Unlike more traditional brokerage style IRAs, self-directed IRAs do not come with any tax, legal or investment advice, nor do self-directed custodians and third party administrators offer or endorse investment products.  Self-directed means just that – it is self-directed and you must find your own investments and decide how you want to structure those investments.  If you make a million dollars in your self-directed IRA all the glory belongs to you, but if you lose everything you have there is no one to blame but yourself.

2) Not investing in what they know best, but rather investing in something they know nothing whatsoever about.

One of the primary benefits of a self-directed IRA is that it allows you to invest in what you know best, especially if that is not the more traditional IRA investments like stocks, bonds, mutual funds or annuities.  Some people get very excited about the idea of self-direction and invest in something they know nothing about, which often leads to an investment disaster.  Most of my mistakes in investing have been because I have strayed from what I know how to do best.

3) Not understanding the disqualified persons and prohibited transaction rules.

Disqualified persons are those persons who are deemed to be too close to make a transaction within your IRA an arms-length transaction, which means these persons cannot enter into transactions with your IRA nor can they benefit from those transactions, either directly or indirectly.  Prohibited transactions are what your IRA cannot do with any disqualified person.  The penalty for entering into a prohibited transaction is DEATH (of the IRA that is) along with taxes and penalties.  If you have a self-directed IRA you must have a good basic understanding of these rules as they apply to your investing strategy.

4) Not vesting assets correctly – all assets in self-directed IRAs should be vested as follows:  “Entrust Retirement Services, Inc. FBO Your Name IRA #Your IRA Number.”

A lot of time is spent in attempting to get clients, title companies, and investment providers to understand that all assets must be vested in a specific way in order to be held within a self-directed IRA.  Common errors include failing to vest in the name of the custodian or administrator at all, or only putting the client name after the “FBO” so that it appears we are holding the asset on behalf of the individual instead of the individual’s IRA.  Another common mistake is where the client attempts to use their own Social Security Number instead of that of the IRA or the administrator or custodian’s trust tax identification number.

5) Failing to submit proper paperwork to allow smooth opening of IRAs and processing of transactions.

Another large time waster is chasing down paperwork from improperly completed documents for opening the IRAs, for transferring money into the IRAs and for transactions.  This leads to a frustrated client and frustrated staff.  Taking the time to learn how to properly submit paperwork and allowing yourself enough time to do so is critical in successfully navigating the self-directed IRA world.  Remember, it is better to ask questions in advance than to submit incorrect paperwork and cause a delay.

6) Not understanding what they are investing in.

This is a big one.  It is almost incomprehensible to me how some people don’t have any understanding of what they are investing in at all.  For example, a person called the other day and thought she had a note and an option agreement.  Instead, she had a simple option where she had paid $28,000 for an option to buy 50% of the property for $10.  This was meant to help the owner out of foreclosure. The homeowner had the right to buy back the option at a profit to the IRA of about $5,000. The good news is that it worked for a time period and the homeowner got to stay in the house for an extra two years.  The bad news is that the homeowner still wasn’t fiscally responsible and the IRA lost every dime when the lien holder foreclosed. Since all the IRA had was an option (not a note as she thought) she could not even sue to recover some of her money, and even if she had exercised her option her IRA would have only owned half of the house.

7) Not understanding Unrelated Business Income Tax and how it may affect your IRA.

IRAs may be taxed in three circumstances.  First, if it runs a business, either directly in the IRA or indirectly through a non-taxed entity such as a partnership or LLC.  Second, if the IRA owns and rents out personal property (rents from real property are exempt from this tax).  Third, if the IRA owns debt-financed property, again either directly in the IRA or indirectly through a non-taxed entity such as a partnership or LLC.  Just to be clear, it is not necessarily all bad to make investments which cause your IRA to pay tax, especially within a Roth IRA or other tax free account, but it is something you should understand up front.

Trusting someone with your hard earned IRA money without doing proper due diligence and proper paperwork.

Let me give you a hint – con men are very good at what they do.  Make sure you understand what you are investing in, and do your due diligence on the investment and on the person you are investing with before making an investment decision.  Also, make sure you have proper paperwork.  I wouldn’t loan money to my own mother without proper documentation!  Proper paperwork protects both your IRA and the person your IRA is investing with.  Think about what would happen if either you died or the person you invested with died.  Would either party’s heirs understand what the investment was all about?  Even if you trusted the person you invested with absolutely, would their heirs know about your handshake deal and honor it?  Probably not!  An excellent rule of thumb in investing is that if it sounds too good to be true it probably is.  Also, a common thread in scams is that it must be done NOW or you will miss out on this incredible opportunity!  This is an attempt to draw you in without allowing you time to think about or due diligence on the investment.

9) Failing to follow proper strategy when loaning your IRA to other investors.

There are at least 10 simple rules to follow when lending your IRA money out (or even your personal money).  They are:

a)         Do not loan on something you wouldn’t be excited to own if the borrower defaults.

b)         Generally, do not advance money for repairs until the repairs are done, and then inspect the repairs before advancing the funds.

c)         Do not loan to someone you would feel uncomfortable foreclosing on!

d)         If the loan goes into default, do not delay – take action immediately!

e)         Collect interest monthly so you will know if the borrower is getting into trouble.

f)          If you are unsure about a loan, hire a professional to help you evaluate the deal (at the borrower’s cost, of course!).

g)         Get title insurance on your loan.  If done at closing the incremental cost to the borrower is very small.

h)        Verify that hazard and, if necessary, flood and wind insurance are in place naming your IRA as an additional insured.

i)          Insist on evidence that taxes, homeowners association dues and hazard insurance are paid when they come due during the term of the loan.

j)          Get a personal guarantee when lending to a non-individual borrower or a weak borrower.

10) Attempting to figure out how to get around the rules to get a benefit for themselves or other disqualified persons rather than simply investing within the rules.

