• Living in one of the units owned by your IRA. • Assets not properly titled in the name of the IRA or IRA- owned LLC. • IRA-owned LLC’s revocation by the state of formation for failure to renew. • Personally guaranteeing a loan to an IRA. • Personally paying for the setup of an LLC owned by your IRA. The tax consequences for engaging in a prohibited transac- tion are extremely costly. Here is an example that many SDIRA account holders can probably relate to: John attends a real estate convention wherein he listened to a speaker tout the benefits of a SDIRA. Tired of the stock market’s unpredictability, John decides to meet with Susan, a represen- tative of ABC IRA, to discuss how he can roll over his $500,000 401(k) account into an SDIRA and have complete control over the investments. Susan explains how, for $3,000, ABC can set John up an SDIRA with an LLC wherein he will have checkbook control over his money. Enticed by the possibility, John pays ABC $3,000 using his personal credit card to set up his plan. John unknowingly engaged in a prohibited transaction when he paid ABC $3,000 to establish a SDIRA and an LLC. Under IRC 219(e)(1), cash is the only permissible IRA contribution. When John paid $3,000 to set up the SDIRA, part of his payment was for the creation of an LLC. Thus, John was making an impermissible contribution of an LLC he paid for to his SDIRA. If John’s transgression is discovered by the IRS, John risks disqualification of his entire IRA, resulting in income taxes on his $500,000, plus a 10 percent early withdrawal penalty and a possible 15 percent prohibited transaction penalty. (Note: If your IRA is disqualified, then you also lose any asset protection benefits afforded your IRA.) If you are wondering how the IRS might discover John’s mis- take, you need only look to John’s IRA custodian, who will re- port John’s LLC/IRA transaction to the IRS on Form 5498. Form 5498 is required to be submitted to the IRS on an annual basis. The form requires your custodian to identify if your IRA holds an interest in real estate, LLCs, limited partnerships, trusts, corporations, deeds of trust, promissory notes or any asset not traded on an established exchange. This is a substantial change from the previous version of Form 5498, which did not require identifying any such assets. Herein lies the concern. If your IRA holds these assets, this information will be provided to the IRS and will possibly fall within its examination program. If your IRA is invested in nontraditional investments, then it
might be in your interest to consider some “spring cleaning” to correct any prior transactions that might result in penalties or disqualification of your IRA if discovered.
UNRELATED BUSINESS TAXABLE INCOME (“UBTI”) In addition to prohibited transactions, you must also be aware of possible transactions that subject your SDIRA to taxes. Earn- ings within an IRA (or IRA/LLC) are exempt from tax. However, certain investments can create taxable income, i.e., UBTI. UBTI is income from a trade or business carried on by the IRA or IRA/ LLC. The Internal Revenue Code does not define active trade or business regarding an IRA, but it does provide some statutory “modifications” that specifically exclude certain types of income out of UBTI. These include, but are not limited to: • Dividends (e.g. paid to the IRA as a result of the IRA-own- ing C Corporation stock). • Interest (includes “points”). • Royalties. • Rent from real property. • Sales proceeds from real property. The issue for some IRA account holders is certain passive activities can rise to the level of a trade or business. Such an example is flipping or developing real estate inside an IRA. It is well recognized by the IRS that an individual can be a “dealer” of real estate (i.e., purchases property with the intent to resell. A dealer is actively engaged in the trade or business of real estate.) This same test can be applied to an IRA. If the IRS determines your IRA is engaging in a trade or business, then the gains will be subject to trust tax rates:
$0 - $2,500 = 15% $2,500 - $5,900 = $375 + 25% $5,900 - $9,050 = $1,225 + 28% $9,050 - $12,300 = $2,107 + 33% OVER $12,300 = $3,179 + 39.6%
Other activities that, taken independently, would not be considered a trade or business inside your IRA, could rise to this level if the IRA account holder actively engages in such activity outside of the IRA as a trade or business. An example would be private lending. If a person actively pursues private lending as a private business venture utilizing his IRA for the same activity could give rise to UBTI. The IRS might argue
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