Does the Proposed Bill Spell Bad News for Self-Directed IRA Investors?

If you’ve been a Tax Smart Investor for a while, you know there are pending legislative changes coming our way – and so far it’s not looking very favorable for real estate investors.

The latest iteration released on September 13th included a surprise that would have negative consequences for those who invest in syndicates, funds, and other private securities through IRAs. 

While it might not make the final bill, it doesn’t hurt to understand how this can affect you and start planning for it now.

The Proposal

If passed, the bill would prohibit an IRA from holding a security if the issuer requires the IRA owner to have a certain minimum level of assets or income, or have completed a minimum level of education or obtained a specific license or credential.

In other words, investments that require you to be an accredited investor would no longer be allowed in an IRA starting December 31, 2021. This includes many real estate syndicates, funds, and other private investment opportunities.

That’s not all, if you currently hold these investments in your IRA you would have a 2-year window to remove them from the IRA. Otherwise, the IRA could lose its status.

Impacts on Investors Who Use Self-Directed IRAs

This is bad news if you have a large amount of your investable assets in IRAs and wish to use private real estate syndicates and funds as a way to diversify your portfolio. 

It gets worse if you already have these investments in your IRA. As you may know, these types of investments generally have a lifespan anywhere from 3-10 years, and depending on when you made your investment, it might not be winding down in the next 2 years. 

If you’re unable to remove the asset within 2 years, your IRA will lose its status, you will generally be subject to penalties, in addition to federal, state, and local taxes where applicable.

What You Can Do About It

While some investment sponsors may be able to make accommodations for their IRA investors, it’s going to be tough to find the liquidity or replacement investors to buy all of them out within 2-years. 

So what can you do about it?

Stop It From Happening in the First Place

At least one Investment group I’m aware of has already started reaching out to their congressional representatives about having these provisions removed from the bill and are encouraging their investors to do the same. 

Might not hurt to join the party. As Ben Franklin once said “an ounce of prevention is worth a pound of cure”.

Make a Transfer In-Kind to a 401(k)

Assuming it does pass and your investment(s) don’t run their course within the 2-year window, one option is to transfer it to a 401(k). 

It’s common for investors with self-employment income to open a Solo 401(k) and do an in-kind transfer to move the investment from their IRA to their 401(k) tax and penalty-free in order to avoid UBIT.

If you already have self-employment income, contact a retirement account specialist and ask if you’re eligible to open a Solo 401(k). If you don’t have self-employment income, it wouldn’t be a bad idea to start generating some – the gig economy is roaring these days.

This should also work with a self-directed 401(k) too. However, unfortunately, they aren’t offered by many employers, but if your employer does, it’s an option as well.

Sell Your Investment to a Third-Party

While there isn’t necessarily a secondary market for private placements, it is still possible to sell your investment to a third-party. 

Generally, the best suitors to buy your interest in the private placement are the other investors already invested in the project. It is entirely possible that sponsors will try to foster such connections in an effort to help their IRA investors, but of course is not guaranteed.

There is also the possibility that the sponsor might offer to buy out their IRA investors. Although they might not have the liquidity to do so if a large number of their investors invest through their IRAs.

Lastly, you can find a third-party to buy the investment yourself. The downside to doing this is that, at least in my experience, they will often sell at a discount. This is generally because there is no readily available secondary market and the buyer has leverage – you’re in a bind, need to get out, and have limited options to exit.

Take a Distribution 

If all else fails, you can distribute the asset from your IRA. 

The consequences of doing this will vary depending on whether you have a traditional or Roth IRA. If you have a Roth, it might be possible to avoid tax and penalties if the amount of the withdrawal is less than the contributions you’ve made to the account. 

Otherwise, generally, you’ll be subject to a 10% early withdrawal penalty if you’re under 59 ½  in addition to paying federal, state, and local taxes where applicable. 

While not the ideal option, it’s still better than having your IRA lose its status and potentially exposing the entire account to penalties and taxes.

Bottom Line

The proposed change to prohibit IRAs from holding most private placement investments is unwelcome news for real estate investors, especially those who currently invest through their IRAs.

However, if the provision makes the final bill, investors do have options that can help them avoid or minimize the potentially unfavorable tax consequences before it’s too late.