IRAs Gone Wild: How To Invest In Private Equity, Real Estate, Gold
By Ashlea Ebeling
A record $7.5 trillion is sitting in individual retirement accounts, the bull market is looking tired, and the Internal Revenue Service’s army of auditors has been shrinking. So the temptation to get creative with IRA money has never been greater and the marketing pitches never more pervasive. You can put real estate, private equity, private loans and even gold coins and bullion (but not collectibles or insurance) in a tax-deferred IRA or a Roth IRA, where all growth is tax-free. You do this through a “self-directed” IRA–which is simply one parked at a custodian that allows you to invest in alternative assets.
But the tax rules surrounding self-directed IRAs are tricky, the penalties for violations can be punishing, and the IRS recently started requiring custodians, in their annual filings, to flag accounts holding alternative assets. At the same time Congress’ Government Accountability Office is studying self-directed IRAs to see how they’re used and if more restrictions are needed.
Seattle tax attorney Warren L. Baker, 37, has spent a decade building a national practice advising owners of self-directed IRAs. He sees both the potential and the peril. One client inherited a $10 million IRA that has grown into a $50 million IRA largely through private equity investments. Another turned a $200,000 Roth IRA into a $10 million tax-free retirement kitty by buying raw land on the edge of a Midwestern city, selling at a profit and investing in more land.
“For the real estate guy driving around looking for deals, it’s not that much of a stretch for him to have his IRA buy property,” Baker says, adding that his typical client prefers investing in areas where he has expertise over investing in the broad stock market.
Example: One client, an engineer, used his IRA to invest in Vicis, a three-year-old Seattle company that has developed a high-tech football helmet to reduce head injuries. The company’s cofounders include an engineering professor and a pediatric neurosurgeon, and its list of 250-plus investors–it has raised more than $20 million–includes dozens of doctors, current NFL players and Roger Staubach, the legendary Dallas quarterback turned real estate entrepreneur.
That’s the promise. The peril? Baker estimates that half of those with self-directed IRAs are violating one or another IRS rule, usually without even realizing it. “If you’re handed a gun, you shoot your foot if you don’t know how to operate it,” he says.
No, Baker isn’t urging all retirement savers to hire $400-an-hour lawyers like him for safety lessons. Instead, he says, those without a good investment reason to hold alternative assets should stick to conventional IRAs. That’s what he does.
Baker and his law partner and wife, Angela Carr Baker, earned their LL.M. s in taxation from the University of Washington School of Law in 2005, then hung out their shingle. They invest their SEP-IRAs exclusively in publicly traded securities and are considering selling the one rental property they own (outside their IRAs) because managing it eats up time they’d rather spend with their two young children or earning legal fees.
Still got the urge to invest in a self-directed IRA? Watch out for these risks.
FRAUD The Securities & Exchange Commission warns that scamsters encourage marks to invest through self-directed IRAs as a way to give their schemes a patina of legitimacy. But investors can’t rely on IRA custodians to vet their alternative investments. In June an administrative law judge rejected the SEC’s first attempt to hold a custodian responsible. The judge agreed with Equity Trust Co., the custodian for 130,000 self-directed IRAs, that it wasn’t responsible for fraudulent promissory notes marketed to 100 of its clients.
Peggy Cramer, a vice president of San Francisco-based Pensco Trust Co., which has offered self-directed IRAs since 1989, was disturbed by some of the presentations she heard from competitors recently at the MoneyShow: “I didn’t feel like they were being clear enough about the need for extensive due diligence and the risks involved.”
CONFLICTS OF INTEREST The punishment for “prohibited transactions” is brutal: Your entire IRA is disqualified, and its assets are considered distributed and taxable as of Jan. 1 of the year of the verboten transaction. What’s prohibited? Basically, any deal between the IRA and the IRA’s owner or his business entities or his immediate relatives.
So while an IRA can invest in a private company, it usually can’t be one that pays you a salary or one you’ve guaranteed loans for. In March the U.S. Tax Court upheld a $180,000 tax assessment against a couple who had personally guaranteed a loan to a corporation owned by their IRAs. Not only did all the money in their IRAs become retroactively taxable; they also got dinged with a 10% early-withdrawal penalty because they weren’t yet 59 1/2 at the point of the violation.
One popular technique these days is to have your self-directed IRA invest in an LLC and then manage investments from that LLC. This provides more flexibility. If you’re investing in real estate, you can write checks for expenses from the LLC without going through the IRA custodian, Baker notes. But the LLC layer doesn’t change what’s prohibited–it can’t pay the IRA owner a salary.
And forget IRA deals involving your spouse, says Robert Finkel, a corporate tax lawyer in Waltham, Mass. He recently nixed a client’s plan to use $250,000 of his wife’s IRA for a cash infusion in his own tech startup and jokes he saved the man from both a tax disaster and a divorce. He also urges anyone investing in a private company to carve up his or her IRA into separate pieces first–that way, if a prohibited transaction is found, only one piece will become subject to tax.
One widely marketed gambit supposedly gets around the prohibition on investing your IRA in your own business. You start a company, establish a 401(k) for it that offers company stock as an investment option, roll your IRA into the 401(k) and then use it to buy company stock. In theory this is legal. In practice? Baker won’t assist people doing it, he says, in part because there are multiple steps where you can make a fatal error.
A dicey pitch now being flogged online: Buy gold for your IRA and take delivery of it. But keeping the gold in your basement, bomb shelter or home safe, Baker says, means you’re in possession of the IRA’s property, likely a disqualifying conflict. Better to store the gold at a depository company.
ANNUAL TAXES An IRA owes annual income taxes on profits from partnerships and LLCs that don’t pay corporate taxes and from investments purchased partly with debt. (The top federal income tax rate of 39.6% and the 3.8% net investment income tax both kick in at just $12,400 of taxable income in an IRA.) Yet some IRA owners, and even tax pros, are unaware of this, Baker says, raising the risk their IRA could get hit later with a big bill for back taxes, interest and penalties.