive of Pensco Trust Co. in San Francisco, which manages $1.73 billion in largely self-directed IRA assets. He estimates that self-directed IRAs are growing about 25 percent annually, or more than three times faster than IRAs overall.

While setting up a self-directed IRA is rather simple, investors need to be extra careful vetting the investments and pay close attention to the rules. Run afoul and you risk triggering a big tax bill, as well as penalties.

''There are a series of rules called prohibited transactions, which are things you can't do -- but it all comes down to one thing: self-dealing,'' says Ed Slott, an accountant and IRA consultant based in Rockville Centre, N.Y. ``That's probably about the worst penalty in the tax code.''

That includes things like selling property to your IRA, or, borrowing or lending money from the account. Investors also can't buy property for personal use with IRA funds, nor can they buy a property and then rent it to a family member.

If you break the rules, the entire IRA will be treated as if every cent was withdrawn; ordinary income tax will be owed on the entire sum, as well as a 10 percent penalty if you're under 59 ½ years old. That's why you should keep tricky investments in your own self-directed IRA, so if you do mess up, even accidentally, only that one account will be disqualified.

Investors also need to consider the tax consequences. For instance, if an apartment building was purchased outside of an IRA (and held for more than a year), investors would owe the lower 15 percent rate on any capital gains, compared with the much higher ordinary income tax owed when making withdrawals from a traditional IRA.

You're also giving up certain deductions by keeping it inside an IRA, like depreciation and other property-related write-offs, Slott adds. That said, you don't have to report the rental income either.

Also, most investments held outside an IRA receive a step-up in basis when you die, which means your heirs inherit it at the market value; when inside, beneficiaries will owe ordinary income tax on the property proceeds upon withdrawal.

Illiquid assets like real estate also present other hurdles. If the property still sits inside the IRA once an investor hits 70 ½ years old you'll have to have the property appraised each year so that you know how much you'll need to withdraw, and you'll have to deed a percentage of the property to yourself each year, unless you have enough cash inside to make the distribution, Slott explains.

Things become even more complicated if you finance a property or run a business through your IRA; taxes may be owed on what's known as ''unrelated debt finance income tax'' or ``unrelated business income tax.''

Be sure to consult with a trusted tax adviser before making a move.