Asset Protection for Your Self Directed IRA

by | Apr 19, 2016 | Uncategorized

Many self directed IRA investors misunderstand or are unaware of the protections afforded to their IRA (Roth or traditional) as it relates to creditors and judgments. This article seeks to address the key areas of the law that every self directed IRA investor should know.

Infographic: four things every self-directed IRA investor should know about creditor protection. Bankruptcy vs. state law, liability inside IRA investments, prohibited transactions, and Solo 401(k)s
Infographic: four things every self-directed IRA investor should know about creditor protection. Bankruptcy vs. state law, liability inside IRA investments, prohibited transactions, and Solo 401(k)s

Bankruptcy Protection vs. State Law

First, your IRA is not always exempt from creditors up to $1Million. Many IRA owners believe that federal law protects their IRA from creditors up to $1M. While Section 522(n) of the federal bankruptcy code protects an IRA owner’s IRA from creditors up to $1M, this protection is only provided to IRAs when an account owner is in bankruptcy. If the IRA owner is not in bankruptcy then the creditor protections are determined by state law and the laws of each state vary. For example, if you are a resident of Arizona then your IRA is still protected from creditors up to $1M even without filing bankruptcy. The approach Arizona takes is the most common, however, many states protections for IRAs outside of bankruptcy are extremely weak. For example, if you are a resident of California then your IRA is only protected in an amount necessary to provide for the debtor and their dependents. That’s a pretty subjective test in California and one that makes IRAs vulnerable to creditors. If your California IRA is from a rollover of a company plan, you may have other protections. California residents should check out my prior article here.

Liabilities Inside Your IRA’s Investments

Second, while your IRA can be exempt from your personal creditors, as explained above, it is not exempt from liabilities that occur in the IRAs investments. For example, if your IRA owns a rental property and something happens on that rental property then the IRA is responsible for that liability (and possibly the IRA owner). As a result, many self directed IRA owners who own real estate or other liability producing assets utilize IRA/LLC’s which protect the IRA and the IRA owner from the liability of the property.

A Prohibited Transaction Removes the Protection

Third, if the IRA engages in a prohibited transaction under IRC Section 4975 then the IRA is no longer an IRA and is no longer exempt from creditors. Despite the bankruptcy and state law protections outlined in my first point above, if a creditor successfully proves that a prohibited transaction occurred within an IRA then account no longer is considered a valid IRA and therefore the protections from creditors vanish. There seems to have been an increase in creditors who are pursuing IRAs, particularly self directed IRAs, and I have been representing more and more self directed IRA owners in bankruptcy and other creditor collection actions in defending against prohibited transaction inquiries.

Solo 401(k)s Don’t Offer More Protection

Fourth, many proponents of solo 401(k)s have argued that investors are better off using a self-directed solo 401(k) plan instead of a self-directed IRA because solo 401(k)s receive ERISA creditor protection (federal law) that is better than most state law creditor protections afforded to IRAs. While it is true that ERISA plan protection is better than state law IRA creditor protection and courts have already held that while a Solo K plan is a qualified plan it is not subject to ERISA. Yates v. Hendon, 541 U.S. at 20-21. Since a Solo K plan is not subject to ERISA, its account holders cannot seek ERISA creditor protection and would instead be treated the same as IRA owners. In sum, there is no difference in creditor protection between a solo 401(k) account and a self-directed IRA. We love Solo 401(k) plans, we just aren’t setting them up instead of IRAs because of asset protection purposes.

In summary, the best way to protect your self directed IRA from creditors is to understand the rules that govern your self directed IRA and to seek counsel and guidance to ensure that your retirement is available for you and not just your creditors.

