PDF Summary:The Self-Directed IRA Handbook, by Mat Sorensen

Allowing you to invest your retirement savings in a wider variety of assets beyond stocks and bonds, The Self-Directed IRA Handbook by Mat Sorensen explains how self-directed IRAs expand your options into areas like real estate, loans, and private companies. Sorensen details the advantages of self-directed plans and walks through key considerations like prohibited transactions, taxes, valuations, and investment due diligence.

While broadening your IRA's reach offers opportunity for higher returns, Sorensen emphasizes the regulations surrounding self-directed accounts. By learning to navigate these rules upfront, you can maximize the growth of your retirement funds while steering clear of penalties and additional taxes.

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Sorensen clarifies that profits from real estate acquisitions through leveraging with nonrecourse loans within self-directed IRAs are liable for UDFI taxation. When using borrowed funds to purchase real estate through a Solo 401(k) plan, such transactions are exempt from the specific tax under discussion. Self-employed individuals looking to boost their income by investing in leveraged real estate might consider the Solo 401(k) as a more attractive option.

Ensuring properties are correctly titled and managing expenses and operations meticulously is essential for an IRA with real estate investments to prevent involvement in disallowed transactions.

Sorensen provides practical guidance for managing real estate investments in a self-directed IRA to avoid engaging in prohibited transactions. Income generated by the property, such as rent, should be paid straight to the IRA custodian to benefit the IRA, and the IRA should also be used to pay for any property-related expenses, including taxes and upkeep. The real estate cannot be occupied or utilized by the owner of the IRA or certain relatives who are disqualified from deriving benefits from it. Violating these rules can result in a transaction that is not permitted, potentially leading to the forfeiture of the tax-advantaged condition of the IRA and possibly incurring tax penalties. Sorensen also advises against overextending the financial capacity of an individual retirement account by investing in properties that exhaust all available funds, potentially leaving no reserve for unexpected expenses or maintenance. It is crucial to carefully organize and maintain a portion of the IRA's assets in a form that can be quickly converted to cash or equivalents.

The act of drafting promissory notes and extending credit

Self-directed IRAs can engage in lending by purchasing promissory notes, as long as these transactions are properly structured and secured to avoid any prohibited dealings.

The writer clarifies that self-directed IRAs are frequently used to provide loans to individuals and companies through the use of written agreements to pay a specified sum. Sorensen emphasizes the importance of securing loans adequately to mitigate financial risks and points out that such investments provide a steady stream of income through interest payments. This could involve obtaining a stake in the borrower's real estate by means of a trust deed or asserting a right over other assets, like equipment. The IRA owner must carefully ensure that the recipient of the loan does not fall into the category of a prohibited individual, such as a family member, to avoid engaging in a transaction that is impermissible.

Income generated from promissory notes tied to the performance of a business endeavor may require careful tax planning to avoid activating Unrelated Business Income Tax (UBIT).

Mat Sorensen suggests that while self-directed IRAs may participate in creating debt instruments that include terms for profit-sharing from endeavors like a company or property appreciation, the income from these contracts could be subject to UBIT tax. Income generated from active entrepreneurial endeavors, in contrast to passive revenue streams like interest, is subject to this tax. Individuals overseeing their own IRAs should carefully consider the tax implications before entering into any profit-sharing loan arrangements. Consulting with a tax expert knowledgeable about self-directed IRAs is recommended to identify potential obligations linked to Unrelated Business Income Tax (UBIT).

Investments made in privately-held companies

Individual Retirement Accounts with self-direction can invest in entities not publicly traded, but they must strictly comply with rules regarding involvement of disqualified individuals and transactions that are self-serving.

Sorensen highlights the unique chance that self-directed IRAs have to be involved in the expansion of private businesses, an option that is generally absent in companies traded on the public stock markets. Investments of this type undergo thorough scrutiny to confirm the absence of prohibited transactions. IRAs are generally barred from investing in companies where individuals who are not eligible for participation own a majority share, defined as 50% or greater, due to the fundamental limitations on these types of dealings. The investment's setup must be carefully designed to avoid any deals that could be seen as self-dealing, ensuring that the IRA owner does not gain any undue benefit, even when disallowed persons have a minority interest.

When utilizing a self-directed IRA to invest in active businesses, one might incur obligations related to Unrelated Business Income Tax (UBIT) due to the exemption of these investments from corporate taxes.

