Have You Jeopardized Your Self Directed IRA?

lockSelf directed IRAs have gained in popularity in the past five years as individuals sought to take control over their investments.  For those of you unfamiliar with this term, a self directed IRA is an IRA (ROTH or Traditional) that allows the IRA owner to direct his investments.  In a non self directed IRA, the type offered by most institutions, the IRA owner’s investment choices are often limited to specific investment choices offered by the select institution.  The attraction of being able to invest an IRA in real estate, tax liens, closely held business interests, private placements, or just about anything that catches the IRA owner’s fancy has catapulted the self directed IRA to revered status.

The flexibility offered by the self directed IRA is indeed attractive if utilized properly.  It is vitally important for every investor to know the limitations of his IRA, which unfortunately requires your becoming partially if not fully versed in the IRA, prohibited transaction rules.  A violation of any of these rules can result in a loss of your IRA’s tax deferred status.  Ernest Willis unfortunately found this out the hard way when he decided to take control over his IRA investments and did not receive adequate counsel on prohibited transactions. 

Ernest Willis filed for relief under Chapter 7 of the Bankruptcy Code on Feb. 16, 2007. He claimed exemptions under Bankruptcy Code for the full value of his three self directed IRAs: 1) a Merrill Lynch IRA valued at $1,247,000, 2) an AmTrust Bank IRA valued at $109,000, and 3) a Fidelity Federal IRA valued at $143,000.  Initially, it appeared Mr. Willis would be able to retain his sizeable IRAs but a creditor objected and successfully argued that Mr. Willis improperly directed the investments of his IRA, thereby disqualifying the IRA funds from exempt status.

The rule all self directed IRA owners must be wary of is Code Sec. 4975.  Under this section, if an IRA owner, a disqualified person with respect to his IRA, engages in a prohibited transaction during a tax year, the IRA is disqualified as of the first day of that tax year, and the IRA owner is treated is having received a taxable distribution equal to the fair market value of all of the assets in the account as of the first day of the tax year. A prohibited transaction includes the lending of money or other extension of credit between a plan and a disqualified person, and any transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan.

The Court found that Mr. Willis undertook various actions in his IRA and these constituted prohibited transactions under Code Sec. 4975. Mr. Willis’ actions included borrowing from his IRA and using its assets to pay off a mortgage on real estate in order to acquire the real estate and later sell it. As a result, the IRA lost its exempt status as of Jan. 1, ’93.  To further Mr. Willis’ distress, the court also found that even though the transaction took place in the Merrill Lynch IRA the other two IRA’s were not exempt because these IRA’s were funded with rollover assets from the Merrill Lynch IRA after its lost its exempt status.

When investing with your IRA remember your ABC’s, “Always Be Careful” because you risk jeopardizing your IRA’s exempt status if the transaction is considered to be a prohibited under Code Sec. 4975.  Sound asset protection savvy dictates dividing your IRA into different accounts to reduce your risk should one account be disqualified. 

For additional information on sound IRA investing contact Clint Coons at 800.706.4741.

Posted by Clint Coons, asset protection attorney, Seattle, WA

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