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Prohibited Transaction Case Lesson: The Substance of the Transaction Matters

by | Mar 29, 2016 | Uncategorized

UPDATE (NOV 2026)

The Sixth Circuit Court of Appeals reversed this Tax Court decision in 2017 (Summa Holdings, Inc. v. Commissioner, 848 F.3d 779). It held that the IRS could not use the substance-over-form doctrine to recharacterize the DISC and Roth IRA structure in this case, and the First Circuit reached the same result in 2018 (Benenson v. Commissioner, 887 F.3d 511). The discussion below describes the Tax Court ruling before it was reversed.

prohibited-transactioncase-studyA prohibited transaction case from 2015 taught an important lesson for self-directed IRA investors. That lesson is that the substance of the actual transaction matters and that you cannot avoid a prohibited transaction by creating entities or other artificial structures that create no business purpose. Summa Holdings, Inc., et al, v. Commissioner, T.C. Memo 2015-119 (2015)

In Summa, two brothers invested a minimal amount of funds from their Roth IRAs into a new corporation called JCH. JCH then established and owned 100% of another new company called JCE. This new company, JCE, then in turn contracted with and received income from a company owned and majority controlled by the Roth IRA owners’ father. Clearly, any transaction between the brother’s Roth IRAs and their father would be a prohibited transaction. The prohibited transaction rules restrict your IRA from transacting with a disqualified person and the list of disqualified persons includes the father of and IRA or Roth IRA owner. IRC 4975 (e)(2)(F).

The Tax Court, in Summa, had to determine if the transactions between companies the Roth IRAs owned and companies in which the Roth IRA owner’s father owned and controlled were a prohibited transaction. The Tax Court relied on what is known as the “Substance Over Form Doctrine” to find a prohibited transactions for the Roth IRAs receipt of income. The Substance Over Form doctrine provides that the substance and not the form of a transaction determines its tax consequences. So, despite all of the companies, three in total, that separated the brother’s Roth IRAs from their father there is still a prohibited transaction as the overall substance of the Roth IRAs transactions was to unfairly shift income and assets to the tax-free Roth IRA accounts.

In fact, the Roth IRA owners stipulated with the IRS  that the sole reason for their Roth IRAs investment into the companies and for the transactions was to accumulate income and assets tax-free. They conceded that there was no other business or investment purpose for the transactions. Consequently, the Tax Court rightly found a prohibited transaction and disqualified the Roth IRAs.

While careful planning and structuring is critical in your self-directed IRA transactions, no structure can overcome the lack of a legitimate investment or business interest for an IRAs investments. When investing your IRA into a deal, make sure your IRAs isn’t receiving any favorable treatment or benefit from a disqualified person (e.g. from the Roth IRA owner’s father). If your IRA is getting some favorable treatment or allocation of income or assets from a disqualified person, as was the case in Summa, you too could have a prohibited transaction.

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What Not To Do With Your IRA/LLC or Checkbook Control IRA: Niemann v. Commissioner

by | Jan 26, 2016 | Uncategorized

The recent case of Niemann v. Commissioner involves a successful real estate investor who unknowingly used his self-directed IRA owned LLC (aka, checkbook control IRA) in a way that caused a prohibited transaction under IRC § 4975. While the Tax Court’s holding and decision focused on other tax matters, the Court did outline the history of the case and the prohibited transactions that occurred and that disqualified Niemann’s IRA. Here are the pertinent facts regarding Niemann’s self directed IRA investments.

Infographic: how the investor in Niemann v. Commissioner disqualified his IRA/LLC, and lessons for checkbook control IRA investors
Infographic: how the investor in Niemann v. Commissioner disqualified his IRA/LLC, and lessons for checkbook control IRA investors

Case Facts

  • ✓Niemann formed Real Estate Rabbit, LLC with his IRA as the sole member and himself as manager.
  • ✓Niemann used Real Estate Rabbit, LLC for numerous real estate investments including buying homes at auction and flipping them for a profit. Real Estate Rabbit, LLC also bought mineral rights investments and held notes.
  • ✓Niemann personally engaged in real estate investments in his own name and in the name of an LLC he personally owned called Magic, LLC. Niemann intended for Magic, LLC to be a multi-member LLC to be owned by himself, his personal LLC, and his IRA/LLC. This LLC was not properly established nor was it properly operated. He learned about it from a seminar and engaged a non-lawyer (“vendor”) to set up the LLC.
  • ✓Niemann transferred properties from his Real Estate Rabbit, LLC (his IRA/LLC) to himself personally and to his personally owned LLC. These transfers caused a prohibited transaction and resulted in the entire distribution of Niemann’s self directed IRA.

