Self-Directed IRA: Real Estate, Crypto, and Prohibited Transactions

What a self-directed IRA actually is — and is not

The term “self-directed IRA” does not appear in the Internal Revenue Code. IRC 408 defines individual retirement accounts without distinguishing between those that hold index funds and those that hold rental properties. The difference is entirely custodial. A standard brokerage IRA at Fidelity, Schwab, or Vanguard restricts you to the investments on their platform — publicly traded stocks, bonds, mutual funds, and ETFs. A self-directed IRA uses a specialized custodian or trust company (Equity Trust, Entrust, Millennium Trust, among others) that permits the account to hold alternative assets.

The IRS restricts IRAs from holding only three categories of assets: life insurance contracts (IRC 408(a)(3)), collectibles other than certain U.S. gold, silver, and platinum coins and bullion meeting fineness requirements (IRC 408(m)), and S-corporation stock (by virtue of the single-class-of-stock rule and the IRA’s tax-exempt status under IRC 408(e)(1)). Everything else — real estate, private company equity, cryptocurrency, promissory notes, tax lien certificates, water rights, LLC membership interests — is permissible.

What the custodian does not do is equally important. An SDIRA custodian does not evaluate your investments, does not provide due diligence, does not verify that a private offering is legitimate, and does not advise you on whether an investment is suitable. The SEC and FINRA have issued multiple investor alerts on this point: the custodian holds the asset and handles IRS reporting, but every investment decision — and every compliance decision — is yours.

Alternative investments you can hold

The universe of SDIRA-eligible investments is broad. The most common categories:

• Real estate. Single-family rentals, multi-family properties, raw land, commercial property, REITs (both public and private). The IRA is the titled owner. All income flows to the IRA; all expenses are paid from the IRA.
• Cryptocurrency. Bitcoin, Ethereum, and other tokens classified as property under IRS Notice 2014-21. Some custodians hold crypto directly; others require a crypto exchange sub-account titled to the IRA.
• Precious metals. Gold, silver, platinum, and palladium in coins or bullion meeting the fineness requirements of IRC 408(m)(3)(B). Must be held by an approved depository — you cannot store IRA gold at home (this is a prohibited transaction).
• Private placements. Equity or debt in private companies, startups, or LLCs. Common in angel investing. The IRA subscribes to the offering; the LLC operating agreement or subscription documents name the IRA as the investor.
• Promissory notes and private lending. The IRA lends money to a borrower (who must not be a disqualified person) and earns interest. The note is an IRA asset; interest payments go into the IRA.
• Tax lien certificates. The IRA purchases municipal tax lien certificates and earns the statutory interest rate if the property owner redeems the lien, or acquires the property if the lien goes to foreclosure.

Prohibited transactions: the line you cannot cross

IRC 4975 defines prohibited transactions as any direct or indirect transaction between the IRA and a “disqualified person.” The penalty is not a fine or a correction opportunity — it is the death of the account. If a prohibited transaction occurs, the IRA is treated as having distributed its entire balance on January 1 of the year the transaction took place. That means:

• The full fair market value of the IRA is included in your taxable income for that year (traditional IRA) or the earnings portion is taxable (Roth IRA if not yet qualified).
• If you are under 59½, a 10% early-withdrawal penalty applies under IRC 72(t).
• There is no partial disqualification. One prohibited transaction — even a $200 repair you pay out of pocket on an IRA-owned property — can trigger taxation of the entire balance.

Who is a disqualified person?

The definition under IRC 4975(e)(2) is broader than most people expect:

• You, the IRA owner
• Your spouse
• Your lineal ascendants (parents, grandparents) and their spouses
• Your lineal descendants (children, grandchildren) and their spouses
• Any fiduciary of the IRA (including the custodian)
• Any entity in which you or the above persons own 50% or more
• Any officer, director, or 10% shareholder of such an entity

Notably absent: siblings, aunts, uncles, cousins, and friends. Your brother is not a disqualified person. Your IRA can, in principle, purchase property from your sibling or lend money to your cousin — although the transaction must still be at fair market value and structured at arm’s length. Your children and parents, however, are disqualified — no exceptions.

Common prohibited transaction traps

The custodian’s role and its limitations

SDIRA custodians are regulated as non-bank custodians under IRC 408 and are typically state-chartered trust companies. They perform three functions: holding the IRA assets, executing transactions on your direction, and filing IRS reports (Form 5498 for contributions, Form 1099-R for distributions). They charge annual account fees (typically $200–$500), per-transaction fees for purchases and sales, and sometimes asset-based fees for real estate or precious metals holdings.

What they do not do — and this is the most dangerous misunderstanding in the SDIRA space — is vet your investments. A custodian will process your direction to purchase a $150,000 rental property or invest $50,000 in a private LLC without evaluating the property’s condition, the LLC’s financials, or the offering’s compliance with securities law. The FINRA Investor Alert on self-directed IRAs explicitly warns: “The custodian may not evaluate the quality or legitimacy of any investment in the self-directed IRA or its promoters.” Due diligence is entirely your responsibility.

