The Self-Directed IRA can be structured as a SEP, Roth IRA or a SIMPLE IRA.
However, these can result in a tax compliance blackhole as you need a good CPA to analyze your working/operating agreements and the contracts signed with the trust company. While working with a trust company/fiduciary is more beneficial than working with a fee based financial advisor, the trust company has an incentive to set up as many accounts as possible even if the fees are minimal. When setting up your self-directed IRA account, it’s important to have checkbook control, what does that mean? It means that you must work with a CPA or Attorney to establish an LLC with clear operating/management agreements. If you decide to go about this yourself without taking into consideration all the legal and tax consequences you are in for a big surprise.

Let’s use a real world example to better explain how as an investor you need to be extremely cautious when using IRA’s for investing in alternative investments. One of our clients, Joe, who was in a high net-worth career, wanted to invest around $50,000 in a startup business using his IRA account. To Joe’s surprise the startup in which he invested in made a significant profit, and by March 15th, K-1’s were directly mailed to the trust company who was in-charge of Joe’s account. Two main questions arise:

1. Are these types of transactions prohibited per the IRS?
2. Do UBIT (Unrelated Business Income Tax) or UDFI (Unrelated Debt Financed Income) Tax issues arise?

The tax blackhole which I mentioned earlier is this exact situation, where the custodian isn’t aware of any UBIT or tax consequences, the taxpayer isn’t aware and the IRS won’t alert or send you a message about your situation. Having a CPA who truly understands the intricacies of UBIT vs. UDFI can help save you thousands of dollars each year. One of our new client’s this year who already had a Self-Directed IRA wasn’t aware that the IRS required her to file the 990-T form every year. Even though our client had a loss, and no taxes were due – the new IRS rules require this to be filed annually. If our client hadn’t reached out to our firm for help, they would be hit with excessive penalties and interest by the IRS for not filing the return.

Similarly, as a real estate investor if you decide to invest in residential or multi-family real estate with the help of a real estate investment firm, the tax consequences become even more critical. Let’s say you and 20 other partners put your money into a “Project LLC” and invest through your Self-Directed IRA along with cash and debt to purchase a multi-family apartment building. This sounds like a very attractive investment right?

Sure, collecting monthly rent checks without having to move a finger and not pay any tax sounds fantastic on paper but income from this kind of an investment could be subject to the UDFI tax. The income is generated partially through debt financing provided by a private banking institution. We didn’t make up these rules, but having a solid qualified team of legal and tax experts can save you a whole world of trouble.