It seems to be very tempting for people to want to use their own IRAs to make money or obtain some other benefit for themselves or other disqualified persons right now instead of letting all the benefits go to the IRA so that they have a nice retirement.  To make matters worse, a lot of gurus are teaching how to hide the fact that you are violating the rules instead of teaching people how to use the rules properly to their advantage.  My personal motto is, use the law to your advantage but don’t abuse the law.  After all, the “R” in IRA stands for Retirement. It is not an INA (or Individual NOW Account)!  To make money now, use OPI (Other People’s IRAs), and to make money for your retirement, use your own self-directed IRA.

11) Attempting to use a “checkbook control LLC” to get their hands on their IRA funds without having to deal with all that pesky paperwork and those silly prohibited transaction rules without understanding the extreme danger involved.

This is popular but is not wise.  However, to explain it fully would take a full weekend with me, Dyches Boddiford and CPA David Worley.  Come to think of it, we are explaining it all in August in Atlanta, Georgia if anyone is interested.

 There is a lot of confusion over self-directed IRAs and what is and is not possible.  In this article I will discuss some of the most important things you need to know about self-directed IRAs. 

1)   IRAs Can Purchase Almost Anything.  A common misconception about IRAs is that purchasing anything other than CDs, stocks, mutual funds or annuities is illegal in an IRA.  This is false.  The only prohibitions contained in the Internal Revenue Code for IRAs are investments in life insurance contracts and in “collectibles.”  Since there are so few restrictions contained in the law, almost anything else which can be documented can be purchased in your IRA.  A “self-directed” IRA allows any investment not expressly prohibited by law.  Common investment choices include real estate, both domestic and foreign, options, secured and unsecured notes, including first and second liens against real estate, C corporation stock, limited liability companies, limited partnerships, trusts and a whole lot more.

2) Seven Types of Accounts Can Be Self-Directed, Not Just Roth IRAs.  There are seven different types of accounts which can be self-directed.  They are the 1) Roth IRA, 2) the Traditional IRA, 3) the SEP IRA, 4) the SIMPLE IRA, 5) the Individual 401(k), including the Roth 401(k), 6) the Coverdell Education Savings Account (ESA, formerly known as the Education IRA), and 7) the Health Savings Account (HSA).  Not only can all of these accounts invest in non-traditional investments as indicated above, but they can be combined together to purchase a single investment.

3) Almost Anyone Can Have a Self-Directed Account of Some Type.  Although there are income limits for contributing to a Roth IRA, having a retirement plan at work does not affect your ability to contribute to a Roth IRA, and there is no age limit either.  With a Traditional IRA, the fact that you or your spouse has a retirement plan at work may affect the deductibility of your contribution, but anyone with earned income who is under age 70 1/2 can contribute to a Traditional IRA.  There are no upper income limits for contributing to a Traditional IRA.  A Traditional IRA can also receive funds from a prior employer’s 401(k) or other qualified plan.  Additionally, you may be able to contribute to a Coverdell ESA for your children or grandchildren, nieces, nephews or even my children, if you are so inclined.  If you have the right type of health insurance, called a High Deductible Health Plan, you can contribute to an HSA regardless of your income level.  With an HSA, you may deduct your contributions to the account and qualified distributions are tax free forever!  All of this is in addition to any retirement plan you have at your job or for your self-employed business, including a SEP IRA, a SIMPLE IRA or a qualified plan such as a 401(k) plan or a 403(b) plan.

4) Even Small Balance Accounts Can Participate in Non-Traditional Investing.  There are at least 4 ways you can participate in real estate investment even with a small IRA.  First, you can wholesale property.  You simply put the contract in the name of your IRA instead of your name.  The earnest money comes from the IRA.  When you assign the contract, the assignment fee goes back into your IRA.  If using a Roth IRA, a Roth 401(k), an HSA, or a Coverdell ESA, this profit can be tax-free forever as long as you take the money out as a qualified distribution.  Second, you can purchase an option on real estate, which then can be either exercised, assigned to a third party, or canceled for a fee.  Third, you can purchase property in your IRA subject to existing financing or with a non-recourse loan from a bank, a hard money lender, a financial friend or a motivated seller.  Profits from debt-financed property in your IRA may incur unrelated business income tax (UBIT), however.  Finally, your IRA can be a partner with other IRA or non-IRA investors.  For example, one recent hard money loan we funded had 10 different accounts participating.  The smallest account to participate was for only $1,827.00! 

5) Caution:  There Are Restrictions on What You Can Do With Your IRA.  Although as noted above in paragraph 1 the Internal Revenue Code lists very few investment restrictions, certain transactions (as opposed to investments) are considered to be prohibited.  If your IRA enters into a prohibited transaction, there are severe consequences, so it is important to understand what constitutes a prohibited transaction.  Essentially, the prohibited transaction rules were made to discourage certain persons, called disqualified persons, from dealing with the income and assets of the plan in a self-dealing manner.  As a result, disqualified persons are prohibited from directly or indirectly entering into or benefitting from your IRA’s investments. The assets of a plan are to be invested in a manner which benefits the plan itself and not the IRA owner (other than as a beneficiary of the IRA) or any other disqualified person.  Investment transactions are supposed to be on an arms-length basis.  Disqualified persons to your IRA include, among others, yourself, your spouse, your parents and other lineal ascendants, your kids and other lineal descendants and their spouses, and any corporation, partnership trust or estate which is owned or controlled by any combination of these persons.  It is essential when choosing a custodian or administrator that the company you choose is very knowledgeable in this area.  Even though no self-directed IRA custodian or administrator will give you tax, legal or investment advice, the education they provide will be critical to your success as a self-directed IRA investor.

6) Some IRA Investments May Cause Your IRA to Owe Taxes – But That May Be Okay.  Normally an IRA’s income and profits are exempt from taxation until a distribution is taken (or not at all, if it is a qualifying distribution from a Roth IRA).  However, there are three circumstances when an IRA may owe tax on its profits.  First, if the IRA is engaged in an unrelated trade or business, either directly or indirectly through a non-taxable entity such as an LLC or a limited partnership, the IRA will owe tax on its share of Unrelated Business Income (UBI).  Second, the IRA will owe taxes if it has rental income from personal property, such as a mobile home not treated as real estate under state law (but rents from real property are exempt from tax if the property is debt-free).  Finally, if the IRA owns, either directly or indirectly, property subject to debt, it will owe tax only on the portion of its income derived from the debt, which is sometimes referred to as Unrelated Debt Financed Income (UDFI).  This may sound like something you never would want to do, but a more careful analysis may lead you to the conclusion that paying tax now in your IRA may be the way to financial freedom in your retirement.  For example, one client made a net gain of over 1,000% in less than four months after her IRA paid this tax.  This is definitely a topic you will want to learn more about, but it is not something you should shut your mind to before investigating whether the after tax returns on your investment would exceed the return you might otherwise be able to achieve in your IRA.

