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IRA Investment Pitfalls

Avoid costly missteps when using nontraditional (and even some plain-vanilla) investments in an IRA.

Natalie Choate, 02/15/2013

Whether your client's IRA investments are plain or fancy, danger lurks. An IRA investment mistake can lead to a costly and stressful cleanup process or even disqualify the IRA.

Question: My client is bored with investing her IRA in mutual funds, publicly traded stocks, and government bonds. She is considering diversifying her investments by having the IRA buy real estate (an apartment building) and a private equity fund partnership, via a "self-directed IRA." Are there any problems to be aware of in using nontraditional investments in an IRA?

Answer: Yes. There are many. Self-directed IRAs and alternative investments are perfectly legal for IRAs. They just come with risks you need to be aware of.

Fraud. Start with the fact that both the IRS and the SEC have warned that self-directed IRAs are a frequent vehicle for fraud. Not all self-directed IRAs are fraudulent; far from it. But the majority of IRA frauds are perpetrated through self-directed IRAs.

Real estate traps. Next consider the risks of direct IRA investment in real estate. Unless an unrelated professional real estate management company is placed between the IRA owner and the apartment building (so that the IRA makes payment only to, and receives payments only from, the management company), it is very difficult to avoid "commingling" of the IRA owner's personal funds and her IRA funds. For example, if she goes to the hardware store to buy cleaning supplies for the IRA-owned building, and pays for the supplies with her personal credit card (intending to have the IRA pay the credit card bill when it arrives), she may have made an "extension of credit" to her IRA, which would be a prohibited transaction (and that would disqualify the entire IRA).

Other drawbacks of direct IRA investment in real estate are:

--Loss of the tax deductions that are normally one of the benefits of real estate investment

--Possible income tax on "unrelated business taxable income" if the IRA-owned building is financed by a mortgage

Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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