Sorensen explains that income generated through investments made by a self-directed IRA in actively managed companies, such as technology corporations or restaurants structured as pass-through organizations like LLCs or LPs that bypass corporate taxes, is likely to be subject to Unrelated Business Income Tax. Tax liabilities can significantly reduce the returns generated by an Individual Retirement Account. Before making an investment, Sorensen recommends carefully examining the structure and financial stability of the organization. Utilizing methods like creating an IRA/LLC or investing through taxable corporations can diminish the chances of being subject to Unrelated Business Income Tax.

An IRA/LLC structure has the potential to simplify the oversight of private entity investments within a self-directed IRA and concurrently reduce the likelihood of participating in transactions that are not allowed.

Sorensen recommends establishing an LLC within an IRA as a strategy to minimize the risk of prohibited transactions when investing in private companies. The IRA creates a distinct barrier by being the exclusive owner of an LLC, thus separating it from the company's activities. However, it is crucial to diligently oversee and control an LLC, particularly when it operates as part of an IRA/LLC structure. The individual in charge of the IRA is prohibited from obtaining any benefits or compensation in connection with managing the LLC's operations. Sorensen advises consulting a lawyer who specializes in self-directed IRAs to ensure the proper establishment and operation of the IRA/LLC, thus avoiding any prohibited transactions.

Other Perspectives

• While self-directed IRAs offer diverse real estate investment opportunities, they also come with higher due diligence requirements and potential for mismanagement, which can be a disadvantage for inexperienced investors.
• The enhancement of portfolio diversity through real estate investments in a self-directed IRA may not be suitable for all investors, especially those who are not knowledgeable about the real estate market.
• Proper asset titling, while crucial, can be complex and may require professional assistance, which can add to the cost of managing a self-directed IRA.
• Although Solo 401(k) plans can help avoid Unrelated Debt-Financed Income tax, they are only available to self-employed individuals with no employees, limiting their applicability.
• Meticulous management of expenses and operations in IRAs with real estate investments can be time-consuming and may require a level of expertise that not all IRA owners possess.
• Engaging in lending through purchasing promissory notes involves credit risk, and if the borrower defaults, the IRA may suffer a loss that can't be easily offset.
• The steady income stream from properly secured loans in self-directed IRAs may be offset by the illiquidity of these investments and the difficulty in valuing them accurately for IRA reporting purposes.
• Avoiding Unrelated Business Income Tax requires careful planning and may limit the types of investments that can be made, potentially reducing the overall return of the IRA.
• Investing in privately-held companies with a self-directed IRA can be risky due to the lack of transparency and regulatory oversight of private companies, which may lead to higher risk of fraud or business failure.
• The use of an IRA/LLC structure to simplify oversight and reduce prohibited transactions can be complex and may not be recognized by the IRS, which could lead to unintended tax consequences.

Choices for overseeing self-directed retirement funds

A setup often referred to as an IRA/LLC.

A self-directed IRA's full ownership of an LLC not only broadens investment options but also solidifies the safeguarding of assets.

Sorensen details how a self-directed IRA can be the sole entity to own a newly established LLC, making it the unique investor. The limited liability company serves as a vehicle for acquiring and managing investments, providing a range of advantages.

• As the LLC's manager, the IRA owner is empowered to manage contractual agreements, supervise the company's financial dealings, and steer the LLC's investment decisions. This method accelerates the investment process by eliminating the need for custodian consent for each investment action, thus preventing possible hold-ups.
• Safeguarding Assets: The inherent safeguarding characteristic of an LLC serves as a barrier, shielding the IRA and its owner from potential legal conflicts or claims associated with the LLC's assets and operations. For example, if a tenant were to sue an LLC owning a rental property, the lawsuit would only affect the assets within the LLC, thereby safeguarding the personal assets of the IRA owner from legal disputes.

It is crucial to follow strict guidelines to comply with regulations and prevent unauthorized transactions, including restrictions on the types of support and remuneration that IRA owners can offer.

Sorensen highlights the critical need for careful oversight and administration of the LLC involved in an IRA/LLC setup to prevent unauthorized transactions. The IRA owner must ensure that they do not benefit personally or receive compensation for managing the LLC, as this would constitute a prohibited transaction due to self-dealing. The documentation for the IRA/LLC should be specifically tailored to clearly demonstrate that the IRA is the sole owner. To ensure proper setup and management, which minimizes the chance of disqualification and subsequent tax penalties, one must consult with an attorney experienced in self-directed IRAs.

An individual who is self-employed has the option to establish a Solo 401(k) plan.

Individuals who are self-employed are attracted to Solo 401(k) plans due to their higher contribution limits relative to IRAs and the exemption from UDFI tax on real estate investments that are financed.

