Self-Directed IRA Bitcoin Investing

Bitcoin is constantly making headlines. We're getting a little sick of hearing about it, to be totally honest.

As Bitcoin becomes mainstream, we hear stories of the crypto-savvy investor buying Bitcoin in its early years and becoming a millionaire. Which leaves more investors asking, “Why not me?”

In 2021, IRA investors are increasingly diversifying with Bitcoin and other cryptocurrencies. Self-Directed Bitcoin IRA investing can deliver high yields along with the tax benefits of non-digital investment.

Here’s a brief primer on Bitcoin and three steps investors can take to start making their own Bitcoin investments using a Self-Directed IRA-owned Business Trust.

Bitcoin Basics

With cryptocurrencies, encryption is used to make new currency units and perform transactions. All this is done in a decentralized system and records are kept in a blockchain, which is a type of digital ledger.

Bitcoin, released in 2009 by Satoshi Nakamoto, is one of thousands of cryptocurrencies but is easily the most popular. Bitcoin must be stored using an online digital wallet or in a personal computer. Due to hacking concerns, some owners use a hardware wallet (a USB-like device protected with a PIN code).

Bitcoin Gets Attention From Investors

Bitcoin turned heads in the investment world by going from a price of under $1 in 2011 to $40,111 on January 14, 2021. The highs and lows have attracted headlines, as in December of 2017, when prices doubled in a matter of weeks. As I write this, its current U.S. value is $33,626.60.

Bitcoin’s wider adoption and impressive gains led to the “Bitcoin IRA," bringing the flashy new investment into the stodgy world of traditional retirement accounts.

Bitcoin Meets the IRA

A traditional IRA (individual retirement account) doesn't permit alternative investments such as Bitcoin and other cryptocurrencies. They're not really known for trying new things.

But what about the Self-Directed IRA (SDIRA), with its more flexible structure? The IRS doesn’t list Bitcoin as a forbidden investment (only list life insurance and collectibles are specified as non-permissible IRA investments). Check out our article, Our 3 Most Popular Self-Directed IRA Investments, to see what else is (and is not) permitted.

How to Invest in Bitcoin Using a Self-Directed IRA

#1 Do Your Research

The information I’ve provided about Bitcoin is a good primer, but is by no means a substitute for doing your own due diligence. Be prepared for the uncertainty that surrounds Bitcoin as a new investment.

Also, since Bitcoin isn’t under a regulated system don’t expect the same type of publicly available financials you’d find with traditional stocks or mutual funds.

You can educate yourself on how the IRS deals with Bitcoin investments; a good cryptocurrency resource is Investopedia.

#2 Choose the Right IRA Custodian

The "custodian" is the financial services company that manages your retirement account for you. To learn more, check out our article, Why Your Self-Directed IRA Needs A Special Custodian.

Traditional IRA custodians won't even think about it, but if you're in the market for the self-directed version, you'll need to make sure your IRA custodian is IRS-approved and allows Bitcoin investments. Still, you probably won’t enjoy true checkbook control over your account.

Your SDIRA is self-directed (as the name says), but it isn’t “self-managed.” This means you can’t write a check out yourself for a Bitcoin transaction without a custodian approving the transaction. The processing time can hurt you when you're trying to buy or sell quickly. Also, the fees can add up when choosing this route.

This doesn’t mean you should give up on Bitcoin investing with a Self-Directed IRA. Royal Legal Solutions may be able to help you eliminate the custodial overhead. Many of our clients are Bitcoin investors who enjoy direct control over their IRA investments. Start with our investor quiz to see if you can take advantage of our custodial services.

#3 Choose a Good Cryptocurrency Exchange

Once your Self-Directed IRA is setup and you have direct access to your funds, you’re ready to purchase Bitcoin. Choose a reputable exchange and understand its fee structures. More importantly, be aware of any security flaws and hacking issues. Currently, Coinbase and Kraken are some of the most reputable exchanges.

#4 Choose a Good Cryptocurrency Wallet

For those new to cryptocurrency, this step may seem like the hardest to understand. A cryptocurrency wallet isn’t a physical wallet, although it can take physical form as a hardware digital wallet. Wallets are accessed via a private key, which is a hexadecimal code that you should guard just as you would a security box key. Like a bank account, the wallet holds your balance and a reference to all transactions. It’s also where you can send and receive currency. Think about security when choosing a wallet. Online wallets are convenient and usually offer a mobile version. However, they are susceptible to hackers. Hardware wallets are more secure because they hold the private key in an offline, unhackable device.

