Choosing your Investments

One of the most common questions about SDRAs is “What can I invest in?” After people have overcome their initial shock that their IRA can buy land, for example, they want to know what else they could buy.

What You Can’t Buy

The Internal Revenue Code does prohibit certain types of investments, but the list is very small. Here’s the list:

  • Life insurance contracts
  • Collectibles

Investments in life insurance contracts and collectibles are treated as distributions to the account holder when the investment is made.

What are “collectibles?”

  • Works of art
  • Rugs and antiques
  • Metals and gems
  • Stamps and coins
  • Alcoholic beverages
  • Certain other tangible personal property

Important exceptions to the coins and metal restrictions are gold, silver and platinum coins, as well as gold, silver and platinum bullion of a grade tradeable on a commodities exchange.

What You Can Buy

Other than life insurance and collectibles, though, there are no restrictions on the types of investments you can make with your SDRA. The range between the few prohibited types of investments listed above, and the investments otherwise available through banks and financial institutions, is where SDRA owners invest. The only real limit is your imagination. We’ve heard of one investor who invested in Alaska fishing rights!

Typically, SDRA investments, outside of investments otherwise available from financial institutions include:

  • Interests in real estate
  • Promissory notes and mortgages
  • Tax titles
  • Gold, silver and platinum coins
  • Gold, silver and platinum bullion
  • Closely held entities including LLCs and C-Type Corporations that hold assets like the above.

Watch out for UBTI

One other issue of which you should be aware is the potential that your SDRA might have to pay income tax on its income from the investment. That’s right, believe it or not, certain types of income received by a SDRA (“unrelated taxable income,” or “UBTI” for short) can be taxable. If your SDRA receives UBTI, it will incur “unrelated business income tax” (“UBIT” for short).

In fact, all income received by a SDRA is potentially taxable, but the exceptions to the UBTI rules are very broad.

The following types of income are generally NOT taxable:

  • Interest
  • Dividends
  • Royalties
  • Rents from real estate and from personal property leased in connection with the real estate
  • Gains from the sale, exchange or other disposition of property (other than inventory or property held primarily for sale to customers in the ordinary course of business)

Watch out for UDFI

Also, even if your SDRA’s income falls within one of these exceptions, it could still be subject to UBIT to the extent that it is derived from “debt financing.”

For example, if your SDRA holds a residential property with tenants, the rents they pay you are not taxable income; but if the property was purchased with a mortgage with an average balance during the year of, say, 60% of the SDRA’s basis (purchase price) in the property, 60% of the net rental income will be taxable, even though rents are otherwise exempt from the tax. (Note, however, that 401(k) plans are not subject to the tax on debt financed income.)

Run the Numbers

Most people make the immediate assumption that they don’t want unrelated taxable income in their SDRA, but it’s important to “run the numbers.” It’s all about return on investment after tax. For example, if your SDRA’s investment will have a net pre-tax return of 15%, but after tax it’s only 14%, wouldn’t you still make the investment? Sure you would, unless you could make another investment that would have a greater return.

When you run the numbers, be sure to include an allowance for the cost of preparing the SDRA’s income tax return, too. Your custodian generally will expect you to prepare the return if there is any UBTI, even though they have to sign it.

Also, although you can pay the accountant who prepares the return from your personal funds, the tax has to be paid by your SDRA in cash. So be sure that when April 15 comes around and it’s time for your SDRA to pay the tax, the account has enough cash to make the payment..

Do’s and Don’ts

So, here are a few fundamental do’s and don’ts in choosing your investment:

  • Don’t invest in life insurance or collectibles.
  • Choose a type of investment with which you are familiar.
    • Remember, those investment choices available from banks and financial institutions are subject to securities regulation that provide a level of safety.
    • Most SDRA investments are exempt from state and Federal securities regulations for one reason or another, so even though the returns may be higher, the risk of loss may be higher, too.
    • It’s best to be experienced to some extent with the type of investment you are choosing.
  • If other people are involved or offering the investment, make sure they are trustworthy.
  • Review the materials involved in any private securities offering carefully so you understand the risks and returns. Have someone else with experience evaluating such securities help you review it.
  • Be sure that the investment will not be taxable to your SDRA. If it is, run the numbers to make sure the after tax return is what you expect.