How a Self-Directed IRA works
A Self-Directed IRA operates like other IRAs for tax purposes: contributions (or rollovers) go into the account, gains grow tax-deferred (traditional) or tax-free (Roth, when qualified), and distributions are subject to the usual rules. The difference is what the account can own. With an SDIRA you can hold:
- Direct real estate (rental homes, commercial property, raw land)
- Membership interests in LLCs or private companies
- Private loans or promissory notes
- Precious metals that meet IRS fineness requirements
- Certain tax-advantaged or alternative investments that brokerage platforms may not support
The account must be administered by an IRA custodian or trustee (a bank, trust company, or a specialized SDIRA custodian). The custodian holds title to the assets on behalf of the IRA and processes transactions, but they generally will not give investment advice or perform due diligence for you. That’s where the account owner’s responsibilities increase.
(For background on standard IRA rules and contribution/distribution basics, see FinHelp’s entry on Individual Retirement Arrangement (IRA).)
Key regulatory points to know
- Custodian requirement: An IRA must have an eligible custodian or trustee to hold assets and keep records (see IRS guidance, Retirement Plans FAQs Regarding IRAs: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-plans-faqs-regarding-iras).
- Prohibited transactions and disqualified persons: The IRS forbids certain self-dealing and transactions between an IRA and the owner (or other “disqualified persons”). Violations can disqualify the IRA and cause immediate taxation and penalties.
- UBIT and UDFI: An IRA that earns unrelated business taxable income (UBTI) or uses debt-financed property may owe unrelated business income tax (UBIT) on that portion of income.
Authoritative sources I rely on when advising clients include the IRS site (Publication 590-A/B and the IRA FAQs), and investor-protection guidance from the SEC (see Investor Bulletin: Alternative Investments Held by IRAs). These clarify both rights and restrictions for SDIRA owners.
Common risks and how they show up
1) Prohibited transactions and self-dealing (highest risk)
- What can go wrong: Using your SDIRA to buy your vacation home, to sell property you already own to the IRA, or to have a family member work on IRA-owned real estate and be paid personally. These transactions can trigger disqualification of the IRA under IRC rules and large tax penalties.
- How to avoid it: Keep every transaction arms-length. Never use IRA-owned property for personal use. Check the IRS rules on prohibited transactions and disqualified persons (see IRS FAQs above).
2) Liquidity and valuation risk
- What can go wrong: Private real estate, private company shares, and notes are illiquid and hard to value. When markets turn, you may not be able to sell quickly to meet required minimum distributions (RMDs) or to rebalance.
- How to avoid it: Maintain cash reserves inside the IRA for fees, taxes, and future distributions. Obtain professional valuations and document basis and appraisals.
3) Unrelated Business Income Tax (UBIT) and Unrelated Debt-Financed Income (UDFI)
- What can go wrong: If your IRA invests in an active business or buys property using nonrecourse financing, it may owe UBIT/UDFI on income generated. These taxes reduce returns and complicate tax filings because the IRA, not you personally, files Form 990-T in the trustee’s name.
- How to avoid it: Understand investment structures ahead of time. Work with a tax advisor knowledgeable about Form 990-T and UBIT rules.
4) Custodian and operational risk
- What can go wrong: Custodians differ widely. Some specialize in alternative assets and charge appropriate fees and robust controls; others offer minimal services and greater operational risk. Poor recordkeeping can cause missed RMDs or misreported transactions.
- How to avoid it: Choose a reputable custodian with clear pricing, insurance, and experience in the asset class you want. Ask for references and read recent reviews.
5) Fraud, scams, and bad deals
- What can go wrong: Unscrupulous promoters target SDIRA investors with high-fee, illiquid, or fraudulent offerings. Because these investments are outside mainstream marketplaces, fraud is harder to detect.
- How to avoid it: Perform rigorous due diligence. Demand independently verifiable documentation, check broker and promoter registration with the SEC and state regulators, and be wary of guarantees of high returns.
