THE BIG PICTURE
SELF-DIRECTED IRA
John’s favor. Unfortunately for John, he wasn’t so lucky.
a blistering rate. This is where the real pain of a prohibited transaction is felt. John didn’t know that his IRA was downgraded, effective the first year that he opened it. As a result: • He continued to make deposits into his IRA each year and took income tax deductions for those deposits to which he was no longer entitled. • He continued to buy and sell assets through his account without paying taxes on the profits, falsely believing he was shielded from tax conse- quences through his IRA. • With each new deduction John took for his deposits, and with each new profitable investment he made, John’s tax liability to the IRS grew. By the time the IRS caught up to John’s error in 2016, he’d been taking deductions and making successful investments for many years, during which time John’s tax liability grew and grew. But the painful part of a growing tax liability isn’t the taxes, it’s the penalties and interest. That is why the tax liability for prohibited transactions routinely cost taxpayers 50 percent or more of their IRA balance. In John’s case, he lost 60 percent of his retirement savings because of this error. HOWTO AVOID JOHN’S FATEWITH YOUR SELF-DIRECTED IRA John was actually somewhat care- ful with his self-directed IRA, and the error that the IRS found in his account was rather esoteric and strange. He did consult an attorney to review each of his transactions and received the “blessing” of his attorney. But that wasn’t enough. John should have done these things to protect himself: • Only use attorneys with specific ex- perience in self-directed IRAs. John’s attorney was his family attorney who “did some research” for John, but had no actual experience with self-direct- ed IRAs. This is an area of law with
substantial nuance, and it should only be trusted to the most knowledge- able counsel. (I suggest Tim Berry at SDIRadio.com/tim.) • Have your attorney review every document you sign, not just the “big” ones. Obviously, your attorney should review your purchase and sale agreements, LLCs, etc. But you also should have the firm review documents required for your bank accounts, insurance policies and anything else involving your self-di- rected IRA. In John’s case, the prob- lematic clause was in the documents he signed when opening a bank account, and not in any document related to his investments. • Use a self-directed 401(k) rather than a self-directed IRA. Self-di- rected IRAs and 401(k)s are similar in many ways, but one of the biggest points of differentiation is in how the law treats prohibited trans- actions. Self-directed 401(k)s are substantially more forgiving of pro- hibited transactions than IRAs. In fact, if John had been using a 401(k) rather than an IRA, he’d likely have escaped with little more than the payment of some legal fees to bring his account back into compliance. John’s outcome was tragic. Fortu- nately for other self-directed investors like you and me, his fate is avoidable by understanding the profound severity of prohibited transactions and working proactively to avoid them. •
RETRO-
INSTANT EFFECT NO. 2
ACTIVE DOWNGRADE The very moment that John’s IRA committed the prohib- ited transaction, his IRA was permanently downgraded, effective as of Jan. 1 of the same year. In John’s case, his prohib- ited transaction happened in October 2009, so his IRA was permanently downgraded as of Jan. 1, 2009. What does this downgrade mean? The best way to answer that is to think of all of the ben- efits that an IRA offers, and to realize those benefits are gone, retroactively. For example: • John lost the right to make tax-de- ductible deposits. • John lost the right to defer taxes on the profits of his transactions. • John’s account was no longer pro- tected from creditors, bankruptcy and other legal problems. These things are huge problems by themselves, but the biggest problem for John—and for anyone who commits a prohibited transaction—is that you don’t know it’s happened, so you continue to use your IRA as if it was never down- graded. You make deposits, you buy assets, you sell assets, and you generally proceed as if everything was totally right with your IRA. But it’s not. You no longer have an IRA, and you don’t even know it. You have no idea whatsoever that you’re tak- ing deductions and other tax benefits to which you’re no longer entitled, which gives rise to …
Cautionary Tale HOW AN OVERLOOKED MISTAKE INVALIDATED ONE INVESTOR’S IRA EVEN BEFORE IT WAS CREATED.
by Bryan Ellis
J
acquiring one property, which he sold a year later for a very large profit, enabling him to buy three more properties. John’s success as an investor contin- ued for years. He was very careful and very precise, always seeking legal and tax expertise whenever he needed it. That’s why, when he was selected for a random audit by the IRS, John wasn’t worried about the outcome. Unfortunately for John, the IRS found a single nine-word clause in a service agreement that John had signed on behalf of his IRA. This clause, the IRS claimed, involved “cross-collateralization” of John’s IRA, which is strictly prohibited.
error? When John signed the fateful service agreement in late 2009, three things happened immediately: SILENCE That’s right—silence. John heard nothing. John saw nothing. There were no red flags waving or IRS agents knocking down John’s door. He experienced a whole lot of nothing. Why? Because neither the IRS nor John knew that he’d committed a pro- hibited transaction at that time. The IRS doesn’t monitor these things in real time, and John certainly didn’t know that he’d stepped over the line. In fact, he thought he’d taken great care to avoid such a fate. Had John not been randomly selected for audit, it’s possible that nobody would ever have known of the trans- gression, and presumably at some point, a statute of limitations would apply in INSTANT EFFECT NO. 1
ust last week, John (not his real name) lost nearly 60 percent of
the value of his self-directed IRA in a single day. There wasn’t a horrible crash in the stock market or an act of fraud that caused this calamity. Instead, John’s misfortune was the result of an esoteric mistake that rendered John’s IRA inval- id months before it was even created. Here’s how it happened: On a bright, beautiful day in 2009, John finally rolled over his old 401(k) plan into a new self-directed IRA. He’d watched in the past two years as the stocks in his 401(k) had been slashed in half by a rap- idly falling market, leaving John with only $150,000 of the $300,000 he started with. John was an accomplished real estate investor, and he decided to buy cash-flow- ing properties in his new self-directed IRA. John quickly encountered success,
Bryan Ellis is CEO of Self Directed Investor Society, America’s only private association for affluent self-directed investors, and host of Self Directed Investor, an audio and video podcast for
owners of self-directed IRAs and 401(k)s. You can hear the show on iTunes or at SDIRadio.com. Ellis manages the SDi Private Equity hedge fund and has substantial experience in private lending, real estate investing and real estate note investing. You can reach him at www.SDISociety.org or by email at bryan@SDISociety.org.
RETROACTIVE
INSTANT EFFECT NO. 3
THE INSTANT EFFECTS OF JOHN’S PROHIBITED TRANSACTION What happened as a result of John’s
TAXES & PENALTIES Unbeknownst to John, he began accu- mulating taxes, penalties and interest at
32 | think realty magazine november :: december 2016
thinkrealty . com / mag | 33
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