7) An Inherited Roth IRA Can Give You Tax Free Income Now No Matter What Your Age.  Many people know that a qualified distribution from a Roth IRA is tax free.  To make the distribution qualify as tax free, it must be distributed after the IRA owner has had a Roth IRA for at least 5 tax years and after one of four events occurs – 1) the IRA owner is over age 59 ½, 2) the IRA owner becomes disabled, 3) the IRA owner dies and the distribution is to his or her beneficiary, or 4) the distribution is for a first-time home purchase, either for the IRA owner or certain close family members.  Although the neither the original Roth IRA owner nor his or her spouse has to take a distribution (assuming the spouse elects to treat the IRA as their own), non-spouse beneficiaries of a Roth IRA do have to take distributions, normally over their expected lifetimes.  However, once the five year test is met, those distributions are tax free, regardless of the age of the IRA beneficiary!  Even a $100,000 Roth IRA left to a 6 year old beneficiary may generate as much as $80,496,367 in lifetime tax free distributions if the IRA can sustain a yield of 12%, which is very possible with a self-directed IRA.

2010 Brings an Incredible Gift From Your Government.  Most people who understand the benefits of a Roth IRA really want one, but many people have not been able to qualify for this incredible wealth building tool because of income limitations which restrict the eligibility of a person to contribute to a Roth IRA or to convert pre-tax accounts like Traditional IRAs into a Roth IRA.  In 2010 the rules for conversions will change so that anyone, regardless of income level, will be eligible to do a Roth conversion.  Beginning in 2010 anyone who has a Traditional IRA (including a SEP IRA), a SIMPLE IRA which has been in existence for at least two years, or a former employer retirement plan such as a 401(k) or a 403(b) can convert those into a Roth IRA and can then begin to create tax free wealth for their retirement.  Even if you do not currently have an IRA but are eligible to contribute to a Traditional IRA, the contribution can be made and immediately converted into a Roth IRA.  This truly is one of the most exciting tax planning opportunities to come along in a very long time!

9) There Are Millions of Dollars Available to Finance Your Real Estate Deals Right Now.  We are in a very exciting time for wise real estate investors.  There are a lot of super real estate bargains out there right now, but it can be very difficult for investors to get financing – unless they know the secret of private financing.  There are billions of dollars of lazy IRA money sitting on the sidelines waiting for the right investment, because many people are very afraid of the stock market.  Included among the many things people can invest in with a self-directed IRA are real estate secured loans or even unsecured loans.  Shakespeare wrote in his play Hamlet, “Neither a lender nor a borrower be, for a loan oft loses both itself and friend, and borrowing dulls the edge of husbandry.”  I believe Shakespeare was wrong, but he might be forgiven since he did not have the advantage of knowing about self-directed IRAs.  You can benefit from your knowledge of self-directed IRAs either by having your IRA be a private lender or by borrowing OPI – Other People’s IRAs – for your real estate transactions.  Networking is the key to success in the area of private lending or borrowing, but there are things you must know to do it properly.

10) Use Options to Dramatically Boost Your Small IRA.  Options are one of the most powerful and under-utilized tools in real estate investing today, and they work beautifully within a self-directed IRA.  The consideration for the option and the property being optioned can be almost anything, not just real estate.  Once an IRA owns an option, it can 1) let the option lapse (which at times is the right answer), 2) exercise the option and acquire the property, 3) assign the option for a fee (assuming the option agreement allows for assignment) or 4) agree to cancel the option for a fee with the property owner, thereby getting paid not to buy the property!  Options are very flexible and can be designed to fit almost any situation.  One client paid $5,000 from his Roth IRA for an option which he later canceled for a fee of over $35,000.   Then he took that money, bought a property at a foreclosure auction for cash, and later sold the property for $70,000 with $5,000 down and a $65,000 seller-financed note.  By using the option he was able to take his $5,000 Roth IRA and turn it into a $70,000 Roth in less than a year!

 Truthfully there are many more things that you should know about self-directed IRAs.  To learn more, attend one or more of Entrust’s many free networking and educational events.  You can get the entire schedule of events in addition to playing pre-recorded webinars by going to our website at www.EntrustTexas.com.  Happy investing!

 H. Quincy Long is an attorney who holds the designation of Certified IRA Services Professional (CISP) and is President of Entrust Retirement Services, Inc., a third party administrator of self-directed IRAs serving clients in the State of Texas and throughout the nation with offices in Houston and Dallas.  He may be reached by email at QLong@EntrustTexas.com.  Nothing in this article is intended as tax, legal or investment advice.
© Copyright 2009 H. Quincy Long.  All rights reserved.

            Good news!  You can buy real estate in your traditional, Roth, SEP, or SIMPLE IRA, your 401(k), your Coverdell Education Savings Account for the kids, and even in your Health Savings Account.  Even better, your IRA can borrow the money for the purchase or even take over a property subject to existing financing.  What could be better than building your retirement wealth using OPM (Other People’s Money)?  However, there are some restrictions which you must be aware of when using your IRA to purchase debt financed real estate.  Below I answer a series of frequently asked questions regarding the purchase of debt financed real estate in an IRA.

Q.        Is it really legal to buy real estate in an IRA?

A.        Yes.  Even the IRS agrees that real estate is a permitted investment.  In its answer to the question “Are there any restrictions on the things I can invest my IRA in?” the Internal Revenue Service states “IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option.”

