A Self-Directed IRA, or “SDIRA,” is a retirement account (Roth, Traditional, SEP, Inherited) that allows the account holder to invest in a wide range of alternative assets not typically available through traditional brokerage firms.
Unlike standard IRAs that are limited to mutual funds, stocks, and bonds, SDIRAs allow investments in real estate, promissory notes, precious metals, private company stock, and more—as long as the investment is permitted by law.
What makes the account “self-directed” is the freedom to choose your investments while working with a custodian who administers them and reports them to the IRS.
If you have funds in a retirement account that restricts your investment options, you can transfer or roll over those funds into a Self-Directed IRA. This process involves moving the funds from one custodian to another, which allows for alternative investments.
There are three methods for transferring or rolling over funds:
All accounts at Directed IRA can be self-directed into virtually any alternative investment permitted under IRS rules. This includes real estate, promissory notes and lending, private funds and offerings, small businesses, startups, venture capital, checkbook IRA/LLC, cryptocurrency, precious metals, stocks, bonds, mutual funds, and more.
While the list of restrictions and prohibited transactions for IRAs is small, it does include collectible items, life insurance, S corporation stock, and investment transactions with parties prohibited from your IRA (e.g., the IRA owner and certain family members). A self‑directed IRA cannot transact with the IRA owner or certain family members, as this results in a prohibited transaction.
When self-directing your retirement account, you must be aware of the prohibited transaction rules found in IRC 4975. These rules don’t restrict what your account can invest in, but rather, with whom your IRA may transact. In short, the prohibited transaction rules restrict your retirement account from engaging in a transaction with someone who is a disqualified person in your account.
A disqualified person to a retirement account includes: The account owner, their spouse, children, parents, and certain business partners. So, for example, your retirement account could not buy a rental property that is owned by your father since a purchase of the property would be a transaction with someone who is disqualified from the retirement account (e.g., father). On the other hand, your retirement account could buy a rental property from your cousin, friend, sister, or a random third-party, as these parties are not disqualified persons under the rules.
An IRA/LLC consists of a self-directed IRA account (Roth IRA, Traditional IRA, etc.) where the IRA owns an LLC. A Checkbook IRA/LLC is a popular self-directed strategy offered by Directed IRA and provides several benefits:
Checkbook Control: A Checkbook IRA/LLC allows you to make investment decisions directly, bypassing the need for custodian approval of transactions. You can write checks directly from the LLC’s bank account, enabling swift management of your retirement funds. This structure allows you to act quickly on investment opportunities and provides greater control over managing assets that may require frequent transactions after purchase (e.g., a rental property or a property being rehabbed and flipped).
Privacy & Asset Protection: By utilizing an IRA/LLC, your investments are conducted in the name of the LLC, not your personal name or IRA account name. This offers privacy benefits while the LLC structure provides an additional layer of asset protection, shielding you and your retirement funds from potential liabilities or creditors.
Faster Transactions: With direct access to the LLC’s funds, you can quickly act on time-sensitive opportunities like real estate or private equity investments. Faster transactions help you stay competitive in dynamic markets and optimize returns.
Your IRA can buy real estate using its own cash and a loan/mortgage to acquire the property. Whenever you leverage your IRA with debt, however, you must be aware of two things. First, the loan your IRA obtains must be a non-recourse loan. A non-recourse loan is made by the lender against the asset, and in the event of default the sole recourse of the lender is to foreclose and take back the asset. The lender cannot pursue the IRA or the IRA owner for any deficiency. Second, your IRA may be subject to a tax known as unrelated debt financed income tax (UDFI/UBIT).
The tax UBIT applies when your IRA receives “unrelated business income.” However, if your IRA receives investment income, that income is exempt from UBIT. Investment income exempt from UBIT includes the following.
• Real Estate Rental Income (IRC 512(b)(3)) – Rent from real estate is investment income, and is exempt from UBIT
• Interest Income (IRC 512(b)(1)) – Interest and points made from the money lending is investment income, and is exempt from UBIT.
• Capital Gain Income (IRC 512(b)(5)) – The sale, exchange, or disposition of assets is investment income, and is exempt from UBIT
• Dividend Income (IRC 512(b)(1)) – Dividend income from a C-Corp where the company paid corporate tax is investment income, and is exempt from UBIT
• Royalty Income (IRC 512(b)(2)) – Royalty income derived from intangible property rights, such as intellectual property, and from oil/gas and mineral leasing activities is investment income and is exempt from UBIT.
So, make sure your IRA receives investment income rather than “business income.”
There are two common areas where self-directed IRA investors run into UBIT issues that fall outside the exemptions outlined above. The first occurs when an IRA invests in and acquires LLC ownership in an operating business (e.g., selling goods or services) that is structured as a pass-through entity for tax purposes (e.g., a partnership) and does not pay corporate taxes. The income from the LLC flows to its owners and would be ordinary income. If the company has net taxable income, it will flow down to the IRA as ordinary income on the K-1, and this will cause tax to the IRA, as this will be business income, and it does not fit into one of the investment income exemptions. If your IRA has UBIT income, it must file its own tax return using IRS Form 990-T. The second instance occurs when the IRA invests in real estate activities, in which case the IRA is deemed to be in the business of real estate rather than investing in real estate (e.g., real estate development, construction, significant short-term real estate flips).
If an IRA uses debt to acquire an investment — such as a rental property — the portion of income that is attributable to the borrowed funds is subject to tax. This tax is known as unrelated debt financed income (UDFI), and it triggers unrelated business income tax (UBIT).
A solo 401(k) is a great self-directed account option. It can be used instead of an IRA for self-employed individuals with no other employees (other than business owners and spouses). If you are not self-employed, the solo K will not work for you.
A solo 401(k) is generally a better option for someone self-employed and still trying to maximize contributions, as the solo 401(k) has much higher contribution amounts ($57,000 annually versus $6,000 annually for an IRA). On the other hand, a self-directed IRA is a better option for someone who has already saved for retirement and has enough funds in their retirement accounts to roll over and invest, as it is easier and cheaper to establish.
Another primary consideration in deciding between a solo 401(k) and a self-directed IRA is whether there will be debt on real estate investments. If there is debt and the account owner is self-employed, they are much better off choosing a solo 401(k) over an IRA, as solo 401(k)s are exempt from UDFI tax on leveraged real estate.
So, which is better? It depends on your retirement goals, income, and investment plans.
Stay ahead in the world of self-directed IRAs with exclusive insights, expert advice, and the latest industry trends. Join tens of thousands of professionals and investors who rely on our trusted newsletter for actionable guidance.
New to self-directed retirement accounts? These resources are designed to help you understand the fundamentals and get started the right way.
Access curated webinars, guides, and educational content covering investment options, account structures, and the rules that govern self-directed IRAs.
Mat Sorensen, Attorney, CEO, and Founder of Directed IRA, wrote the #1 book on self-directed IRAs – selling over 50,000 copies nationwide. The Self Directed IRA Handbook is a comprehensive guide written for both investors and advisors alike. Get access to your SDIRA Handbook resources today!
Mat Sorensen, Attorney, CEO, and Founder of Directed IRA, wrote the #1 book on self-directed IRAs – selling over 50,000 copies nationwide. The Self Directed IRA Handbook is a comprehensive guide written for both investors and advisors alike. Download your free copy today!