6) Fees and cost drag
- What can go wrong: Alternative-asset custodians often charge setup fees, transaction fees, asset holding fees, and appraisal costs. These fees can erode returns, especially on smaller accounts.
- How to avoid it: Compare total cost structures, not just headline fees. Run scenario analyses showing how different fee levels impact net returns over time.
Real-world examples (what I’ve seen in practice)
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Positive: A client used an SDIRA to buy a small multifamily property. The IRA collected rent, paid expenses, and after five years sold the asset tax-deferred inside the IRA. They reinvested proceeds into a diversified mix of private loans and REITs inside the account to improve liquidity. The keys: strong custodian, conservative debt use, and clear documentation.
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Negative: Another client allowed a family member to manage an IRA rental property and accept compensation outside the IRA. The IRS deemed it a prohibited transaction; the account lost its tax-advantaged status and triggered taxes and penalties. We corrected course, but the tax impact was material.
Practical due-diligence checklist before using an SDIRA
- Confirm the investment is permitted for IRAs and will not create a prohibited transaction or benefit a disqualified person.
- Ask the custodian for the complete fee schedule and sample account statements showing how alternative assets are reported.
- Verify the custodian’s process for contributions, distributions, and required minimum distributions (RMDs).
- Assess liquidity needs and hold cash for fees and potential RMDs.
- Get independent appraisals and legal/tax reviews for complex deals.
- Confirm whether the proposed financing will create UDFI/UBIT exposure and plan for Form 990-T filings.
How SDIRAs compare with other retirement options
- SDIRA vs. brokerage IRA: Brokerage IRAs are simpler and better for traded securities, with lower operational risk. SDIRAs add complexity but expand asset choices.
- SDIRA vs. Solo 401(k) for small-business owners: A Solo 401(k) can allow certain types of checkbook control and higher contribution limits; see FinHelp’s guide on Retirement Plan Portability: Moving Pensions, 401(k)s, and IRAs and other comparative articles to determine which structure fits (and always confirm with a plan specialist).
Common questions about taxes and penalties (short answers)
- What triggers disqualification? Engaging in a prohibited transaction with a disqualified person (self-dealing) can disqualify your IRA and cause immediate taxation and penalties.
- Will my SDIRA ever pay tax? Generally no, but UBIT or UDFI rules can create tax liabilities for certain active or leveraged investments. The IRA would file Form 990-T in those situations.
Final recommendations (practical next steps)
- Start small and document everything. If you’re new to alternative assets inside retirement accounts, begin with a single transaction and refine processes.
- Hire specialists when appropriate. Real estate attorneys, tax advisors familiar with Form 990-T/UBIT, and custodians with alternative-asset experience can prevent costly mistakes.
- Maintain liquidity. Keep cash inside the IRA for common expenses and distribution needs.
- Avoid family transactions and personal use of IRA-owned property—these are frequent reasons for penalties.
- Review your SDIRA strategy annually and update beneficiaries, custodian arrangements, and investment holdings as laws and personal circumstances change.
Resources & authoritative reading
- IRS — Retirement Plans FAQs Regarding IRAs (prohibited transactions, custodian rules, RMDs): https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-plans-faqs-regarding-iras
- IRS — Publication 590-A and 590-B (contributions, distributions, and exceptions)
- SEC — Investor Bulletin: Alternative Investments Held by IRAs (watch for fraud and scamming tactics)
- Consumer Financial Protection Bureau — resources on retirement accounts and choosing a custodian
Disclaimer
This article is educational and does not constitute tax, legal, or investment advice. In my practice I recommend discussing SDIRA strategies with a qualified tax advisor, ERISA/retirement attorney, and a custodian experienced in the asset class you plan to hold. Laws and IRS guidance change; confirm current rules before acting.
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If you want, I can create a one-page pre-investment SDIRA checklist you can use before each transaction, or draft suggested questions to ask prospective custodians.
