Clients regularly ask us questions regarding the use of self-directed individual retirement accounts (IRAs) for investments other than cash or publicly traded securities. Examples of such investments include real estate and private equity investments. While it may occasionally make sense to explore holding such investments in IRAs, there are many restrictions on such investments, and there are some potentially significant tax disadvantages in holding such investments in IRAs. This post will briefly explore some of these issues.
Prohibited Types of Investments
IRAs may invest in a vast variety of investments, but certain categories are prohibited. The most common prohibited category is collectibles, including, for example, antique furniture, jewelry, wine, stamps, and most coins. However, certain types of collectibles are allowed, as discussed on pages 45 and 46 of IRS Publication 590.
While S corporation stock is not technically an impermissible investment for an IRA, such an investment would cause the corporation to lose its Subchapter S status.
Neither the IRA holder nor any disqualified person, including a family member, may engage in a prohibited transaction with the IRA. Examples of prohibited transactions include:
- Borrowing money from the IRA.
- Selling property to the IRA.
- Using the IRA as security for a loan.
- Using IRA property personally. Example: IRA buys a condominium for investment purposes and the IRA owner’s daughter lives there while attending college.
- Benefitting personally from a transaction entered into by the IRA. Example: IRA buys a house, and, in exchange for a rent discount, the tenant provides a service to the IRA owner.
Essentially, the IRA holder can have no involvement, except as an investor, with the property held within the IRA.
Potential Disadvantages in Holding Alternative Investments Within IRAs
- While IRAs offer tax-deferred growth of principal, all distributions must eventually be paid out as ordinary income. Thus, holding an alternative investment within the IRA can convert what might otherwise be capital gain income into ordinary income.
- IRAs must make required minimum distributions (RMDs) starting when the owner reaches age 70 ½. This could pose problems if the assets within the IRA are illiquid.
- Because RMDs are based on the value of the assets within the IRA, the IRA may need to undertake costly annual valuations.
- If the IRA assets are debt-financed, or if they are held in a form other than C corporation stock, the IRA might be subject to income tax on unrelated business income.
- Custodians of alternative investments typically charge higher fees than custodians of traditional investments.
- There simply may not be enough value within the IRA to justify dealing with the complexity inherent in holding nontraditional assets within an IRA.
If, in spite of these restrictions, it makes sense to use an IRA to hold an alternative investment, the assets will need to be held by a qualified custodian. Several such custodians have established an organization called the Retirement Industry Trust Association, which might be a good resource for selecting a custodian for your situation. (This should not be construed as an endorsement.)
The above comments are oversimplified and very general. If you are contemplating making an alternative investment within your IRA, it is essential to work with an experienced and knowledgeable tax advisor.