Q.        Can my IRA buy real estate with a loan or take over a property subject to an existing loan?

A.        Yes.  An IRA may borrow money to acquire real estate or take over a property subject to an existing loan, provided that the loan is non-recourse to the IRA and to any “disqualified person.”  This means that typically the lender may only foreclose on the property in the event of a default.  Even if there is a deficiency, the lender cannot come after the rest of the IRA’s assets, nor can the lender come after the IRA owner or any other disqualified person.  Neither the IRA holder nor any other disqualified person is permitted to sign a personal guarantee of the debt.

Q.        Where can I get a non-recourse loan for my IRA?

A.        There are at least four sources for financing which do not violate the non-recourse requirements for IRA’s.  First, there is seller financing.  Most sellers understand that if the loan goes into default they get the property back anyway, so asking for the loan to be non-recourse should not be too difficult to negotiate.  Second, there is private financing from financial friends.  If you cultivate a reputation as a professional real estate investor, there should be no reason that your financial friends would not loan your IRA money on a non-recourse basis, either from their own funds or from their own IRA’s.  I have seen IRA’s borrow the money for both the purchase and the rehab on a non-recourse loan!  Third, there are banks and hard money lenders.  Non-recourse loans are not the norm, so many banks will turn you down.  However, there is at least one bank that lends in all 50 states, and in Houston I have had at least 3 local banks and 2 hard money lenders make non-recourse loans to IRA’s.  Finally, as mentioned above, you could take over a property subject to an existing loan, provided the originator of the loan is not you or another disqualified person.

Q.        Is there any tax effect of having an IRA own debt financed real estate?

A.        Yes.  Income and gains from investments in an IRA, including real estate, are normally not taxed until the income is distributed (unless the distribution is a qualifying distribution from a Roth IRA, a Coverdell Education Savings Account, or a Health Savings Account, in which case the distribution is tax free).  However, if the IRA owns property subject to debt, either directly or indirectly through an LLC or a partnership, it may owe tax on the net income from the property or partnership.

Q.        If the profits from an investment are taxable to an IRA, does that mean it is prohibited?

A.        Absolutely not!  There is nothing prohibited at all about making investments in your IRA which will cause the IRA to owe taxes.

Q.        But if an investment is taxable, why do it in the IRA?

A.        That is a good question.  To figure out if this makes sense, ask yourself the following key questions.  First, what would you pay in taxes if you made the same investment outside of the IRA?  The “penalty” for making the investment inside your IRA, if any, is only the amount of tax your IRA would pay which exceeds what you would pay personally outside of your IRA.  Unlike personal investments, the IRA owes tax only on the portion of the net income related to the debt, so depending on how heavily leveraged the property is the IRA may actually owe less tax than you would personally on the same investment.  Second, does the return you expect from this investment even after paying the tax exceed the return you could achieve in other non-taxable investments within the IRA?  For example, one client was able to grow her Roth IRA from $3,000 to over $33,000 using debt financed real estate in under 4 months even after the IRA paid taxes on the gain!  Third, do you have plans for re-investing the profits from the investment?  If you re-invest your profits from an investment made outside of your IRA you pay taxes again on the profits from the next investment, and the one after that, etc.  At least within the IRA you have the choice of making future investments which will be tax free or tax deferred, depending on the type of account you have.

Q.        If the IRA pays a tax, and then it is distributed to me and taxed again, isn’t that double taxation?

A.        Yes, unless it is a qualified tax free distribution from a Roth IRA, a Health Savings Account (HSA) or a Coverdell Education Savings Account (ESA).  The fact is that you still want your IRA to grow, and sometimes the best way to accomplish that goal is to make investments which will cause the IRA to pay taxes.  Keep in mind that companies which are publicly traded already have paid taxes before dividends are distributed, and the value of the stock takes into consideration the profits after the payment of income taxes.  In that sense, even stock and mutual funds are subject to “double taxation.”

Q.        If the IRA makes an investment subject to tax, who pays the tax?

A.        The IRA must pay the tax.

Q.        What form does the IRA file if it owes taxes?

A.        IRS Form 990-T, Exempt Organization Business Income Tax Return.

Q.        What is the tax rate that IRA’s must pay?

A.        The IRA is taxed at the rate for trusts.  Refer to the instructions for IRS Form 990-T for current rates.  For 2005, the marginal tax rate for ordinary income above $9,750 was 35%.  Capital gain income is taxed according to the usual rules for short term and long term capital gains.

Q.        Is there any way to get around paying this tax?

A.        Yes.  In some ways it may be considered a “voluntary” tax, since investments can often be structured in such a way as to avoid taxation.  Some ways to structure your IRA investment to avoid taxation include loaning money instead of acquiring the real estate directly or purchasing an option on the real estate, then assigning or canceling the option for a fee.  These techniques have a disadvantage in that they may not result in as much profit to the IRA, but will generally be free of tax.  There is also an exemption from this tax for 401(k)’s and other qualified plans in certain circumstances.

Q.        Where can I find out more information?

A.        Visit our website at www.EntrustTexas.com for more information.  Also, Unrelated Business Taxable Income and Unrelated Debt Financed Income are covered in IRS

Publication 598, which is freely available on the IRS website at www.irs.gov.  The actual statutes may be found in Internal Revenue Code §511-514.

            There is one general truth that applies both inside and outside of an IRA – you can do more with debt than you can without it.  Despite the increased risk from debt and the taxes due on income from debt financed property, a careful analysis may lead to the conclusion that having your IRA pay taxes now may be the way to financial freedom in your retirement.  Be sure to have your IRA pay the tax if it owes it, though.  As I always say, “Don’t mess with the IRS, because they have what it takes to take what you have!”

            Many people are under the mistaken impression that a Roth IRA is the only type of self-directed account from which tax free distributions can be taken.  However, distributions from Health Savings Accounts (HSAs) and Coverdell Education Savings Accounts (ESAs) can be tax free if they are for qualified expenses.  In this article we will discuss the benefits of the Coverdell Education Savings Account and, more importantly, what investments you can make with a self-directed ESA.

