The Self-Directed IRA Pitfalls When Considering Real Estate Investments

The self-directed IRA is a widely popular option for real estate investing. Investors can enjoy high yields, while hedging themselves against stock market uncertainties. However, there are some pitfalls to avoid. Knowing these common pitfalls can help make managing your investments easier and more cost-efficient.

Common Pitfalls

Pitfall One: Prohibited Transactions

“Self-dealings” are defined by the IRS as any transaction that involves the self-directed IRA and a disqualified person. A disqualified person includes the IRA holder, but also anyone with significant authority over the account. This includes plan custodians. Family members are also disqualified. A good rule of thumb for defining “family” is to ask yourself if they are lineal descendants, spouses or forebears.

Family members include: Spouses, parents, grandparents, children and their spouses, and grandchildren.
Even if a prohibited transaction isn’t intentional, it can lead to tax penalties or even worst early distribution of your account. Here’s an example of a seemingly harmless transaction that is prohibited:

Sarah owns a real estate investments. She notices that the yard could use some work. Her son- in-law does some landscaping work, so she figures why not pay him to do repairs? Since Sarah’s son-in-law is a “disqualified person,” this transaction would be considered prohibited. In fact, if Sarah herself was a landscaper she would also be prohibited from doing the landscaping work herself. This is considered “sweat equity.” In both these cases, a disqualified person is benefiting from conducting the landscaping work on the IRA owned asset.

Pitfall Two: Unrealistic Expectations

The self-directed IRA owner usually has enough common sense to avoid any claims of “guaranteed returns” or “risk-free investments.” However, I’ve seen a few smart investors fall prey to unreal expectations, especially when it comes to the administrative work and costs required to maintain their investments. The IRA owner must review and sign off on transaction related documents. She must keep up with fees associated with these transactions and fulfill IRS required reporting requirements. While we can’t get rid of most of these requirements, we can make it easier. Our online platform gives investors “checkbook control” and allows transactions anywhere with an internet connection.

Pitfall 3: The Wrong Structure

Investors can reduce fees and gain more control over their IRA account by choosing the right self-directed IRA structure. Investors who who use a custodian managed account, sometimes deal with costly custodial fees and delays. Using an LLC self-directed IRA can reduce custodian involvement, however it can result in additional fees during tax time. We offer a self-directed IRA connected to an FDIC insured asset trust. The trust reduces tax fees while also giving investors “checkbook control” over their account.

Avoid Costly Mistakes

Using the wrong structure, having unreal expectations and participating in prohibited transactions are all common pitfalls self-directed IRA real estate investors face. We’ve helped several clients avoid these pitfalls, while enjoying the benefits of tax-deferred real estate gains. We’d love to help you do the same. Contact us today to address your personal concerns.

Last Updated: 
March 22, 2018

Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.

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