#5 Keep Your BTC Investments in Compliance

The “self-dealing” rules that apply to other alternative assets also apply to Bitcoin. For instance, an investor can’t sell Bitcoin to his own IRA nor can any of his family members. This can disburse the IRA or lead to a taxable event. Also, be mindful of annual reporting requirements which require market valuations similar to real estate properties.

#6 Enjoy Tax-Deferred Earnings

With a Self-Directed IRA you can apply the tax-deferral benefits enjoyed by other alternative investments towards Bitcoin. Bitcoin investments can grow unhindered as taxes aren’t applied till funds are disbursed, which can mean decades of growth.

#7 Explore Other Cryptocurrency Investments

Bitcoin is the most widely-known cryptocurrency. However, once you’ve gotten your feet wet in Bitcoin investing, you can expand towards others currencies such as Ethereum and Litecoin. Like Bitcoin, Litecoin has enjoyed tremendous growth. It’s second to Bitcoin in market capitalization, followed by Ethereum and Ripple.

When expanding your Self-Directed IRA, consider what advantages rival currencies have as an alternative to Bitcoin. For instance, Litecoin enjoys faster transaction times and a larger coin supply limit of 84 million compared to Bitcoin’s 21 million.

Start Investing Today

Like any other investment, investors should complete their due diligence, choose the right custodian and be aware of custodial fees. Check out our Using Your IRA to Invest In Crypto (4 Steps) article while you're at it.

Lastly, keep Bitcoin investments in compliance with IRS regulations. The unique steps Bitcoin investors need to make may be overwhelming at first. They include choosing a cryptocurrency exchange and digital wallet. However, once investors get their feet wet, they’ll be a step ahead in expanding their Self-Directed IRA towards other cryptocurrencies. For now, investors could start off with Bitcoin and other private investments using a Self-Directed IRA.

Which Self-Directed IRA Transactions Trigger the UBTI Tax?

Designating funds for your retirement is a great step if you are planning for your future. You probably already know about the 401(k) and the individual retirement account (IRA). These plans allow owners to invest in various stocks, bonds and mutual funds.

But for those of us who want a little more, there's another option: a self-directed IRA (SDIRA). These plans, which can be traditional or Roth accounts, allow for much more diversified investments. In fact, you can invest is almost anything, including real estate, precious metals, renewable energy and private placements.

SDIRAs and UBTI Tax

Establishing a limited liability company (LLC) in the name of your SDIRA makes a lot of sense. It helps to isolate and protect your investment funds. It also provides you with a level of anonymity that many owners find beneficial.

IRAs and SDIRAs are typically exempt from the Unrelated Business Taxable Income (UBTI) tax. This rule, as established by the Internal Revenue Service (IRS) in 1950, was introduced as a means of preventing tax-exempt businesses from unfair competition related to their profits.

Most passive investments made with your SDIRA LLC are considered tax exempt. However, real estate in particular can trigger the UBTI tax. Why? UBTI taxes are generally applied to incomes generated by “any unrelated trade or business” that is “regularly carried on” by an organization that would be subjected to the tax. To better understand this, let us take a look at the main components of this regulation.

What Does 'Trade or Business' Mean In Relation to UBTI?

The Internal Revenue Code (IRC) Section 162 defines “trade or business” as profit-oriented activities that involve regular actions by a taxpayer. There are very few cases in which activity needs to be attributed to a trade of business, however. This is because most expenses that are incurred from the profit-oriented activities of a taxpayer can be listed as deductibles under IRC 212.

What Does 'Regularly Carried On' Mean In Relation to UBTI?

For an activity to be considered “regularly carried on”, it is compared to those activities of a competitive, taxable business. There are some nuances to this. A short-term activity are typically tax-exempt if a similar commercial occurs all year. An example of this would be an ice cream stand operated by a tax-exempt organization during a state fair. Seasonal activities, however, are likely to be subjected to the UBTI tax. Intermittent activities are typically exempt if they are done so without the same type of promotional actions taken by a commercial enterprise.

UBTI Tax Triggers

It is important to identify and quantify the types of activities your SDIRA LLC has used to generate profits. This will help you to determine whether the activity and its profits are exempt or not. As previously stated, most passive transactions associated with your SDIRA LLC would not be subjected to the UBTI tax. However, there are several that could.

