Self-Directed IRA? What’s Allowed and What’s Not

It’s common for clients to hold a significant amount of their wealth within retirement accounts. It’s also becoming much more common for clients to develop an interest in managing their own investments—often, in non-traditional investments like virtual currency. Self-directed IRAs can allow clients to invest in real estate, venture capital funds and even cryptocurrency if they’re careful. However, it is critical to understand the rules governing self-directed IRAs before engaging in any investment strategy. Violating the prohibited transaction rules has serious consequences—and it’s possible that the IRA could lose its tax-qualified status altogether, generating income tax liability, penalties and other headaches for clients.

Impermissible Investments for IRAs

Certain types of investments cannot be made with IRA funds (whether self-directed or not) because of the IRS’ rules on permitted investments. Those impermissible investments include life insurance and collectibles (certain gold, silver, palladium and platinum bullion are permitted, however). Additionally, the IRA owner cannot pledge the account as security for a loan (unlike with 401(k)s, IRA account owners cannot take loans from their IRA balances).

Clients should also be advised that the definition of “collectible” is evolving and the IRS has announced that it intends to tax nonfungible tokens (NFTs) as collectibles. Pending release of formal guidance, the IRS will use a look-through analysis to determine whether an NFT should be taxed as a collectible.

Making an impermissible investment or using IRA funds for a “loan” will cause the IRA to lose its tax-favored status entirely. That means the entire account becomes taxable.

Other types of investments can generate problems that aren’t related to formal IRA-related prohibitions. For example, clients who wish to invest IRA funds in S corporations should be advised that the investment will cause the S corporation to lose its S-status (IRAs are not permitted S corporation shareholders).

IRAs are permitted to invest in privately held C corporations, LLCs, partnerships and even private equity firms and hedge funds. They can also invest in complex derivatives, options and other financial products that are typically unavailable as traditional IRA investments. However, the IRA owner should be advised about the self-dealing rules (which prohibit the IRA owner from essentially using the tax-preferred funds to do business with themselves and certain related parties or entities).

Some types of investments are not permitted because of rules implemented by the IRA sponsor, rather than formal IRS rules. That means it’s important to carefully review the IRA custodian agreement before making any investment decisions.

Practical Considerations: Reporting to the IRS

Every year, an IRA must report its value to the IRS. The IRA custodian is responsible for reporting the value of IRA assets on Form 4598. For traditional investments, like stocks and bonds, the investment’s price at the close of the day on December 31 is reported.

In self-directed accounts with non-traditional assets, the asset’s fair market value is not so readily available. The IRA owner will have to provide information on the investment’s value to the IRA custodian—and the IRS offers no guidance on what constitutes an acceptable form of valuation. Many IRA custodians will require an independent appraisal each year (the cost of which is paid by the IRA owner or the IRA). Other valuation methods, including use of comparative market analysis for real estate investments, may be acceptable.

It’s important that any appraisal be conducted by an independent appraiser. If the IRA owner or even certain related parties conducts the appraisal, it’s possible that the act could violate the self-dealing rules (meaning that the IRA would lose its tax-favored status).

These valuation rules are important because the account value is used to set minimum distribution amounts once the owner reaches their required beginning date (currently, 73). Proper valuation is also important for purposes of Roth conversions or in-kind distributions.

Clients should also remember that the IRA is an entity that’s separate from the client themselves. Assets held within the IRA must be titled in the IRA custodian’s name, not the account owner’s name. If the account owner is named as the asset’s own on the title, the asset is treated as though it was distributed to the owner (and, thus, is taxable income and subject to penalties).

Conclusion

It’s critical to consult a qualified advisor before engaging in any self-directed IRA investment strategy. The rules are complicated—and one false move could cause the entire account to lose its IRA status.

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