What is Self Directed IRA?

A Self Directed IRA (SDIRA) is an IRA account where you can invest the money in different kinds of assets such as Gold, real estate, cryptocurrencies, private companies and pretty much anything except collectibles (such as fine wine and paintings) and life insurance. The normal IRA accounts usually allow you to invest in stocks, mutual funds and bonds. But a Self Directed IRA opens a whole lot of new investment opportunities to you. It’s similar to an usual IRA – You can have a Self Directed Roth IRA or a Self Directed Traditional IRA.

How can I open a Self Directed IRA?

The usual custodians of IRA such as Vanguard, Merrill Lynch, Fidelity, Charls Schwab do not offer SDIRAs. SDIRA custodians are usually much smaller companies. Investopedia has published a list of top SDIRA custodians here. One important factor to consider while choosing a SDIRA is whether they charge you a fixed fee or a percentage of the assets invested. In my opinion the fixed fee option is much better than a percentage of assets. Most SDIRA options I have looked at charge a fixed fee per year.

Checkbook IRAs

A common pattern we see in SDIRAs is to open an LLC owned by the IRA. This allows custodians to offer you a checkbook for your account. And that means you can simply issue a check for investing in pretty much any instrument barring collectibles (like art, fine wine etc) or insurance vehicles. The custodians who offer this kind of control sometimes brand themselves as checkbook IRA to emphasize on this level of control. You don’t need to have checkbook control to make the investments. In those cases, your custodian will issue a check for the investments instead of you issuing the check directly. 

Tax Treatment

The whole point of having an IRA is to have tax benefits. Traditional IRAs are tax deferred, you avoid paying taxes now, but you pay the tax when you withdraw the money. In Roth IRAs, you pay tax now and all the gains are tax exempt. The same is true with Self Directed IRAs as well. You can have a Traditional SDIRA or a Roth SDIRA. The tax treatment is exactly the same barring  UBIT which is discussed below.

These tax benefits make it ideal to use SDIRA to invest in real estate. This means you can keep collecting the rent and the gains will be tax free – especially if it’s in a Roth SDIRA. Even if you sell the property, the gains will be tax free. This allows you to diversify within your IRA as well.

Even though all the investment income in an SDIRA is tax deferred or tax free (Roth), if the income produced is not an investment income and is an ordinary income, then Unrelated Business Income Tax (UBIT) applies. If you own a business through your IRA such as McDonald’s Franchise and you are running the show, it will be considered as an ordinary income and UBIT will apply. In case of real estate, rental income is considered passive but if you manage the property yourself then it might be considered ordinary income.

UBIT may apply if you make a leveraged investment as well. To understand it you need to understand what Unrelated Debt Financed Income or UDFI is. If your IRA has $40K and If you buy a property worth $100K with a $60K loan, the IRS doesn’t want the leveraged portion of the investment to have the tax advantaged growth. The agency will make you pay taxes on 60% of the income you get from this property. Furthermore, if this is a traditional IRA then you might end up paying taxes when you take the money out of the IRA as well! If you want to learn more about UBIT and UDFI I recommend you to read The Book on Advanced Tax Strategies by Amanda Han and Matthew Macfarland. The easiest way to avoid UBIT because of UDFI is to simply not use any loans for buying the property.

SDIRA and Multifamily Syndications

If you have invested your money in a multifamily syndication and if you are a passive investor, UBIT really doesn’t apply to you. But in most cases these properties are bought with a loan (they are debt financed) and hence UDFI does apply. But here, the advantages of real estate kick in. Let’s say that the property you invested in has a 75% loan. This means 75% of the income will be subject to UBIT because of UDFI rules. But you can deduct interest on the debt and depreciation, thereby reducing the taxable income by a lot. A good rule of thumb is that UDFI taxes may decrease your return by 1%. This means if the syndication is going to give you a 15% return, after paying UDFI taxes, your return will be reduced to 14%. But the main takeaway  here is that if your deal is debt financed, you will have to pay taxes, even if the investment is done through an IRA.

It’s very important to note that not all CPAs are aware of UBIT rules. If you plan to open a SDIRA, it’s important to consult with a CPA knowledgeable in this matter. I do not consider this article as an exhaustive resource on the subject matter. This is not financial advice and you should consult with a knowledgeable CPA before using a SDIRA to make investments.

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