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Ask the Expert: Self-directed IRAs have strict rules, draconian penalties

I want to invest in real estate in a self-directed IRA. Out-of-state financial advisers offer these plans, but none are headquartered in New York. I haven't found any local accountants or attorneys who know about such plans. The out-of-state advisers seem legitimate, but I'd prefer to discuss this type of investment in person.

Companies in the self-directed IRA market typically do business online and on the telephone rather than in person, no matter where they’re headquartered. But an online search for "self-directed IRA NYC and Long Island" shows there are two local law and tax accountant firms serving this market.

All IRA custodians offer an investment menu of stocks, bonds, mutual funds and certificates of deposit. But only custodians for self-directed IRAs also allow investments like real estate, private placements and tax lien certificates. These are legal IRA investments, but they're governed by stringent rules against "self-dealing" with draconian penalties.

"That's why big IRA custodians don’t want to deal with them," said Ed Slott, a Rockville Centre tax accountant.

The rules are intended to prevent you from benefiting from your IRA without withdrawing money and paying taxes. If your IRA owns a house, for example, you can't live in it or rent it to a relative, or renovate it yourself. The penalty for self-dealing is termination of your entire IRA.

“If you have a $1 million IRA, even a minor self-dealing problem in a $10,000 real estate investment makes the entire $1 million taxable," Slott said.

Good self-directed IRA custodians tell you all this. But following the rules is entirely up to you — and they’re easily broken. For example, Slott remembers a contractor who made the mistake of parking his construction company's vehicles on land owned by his IRA.

The bottom line

Most investors should avoid self-directed IRAs.

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