It is quite clear from the case and from the Court’s analysis that Niemann was not intending to unfairly avoid tax nor was he attempting to improperly engage in a prohibited transaction. In fact, his real estate transactions were very successful. And if you were a successful real estate investor looking to illegally avoid taxes, you wouldn’t transfer properties from your IRA owned LLC (that pays no taxes on gains) to yourself personally (where you do pay taxes on the gains). If you were a tax cheat, you’d do the opposite and would transfer properties with gains from yourself personally to your IRA. It is quite clear instead, that Niemann was unaware of the rules and as a result he moved his real estate investments around between his LLCs and his personal name as he would with any property he owned. These transfers were made without regard to IRA rules which require IRA investments to be held separately from personal assets and which restrict transactions between the IRA (and IRA/LLC) and the IRA owner personally.

Niemann conceded with the Court and the IRS that he engaged in a prohibited transaction when his IRA owned LLC (Real Estate Rabbit, LLC) transferred property to himself personally and to his personally owned LLC.

Learn the Rules and Seek Out Qualified Licensed Professionals

This case illustrates a critical point that self-directed IRA investors must first become acquainted with the self-directed IRA rules before they enter into real estate, LLC, or other transactions with their IRA. Niemann was a successful investor and a former engineer but he either received poor advice or he sought no professional legal or tax advice in the process.

Learning how to self-direct your IRA is like learning a new board game. At first, it takes some time to learn what you can and cannot do but once you understand the rules for the investments you intend to make it becomes second nature and you can proceed without having to consult the “rulebook” or a lawyer, or CPA, or other licensed advisor. So, if you’re new to self directing your IRA, make sure you’ve received competent advice from licensed professionals. Don’t rely on something you’ve heard at a seminar or by someone trying to sell you an investment. Instead, seek a specific consult with a licensed attorney or CPA who is competent in the rules affecting your self-directed IRA.

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Self-Directed IRAs, Real Estate Crowdfunding, and UBIT Tax Explained

by | Jan 12, 2016 | Real Estate & Alternative Asset Investing , Tax Planning, Uncategorized

The most common asset class for self-directed IRA accounts is real estate. Real estate investments for self-directed IRAs come in various forms from simple single-family rentals owned 100% by the IRA to LLC or LP investment partnerships with multiple investors in larger commercial or multi-family properties.

Infographic: the two-question test for whether UBIT applies to a self-directed IRA real estate crowdfunding investment, passive versus ordinary income, and how debt financing creates UDFI
Infographic: the two-question test for whether UBIT applies to a self-directed IRA real estate crowdfunding investment, passive versus ordinary income, and how debt financing creates UDFI

Real Estate Crowdfunding and Your IRA

Given the changes in federal securities laws that now allow investment sponsors and real estate syndicators to raise capital more easily, many self directed IRA investors have considered investing their IRAs into these offerings. Crowdfunding sites such as Realcrowd are already offering Crowdfunding type investment opportunities for investors under SEC Rule 506(c). This rule and those investments are currently only available to accredited investors and have no restriction on the investment amount that may come from the accredited investor. These offerings have traditionally been known as private placements or “PPMs” but can now be marketed and there is no requirement that they be “private” so long as the offering company only accepts accredited investors.

For those who are not accredited investors, “true” Crowdfunding under Title III of the JOBS Act goes into effect in May of 2016. Under these Crowdfunding offerings everyone will be able to invest into Crowdfunding opportunities and the investment amount will be based on the investor’s income and assets. These new Crowdfunding rules were enacted in Title III of the JOBS Act and were put into final regulations by the SEC in late 2015.

Before investing your self-directed IRA into a real estate Crowdfunding offering, you must first learn and understand one very important tax called UBIT tax that may apply to your self-directed IRA’s income.

Will My IRA Be Subject to UBIT Tax?

Unrelated Business Income Tax (“UBIT”) applies to an IRA that receives non-passive income. UBIT is a hefty tax and has a maximum rate of 39.6%. IRC § 511. The tax table is copied below.