            Contributions.  Contributions to a Coverdell ESA may be made until the designated beneficiary reaches age 18, unless the beneficiary is a special needs beneficiary.  The maximum contribution is $2,000 per year per beneficiary (no matter how many different contributors or accounts) and may be made until the contributor’s tax filing deadline, not including extensions (for individuals, generally April 15 of the following year).  The contribution is not tax deductible, but distributions can be tax free, as discussed below.  Contributions may be made to both a Coverdell ESA and a Qualified Tuition Program (a 529 plan) in the same year for the same beneficiary without penalty.

          To make a full contribution to a Coverdell ESA, the contributor must have Modified Adjusted Gross Income (MAGI) of less than $95,000 for a single individual or $190,000 for a married couple filing jointly.  Partial contributions may be made with MAGI as high as $110,000 for an individual and $220,000 for a married couple filing jointly.  Since there is no limit on who can contribute to a Coverdell ESA, if your MAGI is too high consider making a gift to an individual whose income is less than the limits, and they can make the contribution.  Organizations can make contributions to a Coverdell ESA without any limitation on income. 

            Tax Free Distributions.  The good news is that distributions from a Coverdell ESA for “qualified education expenses” are tax free.  Qualified education expenses are broadly defined and include qualified elementary and secondary education expenses (K-12) as well as qualified higher education expenses. 

            Qualified elementary and secondary education expenses can include tuition, fees, books, supplies, equipment, academic tutoring and special needs services for special needs beneficiaries.  If required or provided by the school, it can also include room and board, uniforms, transportation and supplementary items and services, including extended day programs.  Even the purchase of computer technology, equipment or internet access and related services are included if they are to be used by the beneficiary and the beneficiary’s family during any of the years the beneficiary is in elementary or secondary school.

             Qualified higher education expenses include required expenses for tuition, fees, books, supplies and equipment and special needs services.  If the beneficiary is enrolled at least half-time, some room and board may qualify for tax free reimbursement.  Most interestingly, a Qualified Tuition Program (a 529 plan) can be considered a qualified education expense.  If you believe that contributing to a 529 plan is a good deal, then contributing that money with pre-tax dollars is a great deal! 

            One thing to be aware of is that the money must be distributed by the time the beneficiary reaches age 30.  If not previously distributed for qualified education expenses, distributions from the account may be both taxable and subject to a 10% additional tax.  Fortunately, if it looks like the money will not be used up or if the child does not attend an eligible educational institution, the money may be rolled over to a member of the beneficiary’s family who is under age 30.  For this purpose, the beneficiary’s family includes, among others, the beneficiary’s spouse, children, parents, brothers or sisters, aunts or uncles, and even first cousins. 

            Investment Opportunities.  Many people question why a Coverdell ESA is so beneficial when so little can be contributed to it.  For one thing, the gift of education is a major improvement over typical gifts given by relatives to children.  Over a long period of time, investing a Coverdell ESA in mutual funds or similar investments will certainly help towards paying for the beneficiary’s education.  However, clearly the best way to pay for your child’s education is through a self-directed Coverdell ESA. 

            With a self-directed Coverdell ESA, you choose your ESA’s investments.  Common investment choices for self-directed accounts of all types include real estate, both domestic and foreign, options, secured and unsecured notes, including first and second liens against real estate, C corporation stock, limited liability companies, limited partnerships, trusts and much more.   

            With the small contribution limits for Coverdell ESAs, you might wonder how these investments can be made.  Often these accounts are combined with other self-directed accounts, including Traditional, Roth, SEP and SIMPLE IRAs, Health Savings Accounts (HSAs) and Individual 401(k) plans, to make a single investment.  For example, I combined my daughters’ Coverdell ESAs with our Roth IRAs to fund a hard money loan with 2 points up front and 12% interest per year. 

            One client supercharged his daughter’s Coverdell ESA by placing a burned down house under contract in the ESA.  The contract price was for $5,500 and the earnest money deposit was $100.  Since the ESA was the buyer on the contract, the earnest money came from that account.  After depositing the contract with the title company, the client located another investor who specialized in rehabbing burned out houses.  The new investor agreed to pay $14,000 for the property.  At closing approximately one month later, the ESA received a check for $8,500 on its $100 investment.  That is an astounding 8,400% return in only one month!  How many people have done that well in the stock market or with a mutual fund? 

            But the story gets even better.  Shortly after closing, the client took a TAX FREE distribution of $3,315 to pay for his 10 year old daughter’s private school tuition.  Later that same year he took an additional $4,000 distribution.  Assuming a marginal tax rate of 28%, this means that the client saved more than $2,048 in taxes.  In effect, this is the same thing as achieving a 28% discount on his daughter’s private school tuition which he had to pay anyway! 

            The Coverdell ESA may be analogized to a Roth IRA, but for qualified education expenses only, in that you receive no tax deduction for contributing the money but qualified distributions are tax free forever.  Investing through a Coverdell ESA can significantly reduce the effective cost of your child or grandchild’s education.  As education costs continue to skyrocket, using the Coverdell ESA as part of your overall investment strategy can be a wise move.  With a self-directed ESA (or a self-directed IRA, 401(k) or HSA for that matter), you don’t have to “think outside the box” when it comes to your ESA’s investments.  You just have to realize that the investment box is much larger than you think!

By now most people have heard of using self-directed IRAs to make purchases other than stocks, bonds, and mutual funds.  Companies like Entrust Retirement Services Inc., operating out of Houston and San Antonio, have been doing a good job, through a series of free education seminars, of teaching people about using self-directed IRAs to buy real estate, foreclosures, foreign property, invest in notes, deeds of trust, private stock, limited partnerships, LLCs, and other non-traditional assets.  In examining some of the other government sponsored savings vehicles available for investing in non-traditional assets I discovered the highly under-utilized Health Savings Account (HSA).  Before my recent employment with Entrust I did not know that you could purchase non-traditional assets with a Health Savings Account (HSA).

