How Does a Self-Directed IRA Work?

A self-directed individual retirement account (IRA) is an option as an individual retirement account that allows for more investment options than a traditional IRA-type account. If concerns arise surrounding your IRA, you may need to bring a lawsuit. As an owner or investor in that account you are able to. 

What is a self-directed IRA?

A self-directed IRA is a retirement account structured like a Roth IRA or other traditional IRA. A self-directed IRA allows alternative investments like real property or cryptocurrency.

A self-directed IRA may be used to buy investment real estate because the income earned from that property is not subject to tax until the IRA owner begins receiving distributions. 

A self-directed IRA cannot be used to purchase property that you yourself own as the account holder. This means an IRA should not be used to purchase a vacation home or primary or secondary residence. 

Real estate sales must be done at an arm’s length so no self-dealing or personal transactions can be made without being taxed. 

An owner can decide how assets are invested, and assets can be invested into a single member LLC. (McGaugh v. Commissioner, T.C. Memo. 2016-28, at *9, aff’d, 860 F.3d 1014 (7th Cir. 2017) citing Swanson v. Commissioner, 106 T.C. 76 (1996).) 

Who can file a lawsuit on behalf of a self-directed IRA?

The owner of a self-directed IRA can sue on their own behalf. This means the plaintiff in such a lawsuit is a real party in interest not the custodian. A custodian is considered uninterested for the purposes of a self-directed IRA because they cannot give advice to the owner or investor. (Deem v. Baron (2016) 2:15-CV-00755-DS.) 

So, to bring a lawsuit on behalf of a self-directed IRA, the person must have some sort of interest in the account. 

Owners and spouses of owners may have the ability to bring suit in the name of the self-directed IRA as to how the borrower of their funds in those accounts was defaulting in payments to investors. (Brown v. California Pension Administrators & Consultants, Inc. (1996) 45 Cal.App.4th 333, 337–338.)

Taxpayer claims for a self-directed IRA

If the holder of a self-directed IRA engages in a prohibited transaction, that ends the IRA and leads to a distribution of everything in the IRA which is taxable. Often through having to pay taxes on distributions from a self-directed IRA, those owner taxpayers will bring suit for their IRA account. These cases are brought in tax court. For example, the owner of an account may dispute the funds as being non-taxable. (Thiessen v. Commissioner of Internal Revenue (T.C. 2016) 146 T.C. 100, 101-102.)

This may arise when a transaction occurs, and the custodian improperly reports it as taxable. For example, the account holder can on behalf of the IRA trustee (or custodian) ensure a check is delivered like a conduit will not make that transaction into one that would result in a distribution. (Ancira v. C.I.R. (T.C. 2002) 119 T.C. 135, 138–139.) This is the same type of behavior like an IRA account holder requested the custodian buy stock on his behalf and requested the custodian initiate a wire transfer for this purpose. This was not a distribution to the account holder, and to the extent he had control over the wired funds he was acting as a conduit for the custodian. (McGaugh v. Commissioner of Internal Revenue (T.C. 2016) 111 T.C.M. (CCH) 1116, aff’d (7th Cir. 2017) 860 F.3d 1014.)

An owner may not have “unfettered command” over the IRA assets without tax consequences. For example, where an owner had control over collectible coins those were considered taxable IRA distributions. (McNulty v. Commissioner of Internal Revenue (T.C. 2021) 157 T.C. 120, 127–129.) Similarly, where real estate is titled in an owner’s name that is considered a taxable distribution. (Dabney v. Commissioner, T.C. Memo. 2014-108.) But an owner can dispute these in court.

What is an example of what such a lawsuit might look like?

For example, Julie opens a self-directed IRA and wants to invest in real estate with her account. The custodian for this account, which is the bank where she opened this account, is Bank of the North. Julie may bring a suit on behalf of this account as she invests in it. If Julie was married, her spouse could bring a suit with her on behalf of their individual accounts. If Julie designated a beneficiary of the IRA besides herself, that beneficiary would have an interest in the IRA and thus could bring a lawsuit on behalf of the account.

Because the custodian does not offer advice, even though the custodian “holds” the account, Bank of the North could not bring a suit on behalf of the IRA.

If the self-directed IRA was used for real estate (like commercial real estate) and the IRA was used for a partnership, it is possible the other partners could bring a lawsuit on behalf of the IRA. This is because through the use of the IRA in a partnership, Julie and the partners now all have an interest.

If Julie had bought real estate through her self-directed IRA and held title through that IRA or as an agent of the IRA, she would be an owner of the real estate, entitling her to partition. (Lawrence v. American IRA, LLC (N.D. Ga., Nov. 26, 2014, No. 1:12-CV-2209-JSA) 2014 WL 11728723 [an agent or owner of an IRA can allege quiet title for IRA real estate]. 

Where an IRA and those future interests can be subject to partition, real estate interest held in an IRA should be subject to partition as well. (Simm v. Ameriprise Financial, Inc. (La. Ct. App. 2022) 360 So.3d 498, 499-501.) If the property at issue is subject to an equitable mortgage under the self-directed IRA, it may be partitioned. (Deem v. Baron (D. Utah, Jan. 10, 2020, No. 2:15-CV-00755-DS) 2020 WL 114138.) 

So, if Julie wishes to dispose of a property associated with a self-directed IRA, she should be able to through a partition action. 

Conclusion

If your interests in a property are associated with a self-directed IRA account, those funds may come into play in a partition action. If you want to pursue a partition action for self-directed IRA property, at Underwood Law, our partition attorneys can help you navigate your partition action efficiently and with care. We are here to help.