2016 UBIT Tax Rates

 If taxable income is: The tax is:
Not over $2550 15% of the taxable income
Over $2550 but not over $5950 $375 plus 25% of the excess over $2550
Over $5950 but not over $9050 $1225 plus 28% of the excess over $5950
Over $9050 but not over $12300 $2107 plus 33% of the excess over $9050
Over $12400 $3179 plus 39.6% of the excess over $12400

UPDATE (NOV 2026)

This table shows 2016 rates. For 2026, the top rate for UBIT (trust tax rates) is 37%, on taxable income above $16,000; it was 39.6% when this article was written. The $1,000 specific deduction still applies. (Source: AAII; IRC 511(b), 512(b)(12))

Although not shown on the table, the first $1,000 in UBIT gross income is exempt and you receive an automatic $1,000 deduction.

UBIT will apply to your self-directed IRA’s real estate investment in two scenarios. First, it will apply if the income to the IRA is ordinary. And second, it will apply if the offering company uses debt to acquire its properties.

Step One: Is the income passive?

First, UBIT will apply if the investment is an ordinary income producing business. An ordinary income business in real estate investing would include investing into an LLC or LP that conducts new construction, real estate developments held for sale, or other activities that are deemed business activities. Passive income investments, on the other hand, are specifically exempt from UBIT and include real estate rental income, capital gain income, interest income, and dividend income from a c-corp. IRC § 512(b). The vast majority of real estate Crowdfunding offerings are structured to obtain passive income such as rental income while the property is held and capital gain income when the property is sold. Typical real estate offerings where UBIT can be due include offerings to fix and flip properties or offerings for new construction or real estate development where the investment strategy is to buy properties to then immediately sell.

If you have an investment offering that is ordinary income (e.g. a fix and flip fund), then the income to the IRA from the fund will be subject to UBIT tax and the IRA will be required to file and pay the tax each year by using IRS Form 990-T. This responsibility to file the return each year is on the IRA account owner and not the investment sponsor or the IRA custodian so IRA owners need to know for themselves whether the IRA is subject to UBIT or not. So for example, let’s say that a self-directed IRA invested into a Crowdfunding offering that was a real estate development with properties held immediately for sale and that the income was ordinary income. Let’s further assume that the self-directed IRA received a K-1 for profits to the IRA for the year of $10,000. Based on the UBIT tax table, and after the $1,000 deduction, the IRA would owe UBIT tax in the amount of $2,079. This amount is due from the IRA to the IRS and is reported and payable using form 990-T.

If you’ve determined that the Crowdfunding offering income is passive (e.g. rental, capital gain), then you may still be subject to UBIT if the LLC or LP offering company is using debt to leverage and acquire its properties.

Step Two: Will the investment be leveraged with debt?

EXAMPLE

Second, UBIT will apply to profits returned to your IRA from a Crowdfunding real estate offering (and really any real estate owned by your IRA) if the offering company uses debt to leverage its acquisition of properties. For example, let’s say the offering company raises $1M in cash to buy a $4M multi-family property. There will be $1M of cash invested into the property and $3M of debt. The property will therefore be leveraged 75% with debt.

Whenever an IRA’s investment is leveraged with debt, the tax code requires the IRA owner to determine what profits are attributable to the IRA’s cash and what profits are attributable to the debt. The profits attributable to the cash invested is still treated as tax deferred (traditional IRA) or tax free (roth IRA) and is not subject to UBIT. The profits and income attributable to the debt, however, is called unrelated debt financed income (“UDFI”) and is subject to UBIT. IRC § 514. So, in the multi-family property example above where the property is leveraged 75% with debt, the self-directed IRA will be subject to UBIT tax on 75% of the income.

In order to calculate UBIT tax based on debt, you must first determine the leverage ratio. Once we know the leverage ratio, we can then begin to calculate how UBIT will apply. The good news is that the IRA is also allowed to take expenses against the property using the same leverage ratio and is able to take depreciation expenses which help to offset UBIT. In many situations, even where a property is cash-flowing the IRA will not be subject to UBIT because the property expenses and depreciation will offset UBIT income.

Let’s continue through this example to illustrate how this works.

Example

EXAMPLE

Property Purchase Price = $4M

Debt/Leverage = $3M

Leverage Ratio = 75%

Income = $1.3M

Income at Leverage Ratio (75%) = $975,000

Operating Expenses= $1,000,000

Operating Expenses at Leverage Ratio (75%) = $750,000

Net Leveraged Income = $225,000

Depreciation Expense ($4M / 27.5) = $145,500

Depreciation Expense at Leverage Ratio = $109,125

Net UDFI/UBIT Income = $115,875

SDIRA Investor Invested $20K and received 1.5% of Company Profit/Loss

SDIRA Investor 1.5% of Net UDFI/UBIT = $1,738.

