One of the advantages of self-directed IRAs is that they provide more than one way to invest in any given asset. Let’s look at an example to see how.
Say there’s a local pizza place that is looking to open a new location across town. They approach you to invest but unfortunately all your personal investment funds are tied up at the moment. However, you have a pool of $300,000 in cash in your IRA ready to be invested.
You have several ways to invest in the pizza place. You can issue a loan—you and the borrower will determine the interest rate and the term of the loan. Or you can buy equity in the pizza company and receive either stock or a percentage ownership. Your return may not be as cut and dried as the loan but your opportunity for profit could be greater if the new location prospers.
Determining which route to go could make a difference. Let’s look at loans and equity investments for IRAs.
Loans – In this structure, you and the company you’re investing in will determine the amount and terms of the loan and sign a promissory note together. Your IRA earns money on the interest rate and points you assign to the loan. This is an advantage unique to notes as you will have a fixed return in an agreed upon amount of time. Your borrowers can be companies and/or people with whom you feel comfortable.
Note that the company you invest your IRA in cannot be owned or controlled by a disqualified person (including lineal ascendants and descendants, spouse and certain fiduciaries).
One advantage of loans is that you will typically not be subject to Unrelated Business Income Tax, or UBIT, which could be assessed on an equity share of an entity by an IRA.
Private Equity/Stock – Some companies elicit investment capital by offering equity or stock. Via these private placements, your IRA can invest in private companies and earn a percentage of their profits based on how much equity you have. Equity can be expressed as either shares of a company or an ownership percentage.
The advantage of private equity is that the return on the investment can be directly tied to the performance of the company.
As mentioned above, equity ownership may incur UBIT. This is a business tax that some tax advantaged entities pay when they have revenue-producing operations. For an IRA, business tax can paid by the company before profits are paid to the IRA and in that case, UBIT would not be assessed to the IRA. Or, the company can pay profits to the IRA before business taxes, and the IRA would be subject to calculating UBIT, which would be assessed at trust rates if tax was due.
If you have any questions, give us a call at New Direction IRA or visit us at www.ndira.com.
