Many investors come to us with an opportunity to participate as an investor in some kind of larger deal. Perhaps it is a partnership that will be investing in an apartment complex or other larger real estate deal. Sometimes it could be fractional ownership in some form of business. There are many ways that a self-directed IRA can join into such ventures, but also many questions that need to be asked to ensure you are pursuing the best strategy.
When we speak about private placements or syndicated deals, we are referring to an investment where several participants are bringing capital to the table to execute a venture. A private placement is simply an investment in some kind of closely held venture that is not offered as a public security. Common examples include:
With most such opportunities, there is an investment sponsor or general partner that is putting the deal together, attracting investors, and executing the project. Investors such as those using a self-directed IRA or Solo 401(k) would be passive investors or limited partners in the entity, and simply providing capital to the project.
If a venture is using debt-financing in addition to investor capital, an IRA invested in such a deal would have exposure to taxation on Unrelated Debt-Financed Income (UDFI). The impact of such taxation will vary based on the degree leverage is used and the overall amount of income, but this is definitely a topic you will want to review with your licensed tax advisor. Since UDFI taxation is applied to the gains from a deal, it is effectively reducing your net return on investment. On a syndicated opportunity that is projected to produce 10-12% return or greater, this may not be a big deal. If the pre-tax returns on a deal are going to be in the 6-8% range, then the small impact of UDFI taxation may temper the appeal of such an opportunity.
Solo 401(k) plans are exempted from UDFI taxation when the debt instrument is used for the acquisition of real property. Other forms of debt-financing would expose a 401(k) plan to UDFI taxation.
If the underlying income producing activities of a venture are considered a trade or business, then an IRA or Solo 401(k) could have exposure to Unrelated Business Income Tax. If the source of income to investors is passive in nature, then this tax will not apply. While not exhaustive, the following list illustrates the difference:
Passive Income Not Subject to UBIT
Active Income Subject To UBIT
Most private placement opportunities are encountered via networking and other word-of-mouth means within relatively close-knit circles. As such, it is especially important to ensure that your IRA is not dealing with disqualified parties.
If the investment sponsor, sales team, or management team of a venture includes one or more disqualified parties to your IRA, then your IRA may not be able to participate. Disqualified parties include you as the account holder, lineal family like parents/children, as well as fiduciaries to your account or a business/join venture partner.
We are often approached by the general partners of such deals questioning whether they can invest their own IRA into the deal, and the answer is unfortunately no.
Many private placements are open only to accredited investors. Your self-directed IRA or Solo 401(k) will inherit your status as an accredited investor. If you are not accredited, your plan will not be able to participate.
Private Placements are one of the areas where performing diligence on the project and the investment sponsor is critical. Of all the investment classes where fraud such as Ponzi schemes is most prevalent, private placements are at the top of the list. Be sure you understand the underlying investment and have the opportunity to review contracts, check the backgrounds of the parties executing deal, and will receive regular, audited financials as applicable.
Investing in private placements and other syndicated opportunities can be a very hand’s off way to step into solid deals and leverage the expertise of professionals in a field. If you have an opportunity for such investments and want to discuss whether the use of IRA or 401(k) funds may be appropriate, please feel free to contact us. One of our expert advisors will be happy discuss your strategy.