Automatic IRS $1,000 deduction = $738 subject to UBIT/UDFI

UBIT Table Rate of 15% of $738 = $110 in UBIT is Due

As the example demonstrates, given the low-level of investment from the IRA it isn’t subject to much UBIT as the net UBIT income (after expenses and depreciation) keeps the tax rate on the low end of the tax table. That being said, 990-T tax returns must be filed by the IRA investor for the IRA and the IRA will be responsible for the tax due. Factors that will cause more UBIT are higher returns and income, larger investment amounts and ownership, and more leverage.

While self-directed IRA’s are subject to UDFI and UBIT on leveraged real estate investments, it is worth noting that self-directed 401(k) and other employer based plans are exempt from UDFI on leveraged real estate investments. IRC § 514(c)(9). Unfortunately, self-directed IRAs do not receive this exemption.

So, in short, the quick list to determine whether UBIT will be due a self-directed IRA Crowdfunding real estate investment requires analysis of two issues. First, is the offering company’s income passive or is it ordinary. If it is ordinary then it is subject to UBIT. If it is passive, then it is only subject to UBIT if the company uses debt to leverage its investments. Once you can answer these questions you know whether UBIT will apply to your investment and whether your IRA will need to report and pay tax on its income.

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Correcting Your IRA’s RMD Failures and Avoiding the Penalty

by | Jan 5, 2016 | Retirement & IRAs, Uncategorized

If you failed to take required minimum distributions (RMD’s) from your IRA, then you are subject to a 25% penalty (10% if corrected within two years). The penalty is 25% on the amount you should have distributed from your IRA to yourself. It’s a steep penalty for simply failing to pay yourself from your own IRA and it’s something every IRA owner with RMD needs to understand. For my prior article explaining RMD rules for IRAs, please click here.

Infographic: the steps to request an IRS waiver of the missed RMD penalty on Form 5329, and examples of reasonable errors
Infographic: the steps to request an IRS waiver of the missed RMD penalty on Form 5329, and examples of reasonable errors

Waiver of the Penalty Tax

UPDATE (NOV 2026)

The penalty for a missed RMD is now 25% of the amount not taken, or 10% if you correct it within two years. It was 50% when this article was written. (Source: IRS)

If you’ve failed to take RMD for your IRA, you have a chance at obtaining a waiver from the penalty but you must admit the mistake to the IRS by filing IRS form 5329. In the instructions to form 5329, the IRS outlines the waiver process to avoid the 50% penalty tax.

What You Need to Do

  1. 1Complete Section IX of Form 5329. You need to specify what you should have taken as RMD  and then you calculate the penalty tax due. You then write the letters “RC” next to the amount you want waived on line 52.
  2. 2Statement of Explanation. Attach a Statement of Explanation outlining two items.
    1. First, explain what was the “reasonable error” that caused a failure to take RMD. The IRS does not provide a definition or acceptable examples of “reasonable error”. See IRC 4974(d)(1). From my own experience and from examples I’ve heard from colleagues, the IRS does recognize reasonable errors and oversights in most situations where there is reason for the error. This would include situations such mental health, to turning 73 and being new to RMD, to relying on bad advice from an advisor, custodian or accountant, to holding an illiquid asset for sale in a self directed IRA.
    2. Second, explain the reasonable steps taken to correct the error. Ideally, by the time you’re filing the exemption request you would’ve already contacted your IRA custodian and would’ve taken the late RMD so that by the time you submit the RMD penalty tax waiver, you would be caught up and would have already remedied the error.  This makes for an easy and clean explanation of what steps you’re going to take as your explanation will be that you already corrected the RMD failure once you realized the error.

WATCH OUT

Keep in mind that RMD failures won’t go away as your IRA custodian will be updating your account each year with the IRS. Eventually, you’ll start getting collection letters from the IRS requesting the penalty tax. Consequently, IRA owners are well advised to correct the RMD failure and request the waiver as soon as they become aware of the error or oversight.

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