A Health Savings Account is a powerful investing tool that many people overlook.  Because it is the only account where contributions are tax deductible and qualified distributions are tax free, it is the best of both worlds.  Furthermore, the definition of “qualified medical expenses” is fairly broad.  IRS Publication 502 has an available list of qualified medical expenses. These include a broad range of medical, dental and vision expenses, but generally do not include the cost of health insurance premiums.  You can, however, treat premiums for long-term care coverage, health care coverage while you receive unemployment benefits, or health care continuation coverage required under any federal law (COBRA) as qualified medical expenses for HSAs. If you are age 65 or older, you can treat insurance premiums (other than premiums for a Medicare supplemental policy, such as Medigap) as quailed medical expenses for HSAs.

In order to be an eligible individual and qualify for a Heath Savings Account you must have a High Deductible Health Plan (HDHP), you cannot be enrolled in Medicare, and you cannot be claimed as a dependent on someone else’s tax return.  Recent changes in HSA rules allow you to contribute the maximum amount to your HSA even if your deductible is less than that amount.  If you are an individual the amount you can contribute for the year 2007 is $2,850 and for a family it is $5,650.  In addition, if you are over the age of 55 you are allowed an $800 catch up contribution.  Unlike other plans you may have heard about, the amount you put into a Health Savings Account is allowed to rollover from year to year and the profits on any investments with the money are tax deferred.  When the money is used to pay or reimburse for qualified medical expenses the distributions are tax free.

 The knowledge of how to invest with a self-directed Health Savings Account from Entrust Retirement Services Inc. allowed me to do some amazing investments this year.  I have a High Deductible Health Plan (HDHP) for my family.  This health plan works well for me.  I personally like high deductible insurance policies. My family rarely turns in a claim on most of our insurance policies.  Because my family is financially stable, in the event of an accident or major illness paying a few thousand dollars would not be a problem. Over the years I have saved a lot of money by using high deductible insurance policies.  When I discovered that Entrust offered self-directed Health Savings Accounts I saw a great opportunity.

 This year my wife needed extensive dental procedures.  The cost went well over $5,650.  The insurance company did not pay because it was a dental procedure and I don’t carry any dental insurance.  I opened an HSA with Entrust Retirement Services Inc. with a maximum deposit of $5,650. I could have immediately taken a distribution for my wife’s dental expenses, effectively negotiating a discount on the dental bill equal to my marginal tax rate.  Instead I chose to leave the money in the HSA and invest the money in partnership with my son’s Roth IRA and my wife’s Roth IRA to purchase a note secured by a first lien on real estate.  The note was for 12% with a 2% origination fee and all costs were paid by the borrower, including Entrust’s fees, with an 18 month balloon. 

 I can add $5,800 again to the HSA in January of 2008.  As the money grows I can take any amount of money out of the account as long as I have qualified medical expenses, including dental or vision expenses, to be reimbursed.  Since I already have a large amount of dental bills I just keep these bills along with any others in a file.  When I want to withdraw some money for any reason I just request a reimbursement for the expenses regardless of the year the expenses were incurred, as long as the expense was incurred after opening my HSA.  That being said, don’t make the same mistake I made.  I opened my HDHP at the first of the year but waited to fund my Entrust HSA until I could fund it fully.  My wife had some of the dental work done before I opened the HSA.  The work done before the HSA was opened will not qualify for a tax free reimbursement.  If I would have simply opened the account with a small amount then funded the rest later in the year I could have used those expenses as well.

 If in the future we decide that a HDHP is not good for our family we can switch to another plan.  We will not be able to continue to contribute to the HSA, but we can keep the HSA open and withdraw the money out as needed tax free for qualified medical expenses.

 If I had just paid for the dental expenses out of my pocket like I originally planned to, I would have lost the opportunity for a $5,650 deduction on my taxes and the opportunity to make a great investment. Remember, I can take the money out as my investments mature and gains on the investments can be withdrawn tax free. Like we always say here at Entrust Retirement Services, Inc., “You don’t have to think outside the box, just realize the box is bigger than you think!”

By now you have probably heard of the Health Savings Account (HSA).  What you may not know is just how amazing this type of account actually is, in terms of premium savings, tax savings, and, most importantly, what you can invest in with your HSA.

Qualification Requirements.  In order to have a Health Savings Account, you must be an “eligible individual.”  To be an eligible individual, you must 1) have a High Deductible Health Plan (HDHP); 2) have no other health coverage, with certain exceptions; 3) not be enrolled in Medicare; and 4) not be claimed as a dependent on another person’s tax return.

While a full description of a HDHP is beyond the scope of this article, its key features are a higher deductible than many insurance policies and a maximum limit on the out-of-pocket expenses (including the deductible and co-payments, but excluding the premium payments).  For 2008, the minimum deductible is $1,100 for self-only coverage and $2,200 for family coverage, and the maximum out-of-pocket expense is $5,600 for self-only coverage and $11,200 for family coverage.  All major insurance companies offer HSA compliant plans.  Employers may also offer an HSA compliant plan, since these policies tend to be less expensive.  If the employer makes contributions to your HSA it is excluded from your income.

Premium Savings.  Because of the higher deductibles and plan features, HSA compliant plans tend to cost less.  When I switched from a policy with a $2,000 general deductible and a $200 drug deductible to an overall deductible of $2,200, the premiums for my family were reduced from $754 per month to $450 per month.  That’s a total premium savings of $3,648 per year!

Tax Savings.  One of the best features of an HSA is the tax savings for contributing to the account.  Beginning in 2007, the contribution limit is no longer tied to the deductible.  The contribution limit for 2008 is $2,900 for self-only coverage and $5,800 for family coverage.  To the extent you make the contribution (as opposed to your employer), these amounts are fully tax deductible, no matter what your income.  If you are age 55 or older, you may contribute an additional $900 for 2008.  There is even a one time ability to take a distribution from your IRA to fund your HSA with no taxes or penalty.

In my tax bracket, the ability to deduct my contributions is significant.  I will contribute $5,800 for 2008 and save $2,030 on my taxes.  The total benefit to me for switching to an HSA compliant health plan, considering the premium and tax savings, is $5,678 for 2008, which nearly covers my $5,800 contribution!