Income generated by the actions of a trade or business that would be considered active but the IRS;
Income that is generated by a convenience store;
Income generated by a manufacturing company;
Business income that is generated by an LLC that is used as a pass through entity;
Income that is generated by a business that is owned by your SDIRA LLC and you, the plan owner, are an investor;
Unrelated Debt Financed Income (as defined by IRC Section 514(e));
When a nonrecourse loan is used to purchase property; or
Income generated by a real estate investment, which is treated as a business inventory vice an investment.

Legal Examples

There are plenty of examples of taxpayers butting heads with the IRS. Let us take a look at two examples that resulted in very different court rulings.

Brown v. Comm., 143 F.2d 468 (5th Cir. 1944): In this case, the taxpayer (Brown) inherited 500 acres of land from a deceased relative. This land was used for grazing purposes only and, as such, was considered tax-exempt. After taking ownership of the property, the taxpayer decided to sell it. They listed it with a real estate broker. The broker was instructed to subdivide the property into lots and develop the land for sale by the tax-exempt organization. The broker did as directed. Streets were constructed, wells were installed, gas and electric lines were laid, and storm sewers were put in. Every year, between 20 and 30 lots were sold. In this ruling, the court found that the lot sales were being conducted regular course of business. The court ruled in favor of the IRS.
Farley v. Comm., 7 T.C. 198 (1946): In this case, the taxpayer (Farley) owned a tract of land that was being used as a part of his nursery business. Without further developing the land, the taxpayer sold off 25 lots for residential development. Unlike the Brown case, the court ruled in favor of the taxpayer. Because the taxpayer did not further develop the land, the court viewed it as a “gradual and natural liquidation of an asset”.

Invest with a Professional

Finding the right plan can be hard. However, when you open an account with a reputable professional, like IRA Business Trust, our experts go to work for you. Not only do we handle any documents and tax forms you may need, but also as experts, we understand where the IRS draws a line. Your SDIRA is a vital part of your future. To find out more about opening a SDIRA, forming an LLC, or understanding UBTI, contact us today!

Self-Directed IRAs: Your Tax Questions Answered!

The maximum contribution for a self-directed IRA remains $5,500 per year for those who are under 50 years of age and $6,500 per year for those who are 50 or over.

Roth IRAs can also be limited depending on your income. For a Roth IRA, the more you make, the less money you are allowed to put into the account. That amount diminishes until you’ve crossed a threshold which limits your contributions to zero dollars per year.

Are My Contributions Still Tax-Deductible?

It seems like each time a new president takes office and passes their tax plan, there ends up being a great deal of confusion over what you can or cannot claim. While it’s true that the Tax Cuts and Jobs Act limits the amount of deductions you can claim in property taxes, retirement accounts were left largely untouched.

So the answer for now is yes, you can still claim contributions to your retirement accounts on your taxes, but there are other changes to the tax code relevant to IRAs that are no longer deductible. Those include:

Costs associated with maintaining the IRA
Other miscellaneous fees related to the IRA

My Employer Offers a Retirement Plan, But I Want to Start My Own. Now What?

You are still allowed to make the maximum contribution of $5,500 per year to your self-directed IRA. This is true regardless of whether or not you have an employer-sponsored retirement plan, even if it is an IRA. There may, however, be a limitation regarding whether or not you’re allowed to claim these funds as a deduction on your tax return.

I Filed a Joint Return with My Spouse, But Only One of Us Works. Now What?

Both you and your spouse can make separate contributions to your IRA regardless of the fact that only one of you works and thus has taxable revenue. So long as the combined amount does not exceed the limit of $5,500, Uncle Sam doesn’t care where the money came from. You can also write off the contribution on your joint tax return.

I Filed a Joint Return with My Spouse. How Does This Affect Our Roth IRA?

Roth IRAs are capped for both single and married couples. For married couples, the threshold begins at $181,000 of cumulative gross income. Once that threshold is crossed, the amount you are allowed to contribute diminishes until it reaches zero. The IRS provides a formula for calculating this amount.

Converting a Traditional IRA to a Roth IRA

Before 2018 there was a loophole that allowed people to make contributions to their traditional IRA and then characterize the account as a Roth IRA. The Tax Cuts and Jobs Act closed this loophole, at least partly. You can no longer convert your traditional IRA back to a Roth. Nonetheless, the new tax bill lowered the amount of taxes you would have to pay in order to transfer funds from a traditional IRA to a Roth.

Remember, Roth IRAs are built on contributions that are taxed on their way in, while traditional IRAs are taxed on their way out. In order to convert the account, you will need to pay taxes on the entire contents of your traditional IRA. For some, this will be worth it. For others, not so much.