In our last blog post, we talked about what a Self-Directed IRA is, why you should have one, what the benefits are for BMG Rentals Property Management clients, and the allowable investments for an IRA account. In this second part of our three part series, we’re going to talk to you about Self-Directed IRA rules, Custodians and how to select a Self-Directed IRA custodian.
It’s important to know the rules set forth for self-directed IRAs. Not knowing the rules can risk the tax-deferred status of your account. This could lead to disqualifying your IRA and could have serious tax consequences.
The first rule to know about is Prohibited Transactions. The IRS defines a prohibited transaction as follows:
“Generally a prohibited transaction is any improper use of your IRA account or annuity by you, your beneficiary or any disqualified person. Disqualified persons include your fiduciary and members of your family (spouse, ancestor, lineal descendant, and any spouse of lineal descendant).
For purposes of this section, the term “prohibited transaction” means any direct or indirect—
- (A) sale or exchange, or leasing, of any property between a plan and a disqualified person;
- (B) lending of money or other extension of credit between a plan and a disqualified person;
- (C) furnishing of goods, services, or facilities between a plan and a disqualified person;
- (D) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
- (E) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account; or
- (F) receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.” (Legal Information Institute)
To avoid making a prohibited transaction it’s important to know what constitutes as a Disqualified person.
A disqualified person is:
- a fiduciary;
- a person providing services to the plan;
- an employer who has employees covered by the plan;
- an organization whose members are covered by the plan;
- a family member
- an officer and/or director (including individuals who may have powers or responsibilities similar to those of an officer and/or director),
- a 10 percent or more shareholder or a highly compensated employee
Investments made with self-directed IRAs need to be kept at arms-length, which most often is defined as a willing buyer and seller coming together with no influence from outside sources.
You may not buy from or sell an investment to a disqualified person. Doing so is known as “self-dealing.”
Some examples of Self-Dealing are:
- Having your Self-Directed IRA purchase real estate that you already own
- Having your Self-Directed IRA purchase real estate that is owned by a family member
- Issuing a mortgage on a relative’s new residence which was purchased by a family member
- Granting a child a second mortgage for the down payment on their first home
- Buying stock from the IRA owner
Indirect Benefits Rule:
The reason you have an IRA is so that it will provide for retirement later. An IRA is not intended to benefit you now. If your IRA is in some way making transactions that benefit you personally, it’s called an “indirect benefit” – and this is not allowed.
Some examples of Indirect Benefit are:
- Personally using your IRA property, such as using property purchases through your IRA as a work office, vacation home, personal residence etc.
- Receiving benefits from your IRA such as lending yourself money
- Using your IRA funds to buy a vacation home that you or your family uses
These are the most basic and fundamental rules to be aware of. Be sure to check with your IRA provider to find out about more specific rules.
Self-Directed IRA Custodians
We’re now going to talk about self-directed custodians, what they are and how to select one.
IRAs were created to encourage people to save for their future. Laws prevailing over IRAs require that they have what is called a custodian. A custodian takes care of paperwork/information, directing investments and providing reports on the account(s) to the government
Normally there are two types of IRA custodians:
- An “active” custodian that gives advice about investments and/or provides investment products
- A “passive” custodian that does not give advice or sell products
The popularity of IRAs has been growing leading to an increase in the number of custodians and administrators offering self-directed investing opportunities. As the number of providers continues to multiply, it’s imperative that you research potential providers to make sure you have confidence in the way they handle investments.
Here are some sample questions you can ask when talking to potential providers:
• How are you regulated and for how long?
• What are your financial resources? Can I see your financial statements?
• How are you insured (FDIC, SPIC)?
• Do you have error-and-omissions insurance?
• Are you audited—how and by what entity? When was the last audit completed?
• How are accounts managed? Is there an online account management system?
• How are investments processed?
• How does the operations portion of the business run and what best practices do you observe?
• Do you have online brokerage as part of your company for my diversified investments?
There is so much to learn about Self-Directed IRAs that we can’t possibly cover it in one or even two blog posts! Stay tuned for our third and final part in this IRA series where we will tell you how self-directed IRAs actually work, how BMG Rentals Property Management serves self-directed IRA clients, and which IRA is best for you!