 
Distributions from an HSA for “qualified medical expenses”, which are broadly defined and include expenses for yourself, your spouse and your dependents, are tax free forever!  Because the expenses only have to occur after the HSA has been established, virtually everyone will end up with qualified medical expenses at some point in their life.  You can take a qualified distribution at any point after the expense is incurred, even in later years, provided you keep track of the expenses.

Investment Opportunities.  Even better than the premium and tax savings is the ability to invest your HSA funds in non-traditional investments, just as you would in a self-directed IRA.  Many banks and other companies offer the convenience of an HSA account with a debit card for you to pay medical bills with.  However, if you are healthy and don’t have a lot of expenses or you can fund the expenses out of pocket, you can make your HSA account grow much faster with investments other than mutual funds or savings accounts which may pay very little. 

 With a self-directed HSA, you choose your HSA’s investments.  Common investment choices made by self-directed HSA participants at Entrust Retirement Services Inc. in Houston, Texas include real estate, both domestic and foreign, options, secured and unsecured notes, including first and second liens against real estate, C corporation stock, limited liability companies, limited partnerships, trusts and much more.  For example, I combined my 2007 HSA contribution with my 401(k) and other self-directed accounts to fund a hard money loan with 2 points up front and 12% interest per year.

 The Health Savings Account is truly the best of all worlds.  It can significantly reduce your health care premiums, reduce your taxes, and produce tax free wealth through non-traditional investments in a self-directed HSA.  With a self-directed HSA (or IRA), you don’t have to “think outside the box” when it comes to your HSA’s investments.  You just have to realize that the investment box is much larger than you think!

            Tax time is coming, and many of you are considering whether or not to make a 2007 contribution to your Traditional or Roth IRA.  I have good news!  If you are at least 18 years old, you are not a full-time student, you are not claimed as a dependent on another person’s tax return and you meet the income requirements listed below, you are entitled to a tax credit of up to 50% of your contribution to almost any type of retirement plan, including a Roth IRA!  If you then take your refund from the government and put it back into your IRA, your retirement savings will increase by as much as 50%!

            Begun in 2002 as a temporary provision, the saver’s credit was made a permanent part of the tax code as part of the Pension Protection Act of 2006. To help preserve the value of the credit, income limits are now adjusted annually to keep pace with inflation.  To qualify for the Saver’s Tax Credit, you must have Modified Adjusted Gross Income (MAGI) within the following limits for 2007:

            Credit              Income for Married     Income for Head of    Income for

            Rate                 Filing Jointly               Household                   Others

            50%                 up to $31,000              up to $23,250              up to $15,500

            20%                 $31,001 to $34,000     $23,251 to $25,500     $15,501 to $17,000

            10%                 $34,001 to $52,000     $25,501 to $39,000     $17,001 to $26,000

            The maximum tax credit allowed for 2007 is $1,000 (with a $2,000 contribution), or up to $2,000 if married filing jointly and each spouse makes a contribution.  Simply attach Form 8880, Credit for Qualified Retirement Savings Contributions, to your income tax return, and you will receive up to a $2,000 tax credit.  A tax credit is a dollar for dollar reduction in your tax bill, as opposed to a tax deduction, which only reduces the amount of money on which you pay income taxes.  You may get more information on this credit from IRS Publication 590.

            To prevent abuse, the IRS has rules which will reduce the amount of contribution which qualifies for the saver’s tax credit if the IRA owner has taken distributions from any eligible employer plan or IRA during a specified testing period.  The testing period includes the two taxable years prior to the year the credit is claimed, plus the taxable year the credit is claimed and the following year up until the tax filing deadline for the year the credit is taken, including extensions.   For example, if Josh contributes $2,000 to his Roth IRA for 2007 but had previously removed $500 from his IRA in 2006 and removes an additional $500 in 2008 before October 15, only $1,000 of his $2,000 Roth IRA contribution for 2007 may be used toward the saver’s tax credit on his 2007 tax return.

            Let me give you an example.  Lucky Larry, a married man, was downsized from his job in the corporate world in December, 2006.  Larry decided that he wanted to be a real estate investor instead of looking for another j-o-b.  Things went fine in 2007, but Larry’s modified adjusted gross income after all of his expenses will be $30,000 due to his various write-offs, and his taxable income after the standard deduction and 2 exemptions will be $13,500.  Therefore his taxes before the tax credit will be $1,353 (see instructions for Form 1040, page 65).  He and his wife contribute $1,353 each to a self-directed Roth IRA at Entrust, which they can use to purchase real estate options, debt-leveraged real estate, and many other things.  Larry and his wife will receive a tax credit of $1,353 (50% of each of their contributions). 

            Although the maximum contribution for purposes of the tax credit is $2,000 each, the tax credit is non-refundable.  This means that the maximum tax credit Larry and his wife can receive is equal to the taxes they would otherwise pay.  With the tax credit, Larry’s income tax for 2007 is ZERO!  Larry and his wife wisely decide to contribute the tax refund back into their Entrust self-directed Roth IRAs.  Each Roth IRA grows by 50% to $2,029.50 absolutely FREE, courtesy of the United States government!

            One of the most popular ideas in the self-directed IRA industry today is the “checkbook control” IRA.  You may have wondered what exactly it means to have “checkbook control” over your IRA’s funds.  In this article we will examine the celebrated case of Swanson v. Commissioner, on which the idea of “checkbook control” is based.  The entire text of the Swanson case is available on our website at www.EntrustTexas.com.

            The essential facts of Swanson are as follows:

1)         Mr. Swanson was the sole shareholder of H & S Swansons’ Tool Company (Swansons’ Tool).

2)         Mr. Swanson arranged for the organization of Swansons’ Worldwide, Inc. (Worldwide). Mr. Swanson was named as president and director of Worldwide.  Mr. Swanson also arranged for the formation of an individual retirement account (IRA #1).

3)         Mr. Swanson directed the custodian of his IRA to execute a subscription agreement for 2,500 shares of Worldwide original issue stock. The shares were subsequently issued to IRA #1, which became the sole shareholder of Worldwide.