Solo 401(k) plans are designed specifically for business owners with no employees other than their spouses and for individuals who are self-employed, as Mat Sorensen details. The primary advantages of a Solo 401(k) plan include:

• In 2018, individuals overseeing their Solo 401(k) plans had the option to contribute as much as $55,000 each year, a figure significantly higher than the caps set for IRA contributions. Self-employed individuals can enhance the growth of their retirement savings more rapidly.
• Income generated from debt that is not related to tax liabilities: Solo 401(k) plans are exempt from the tax on Unrelated Debt-Financed Income, which frequently affects leveraged real estate investments in self-directed IRAs. Individuals seeking to improve their investment outcomes through the acquisition of real estate using leveraged capital might discover considerable advantages by utilizing a Solo 401(k) plan.

Proper establishment and management of Solo 401(k) plans are crucial to comply with the rules regarding prohibited transactions and relevant regulations.

Sorensen emphasizes the necessity of complying with the rules that restrict certain activities in Solo 401(k) plans, which are similar to the ones that apply to self-directed IRAs. Transactions involving the retirement plan and disallowed parties, such as the account owner or their family members, are prohibited and could result in significant tax implications. Understanding that limitations on specific transactions apply equally to both Traditional and Roth Solo 401(k) plans is crucial. The owner of the plan is responsible for meticulously overseeing the plan and its investments as trustee, while ensuring that no conflicts of interest occur.

Cryptocurrency

Utilizing a Limited Liability Company within an IRA, individuals can strategically and efficiently manage the buying, holding, and selling of cryptocurrencies.

Sorensen acknowledges the increasing popularity of digital currencies, which offer the potential for significant profits, as a viable choice for investment. He clarifies that self-directed IRAs can encompass investments like cryptocurrencies, including Bitcoin and Ethereum, thereby providing investors with a chance to participate in this rapidly growing class of assets. Sorensen recommends establishing an IRA/LLC as the best method for managing cryptocurrency investments. The IRA establishes a digital currency account with a reputable cryptocurrency exchange, ensuring it has full control over the LLC that facilitates the acquisition, trading, and safeguarding of cryptocurrencies.

To maintain the tax advantages of a self-directed IRA with cryptocurrency investments, one must follow certain protocols.

Sorensen highlights the critical need to adhere to the required protocols for tax declarations and valuation of assets in transactions involving cryptocurrency within an IRA, which the IRS classifies as property and usually does not fall under the scope of Unrelated Business Income Tax. Owners of IRAs are obligated to evaluate the worth of their cryptocurrency holdings each year and accurately report these valuations to the IRA custodian, who in turn is tasked with relaying this information to the IRS. Ensuring the security of digital currencies is essential, and this objective can be achieved through the utilization of various wallet alternatives, including web-based services, applications on desktops or smartphones, or tangible hardware units, to prevent loss or unauthorized access. Selecting a trustworthy and safe system for handling cryptocurrency dealings is essential.

Other Perspectives

• While an IRA owning an LLC can provide investment flexibility, it also introduces complexity and potential for regulatory missteps, which may not be suitable for all investors.
• Managing an LLC within an IRA can be time-consuming and may require a level of financial expertise that not all IRA owners possess.
• The safeguarding of assets through an LLC might not be absolute; legal challenges and creditor claims can sometimes pierce the LLC veil, especially if there are management errors or non-compliance with legal formalities.
• Following strict guidelines to prevent unauthorized transactions can be burdensome and may require ongoing legal and financial consultation, which could offset some of the financial benefits.
• The prohibition on personal benefits or compensation for managing the LLC might deter some investors who seek to be rewarded for their active management efforts.
• Solo 401(k) plans, while offering higher contribution limits, are only available to self-employed individuals or small business owners without employees, excluding a large segment of the workforce.
• The exemption from UDFI tax in Solo 401(k) plans may not benefit all investors, particularly those who do not use leverage in their real estate investments.
• The high contribution limits of Solo 401(k) plans may contribute to wealth inequality by allowing high-income earners to defer large amounts of tax, while those with lower incomes cannot afford to contribute as much.
• Cryptocurrency investments within an IRA/LLC can be highly volatile and risky, which may not align with the risk tolerance or investment goals of all retirement savers.
• The valuation of cryptocurrencies can be highly speculative and challenging, potentially leading to inaccurate reporting and tax issues.
• The security of digital currencies is not guaranteed, and the use of various wallet alternatives may introduce additional risks such as hacking or technological failure.
• The rapid evolution of cryptocurrency regulations could render current structures non-compliant in the future, leading to potential tax liabilities and penalties.

To ensure the soundness of a self-directed IRA, one must rigorously evaluate and scrutinize the worth of its contained investments.

Thorough investigation is essential.

