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GAO Finds Self-Directed IRA Investors Need Clearer Guidance on Unconventional Assets

  |  By Patrick Hughes

The Government Accountability Office (GAO) has released a new report exploring the use of "unconventional assets"—such as real estate, private equity, precious metals and promissory notes—in self-directed IRAs. The report, based on a survey of 17 self-directed IRA custodians, found that nearly $50 billion in unconventional assets were held in more than 500,000 IRAs.

That $50 billion represents only a fraction of the total IRA market, which stands at $7.5 trillion. But it offers a new window into how self-directed investors are using  "unconventional" or "alternative" assets to grow their retirement nest eggs and the road blocks they are encountering in doing so.

Within the retirement industry, the term "self-directed IRA" is used to describe an IRA in which the custodian allows investors to go beyond traditional assets, such as stocks and bonds, to invest their retirement dollars in alternative assets (described by the GAO as unconventional assets).

But the new GAO report warns that not all IRA owners understand the added responsibilities that come with a self-directed IRA. The role of an IRA custodian is to ensure an asset is qualified to be held in an IRA, but self-directed IRA custodians do not provide investment, tax or legal advice. That means self-directed IRA owners are taking on a fiduciary role and mistakes made in managing their self-directed investments can trigger significant taxes and penalties.

To help investors better understand and manage self-directed IRAs, the GAO report highlights three areas where IRS should provide clearer guidance for investors:

  1. Prohibited transactions: IRA owners are not allowed to engage in prohibited transactions—transacting with disqualified persons or personally benefiting from an IRA's investment—or else their IRA will lose its tax-favored status. While the GAO says this is the most prominent compliance risk associated with investing IRA dollars in alternative assets, it also says the IRS has not done enough educate investors about prohibited transactions. Unless the IRS increases its investor outreach, the GAO states these taxpayers may not be able to ensure compliance with rules on prohibited transactions.   
  2. Unrelated business taxable income (UBTI): The GAO found that many IRA owners were unaware that certain IRA transactions could generate unrelated business taxable income—income that is subject to taxation. Without explicit guidance from IRS, the GAO cautions that self-directed IRA owners may inadvertently invest in assets that trigger UBTI. Once UBTI is triggered, the GAO then states that IRA owners have limited guidance to assist them in identifying and calculating their tax liability, which could lead to underpayment penalties. The GAO recommends the IRS add more explicit language about UBTI to Publication 590, which provides information on IRAs, including penalties IRA owners might face if regulations are not followed properly.  
  3. Fair market value (FMV): Assets held in an IRA must be valued on an annual basis for IRS Form 5498 reporting. While determining the value of a publicly traded stock is pretty straightforward, determining the fair market value of an alternative asset held in an IRA is more challenging. However, the GAO found that the IRS currently provides no guidance for custodians or IRA owners on how to determine the FMV of an alternative asset. The GAO recommends the IRS develop guidance on how to determine and document fair market value for unconventional assets.

As a leading self-directed IRA custodian with more than $12 billion in assets under custody, PENSCO is fully supportive of efforts to enhance investors' understanding of the rules that govern these retirement accounts. Our blog and website offer in-depth information on many of the topics addressed by the GAO, including prohibited transactions and the need for account holders to update the valuation of their alternative investments on an annual basis.

We also recently hosted a webinar with Mat Sorensen, an attorney specializing in self-directed IRAs, that focused on understanding prohibited transactions when investing in real estate.

In addition, through our participation in the Retirement Industry Trust Association (RITA), we are working with regulators to support the formalization of regulations around the valuation of alternative assets held in self-directed IRAs.

PENSCO clients looking for more guidance on these issues can visit www.pensco.com or call us at 800.962.4238.

This Blog does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Investments are not FDIC insured and are subject to risk, including the loss of principal.

PENSCO Trust Company performs the duties of an independent custodian of assets for self-directed individual and business retirement accounts and does not provide investment advice, sell investments or offer any tax or legal advice. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as selecting any professional to assist them with an investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. PENSCO is indirectly affiliated with a registered broker dealer and with a licensed small business investment company through Opus Bank (“Opus Affiliates”). Other than the Opus Affiliates, PENSCO is not affiliated with any financial professional, investment, investment sponsor, or investment, tax or legal advisor.