4)         Swansons’ Tool paid commissions to Worldwide with respect to the sale by Swansons’ Tool of export property. Mr. Swanson, who had been named president of Worldwide, directed, with the IRA custodian’s consent, that Worldwide pay dividends to IRA #1.

5)         A similar arrangement was set up with regards to IRA #2 and a second corporation called Swansons’ Trading Company.

6)         Mr. Swanson received no compensation for his services as president and director of Swansons’ Worldwide, Inc. and Swansons’ Trading Company.

            The IRS attacked Mr. Swanson’s setup on two fronts.  First, the IRS argued that the payment of dividends from Worldwide to IRA #1 was a prohibited transaction within the meaning of Internal Revenue Code (IRC) Section 4975(c)(1)(E) as an act of self-dealing, where a disqualified person who is a fiduciary deals with the assets of the plan in his own interest.  Mr. Swanson argued that he engaged in no activities on behalf of Worldwide which benefited him other than as a beneficiary of IRA #1.

            The court agreed with Mr. Swanson, and found that the IRS was not substantially justified in its position.  The court said that section 4975(c)(1)(E) addresses itself only to acts of disqualified persons who, as fiduciaries, deal directly or indirectly with the income or assets of a plan for their own benefit or account.  In Mr. Swanson’s case the court found that there was no such direct or indirect dealing with the income or assets of the IRA.  The IRS never suggested that Mr. Swanson, acting as a “fiduciary” or otherwise, ever dealt with the corpus of IRA #1 for his own benefit.  According to the court, the only direct or indirect benefit that Mr. Swanson realized from the payments of dividends by Worldwide related solely to his status as a participant of IRA #1.  In this regard, Mr. Swanson benefited only insofar as IRA #1 accumulated assets for future distribution.

            The second issue the IRS raised was that the sale of stock by Swansons’ Worldwide to Mr. Swanson’s IRA was a prohibited transaction within the meaning of section 4975(c)(1)(A) of the Code, which prohibits the direct or indirect sale or exchange, or leasing, of any property between an IRA and a disqualified person.  Mr. Swanson argued that at all pertinent times IRA #1 was the sole shareholder of Worldwide, and that since the 2,500 shares of Worldwide issued to IRA #1 were original issue, no sale or exchange of the stock occurred.

            Once again, the court sided with Mr. Swanson.  The critical factor was that the stock acquired in that transaction was newly issued – prior to that point in time, Worldwide had no shares or shareholders.  The court found that a corporation without shares or shareholders does not fit within the definition of a disqualified person under section 4975(e)(2)(G).  It was only after Worldwide issued its stock to IRA #1 that petitioner held a beneficial interest in Worldwide’s stock, thereby causing Worldwide to become a disqualified person.  Accordingly, the issuance of stock to IRA #1 did not, within the plain meaning of section 4975(c)(1)(A), qualify as a “sale or exchange, or leasing, of any property between a plan and a disqualified person”.

            On the surface it seems like the court endorsed the idea of an IRA holder being the sole director and officer of an entity owned by his IRA.  In other words, by having the IRA invested in an entity such as an LLC of which the IRA owner is the manager, the IRA owner gets to have “checkbook control” over his or her IRA’s funds.  This sounds like a great idea.  However, before jumping too fast into this area, there are some issues to consider.

            One thing to remember is that the LLC does not insulate the IRA from the prohibited transaction rules.  Amazingly, the IRS and the court in Swanson v. Commissioner ignored completely the fact that Mr. Swanson’s non-IRA owned corporation, Swansons’ Tools, paid commissions to Worldwide, thereby reducing Swansons’ Tools’ taxable income and indirectly benefiting Mr. Swanson.  Especially after the recent case of Rollins v. Commissioner, it seems clear that this would be a prohibited transaction.  In the Rollins case, Mr. Rollins loaned money from his 401(k) plan to corporations in which he served as president but of which he owned only a minority interest.  The corporations were clearly not disqualified persons, but the court nonetheless held that there was an indirect benefit to Mr. Rollins, who was the largest shareholder and an officer of each corporation.

            The IRS also might have argued that Mr. Swanson’s service as the president and sole director of Worldwide was a prohibited transaction as described in 4975(c)(1)(C), which prohibits the furnishing of goods, services or facilities between an IRA and a disqualified person.  Although Mr. Swanson stated that Worldwide had no “active” employees, one has to wonder at what point the services rendered to an IRA-owned entity become a problem.  Another question which was not raised in the Swanson case was whether or not an IRA owner having checkbook control over his IRA funds through a 100% IRA-owned entity violates IRC Section 408(a)(2), which requires that the custodian of an IRA be a bank or other qualified institution.  Why have that requirement at all if the IRA owner can get around it merely by having his or her IRA own 100% of an LLC managed by the IRA owner?

            Although the Swanson case appears to be good case law, a great deal of care is merited when relying on this case.  Several questions which were not raised in the Swanson case remain unanswered.  As noted by the court, Mr. Swanson was “following the advice of experienced counsel.”  Even then, Mr. Swanson had to fight the IRS in tax court to win his case.  For most people, even getting into a battle with the IRS is a losing proposition.  Some people, perhaps through ignorance of the rules, appear to be abusing Swanson-type entities.  For example, in IRS Notice 2004-8 on abusive Roth transactions, the IRS states that it is aware of situations where taxpayers are using a Roth IRA-owned corporation which deals with a pre-existing business owned by the same taxpayer to shift otherwise taxable income into the Roth IRA.  If the IRS has become aware of the problem, there may come a day when they decide to go after these types of arrangements more actively.

            When relying on the Swanson case to set up a checkbook control LLC or other entity, always use experienced legal counsel who is very familiar with how to set up this type of entity and who will be there to guide you on issues such as the prohibited transaction rules, the plan assets regulations, unrelated business income tax issues and the other rules and regulations which may apply.  What happens after the LLC is formed is just as important as the initial setup and can get you into just as much trouble.  To attempt a “checkbook control” entity without knowledge of all the rules and regulations or competent counsel to guide you is sort of like jumping out of an airplane without a parachute – it may be fun on the way down, but eventually you’re going to go SPLAT!