Individuals managing their self-directed IRAs must diligently assess potential investments to identify and mitigate risks, including the risk of fraudulent activities.

Sorensen emphasizes the importance of thorough investigation and assessment prior to allocating self-directed IRA resources to an investment, especially in the case of non-traditional assets. Account holders are primarily accountable for thoroughly investigating and evaluating the risks that come with managing self-directed IRAs, as opposed to traditional brokerage IRAs where such responsibilities usually lie with the financial institutions. A significant amount of personal retirement funds often consists of self-managed IRAs. Mat Sorensen cautions that these accounts could become the focus of fraudsters presenting alluring but misleading investment propositions.

Essential actions encompass scrutinizing investment-related documents, confirming the histories of all participants, and obtaining guidance from independent experts.

Sorensen provides a comprehensive due diligence checklist, incorporating advice aligned with the Securities and Exchange Commission's guidance and utilizing his expertise in the complex legal aspects of self-directed IRAs. He recommends scrutinizing investment documentation, verifying the track record of promoters and partners, and seeking independent valuations from professionals. Additionally, he advises investors to remain vigilant and prepared to walk away from deals that appear dubious, particularly those presented with high-pressure sales tactics, such as claims of limited-time offers. Ultimately, Sorensen stresses the importance of assuming a skeptical, "think like a banker" mentality, gathering sufficient information to make informed decisions and safeguard retirement savings from potential losses or fraudulent activities.

Valuation

It is crucial to assess the value of holdings within self-directed IRAs every year to ensure their market value is reported correctly to the IRS.

Sorensen underscores the necessity of accurately determining the worth of holdings in self-directed IRAs to maintain adherence to regulatory standards. IRA holders must each year determine the current market value of their assets and relay that information to the IRA custodian, who then uses it to prepare and send Form 5498 to the IRS. Accurately reporting FMV is crucial for several reasons:

• Obligations for yearly reporting: The yearly report required by the federal tax authority details the present market value of all assets within Individual Retirement Accounts, crucial for precise tracking of retirement savings and related tax responsibilities.
• Upon attaining the age of 70 and a half, individuals who have traditional IRAs are obligated to commence annual withdrawals based on the market value at that time.
• Roth Conversions: The taxable income arises from the conversion of assets from a traditional IRA to a Roth IRA and is determined by the current market value of those assets.

The methods used to determine the value of various asset types vary; typically, an appraiser's evaluation or a broker's price opinion is used to ascertain the value of real estate, whereas the assessment of other investments depends on their financial data.

Sorensen provides guidance on determining the appropriate market price for a range of asset types. He recommends obtaining an expert appraisal or consulting with a real estate agent to determine the precise value of the property. In circumstances where tax implications come into play, such as when converting to a Roth IRA or distributing assets in kind, a formal appraisal or Broker Price Opinion is generally required, but for matters unrelated to taxes, certain administrators may consent to less formal valuation methods. Sorensen clarifies that to ascertain the fair market value of promissory notes, one must sum the accrued interest with the outstanding principal amount. In assessing the worth of shares in private entities like LLCs and LPs, he recommends following the guidelines of IRS Revenue Ruling 59-60, which provides a structure for assessing fair market value by considering aspects like the financial health of the business, its potential for generating income, and the record of past transactions involving ownership interests.

Transfers of assets into a Roth IRA are required to comply with stringent valuation guidelines to ensure accurate tax records.

Sorensen underscores the importance of using detailed and professionally confirmed valuations when dealing with tax events that include distributions of assets in-kind and the conversion of traditional IRAs into Roth IRAs. Should the account owner's valuations not reflect accuracy, penalties from the tax authority could be imposed. When confronted with these circumstances, it is essential to secure a professional valuation to ensure compliance with pertinent IRS rules and established standards of the industry.

Other Perspectives

• While thorough due diligence is important, it can be overly burdensome and costly for individual investors, potentially limiting their ability to diversify or make timely investments.
• The emphasis on fraud risk might discourage individuals from considering self-directed IRAs, despite the potential benefits of having more control over one's investment choices.
• Annual valuation of assets can be a complex and expensive process, especially for non-traditional investments, which may not have a readily ascertainable market value.
• The requirement for professional appraisals or valuations can create a barrier to entry for smaller investors or those holding niche or unconventional assets.
• Strict adherence to valuation guidelines for Roth IRA conversions may not account for rapid market fluctuations, potentially leading to inaccuracies that are not the fault of the account holder.
• The focus on individual responsibility for due diligence and valuation may overlook the need for better regulatory frameworks and professional standards to protect investors and ensure fair valuations.