UBIT and UDFI: the hidden tax inside a tax-advantaged account

IRAs are tax-exempt entities under IRC 408(e)(1), but two provisions can trigger current-year taxation inside the IRA:

Unrelated Business Income Tax (UBIT) under IRC 511–514 applies when the IRA earns income from an active trade or business. If your SDIRA owns an LLC that operates a car wash, the net income from the car wash is unrelated business taxable income (UBTI). The IRA must file Form 990-T and pay tax at trust rates on UBTI exceeding $1,000. Passive rental income from real estate is generally exempt from UBIT — but only if the property is not debt-financed.

Unrelated Debt-Financed Income (UDFI) under IRC 514 applies when the IRA uses leverage (a non-recourse mortgage) to purchase property. The portion of income attributable to the debt-financed percentage is subject to UBIT. For example, if your SDIRA buys a $200,000 rental property with $100,000 of IRA cash and a $100,000 non-recourse loan, 50% of the net rental income is UDFI and subject to UBIT. The UDFI percentage decreases as the loan is paid down. This is a meaningful cost that reduces the tax advantage of holding leveraged real estate inside an IRA versus in a taxable account.

Contribution limits and funding mechanics for 2026

Because an SDIRA is just a traditional or Roth IRA held at a specialized custodian, the contribution limits are identical to any other IRA:

At $7,000 or $8,000 per year, you cannot build a real estate portfolio through annual contributions alone. Most SDIRA real estate investors fund the account through one of three mechanisms:

1. Rollover from a 401(k) or other employer plan. After separation from service (or via an in-service withdrawal if the plan allows it), you roll the balance into the SDIRA. A $300,000 401(k) rollover creates a $300,000 SDIRA balance — enough to purchase a rental property outright. See IRS Publication 590-A for rollover eligibility rules.
2. Transfer from an existing IRA. A trustee-to-trustee transfer from a traditional IRA at Fidelity to a traditional SDIRA at Equity Trust is tax-free and has no dollar limit. This is the simplest path.
3. Non-recourse mortgage. The SDIRA uses a non-recourse loan (one secured only by the property, with no personal guarantee from you) to leverage the IRA’s cash. Most conventional lenders do not offer non-recourse IRA loans; specialized lenders like North American Savings Bank or First Western Federal Savings Bank do, typically at higher interest rates and lower LTV ratios (50–60% maximum). Remember: debt-financed income triggers UDFI.

Worked example: Marcus, age 52, rolling a 401(k) into an SDIRA to buy a rental property

Marcus leaves his employer at age 52 with a $210,000 traditional 401(k) balance. He has 15 years of rental-property management experience and wants to hold a single-family rental inside a tax-advantaged account. He rolls the $210,000 into a self-directed traditional IRA at a specialized custodian.

The purchase

Marcus identifies a single-family rental in a mid-market metro listed at $155,000. After inspection and negotiation, the SDIRA purchases the property for $150,000, paying cash from the IRA. Closing costs ($4,500) are also paid from the IRA. Remaining IRA cash balance: $55,500. This reserve covers property taxes, insurance, repairs, and property management fees for approximately two years, assuming no rental income.

Ongoing operations

The property rents for $1,350 per month. After property management fees (8%, or $108/month), property taxes ($180/month), insurance ($85/month), and a maintenance reserve ($135/month), net cash flow to the IRA is approximately $842 per month, or $10,104 per year. All of this income stays inside the traditional IRA — no current-year income tax. Because Marcus did not use leverage, there is no UDFI.

The tax comparison

The SDIRA defers all income tax but forfeits the depreciation deduction — a deduction worth $4,364 per year in this example. Over 15 years, that is $65,460 of cumulative depreciation that Marcus can never claim. The SDIRA also converts what would be capital gain at sale (15% or 20%) into ordinary income at distribution (up to 37%). Whether the deferral benefit outweighs the rate conversion and lost depreciation depends on Marcus’s tax bracket at distribution, his time horizon, and whether he uses a Roth SDIRA (which eliminates the rate-conversion problem entirely, since qualified Roth distributions are tax-free).

Roth SDIRA: the strongest structure for alternative assets

If you can get money into a Roth SDIRA — either through direct Roth IRA contributions (if income-eligible), a backdoor Roth conversion, or a Roth 401(k) rollover — the economics change dramatically. Inside a Roth SDIRA:

• Rental income accumulates tax-free, not tax-deferred
• Property appreciation is never taxed if the eventual distribution is qualified (age 59½ and five-year rule met)
• There is no rate-conversion problem: gains are not recharacterized as ordinary income
• There are no required minimum distributions during the owner’s lifetime (SECURE 2.0 eliminated Roth 401(k) RMDs starting in 2024, and Roth IRAs have never had owner-lifetime RMDs)

The challenge is getting a large enough balance into the Roth SDIRA. Annual Roth IRA contributions are capped at $7,000/$8,000, and backdoor Roth conversions trigger the pro-rata rule if you hold pre-tax IRA balances (which you likely do if you are also rolling a 401(k) into a traditional SDIRA). Planning the funding sequence matters.

Checkbook control: the LLC structure

Some SDIRA investors use a “checkbook control” structure: the IRA invests in a single-member LLC, and the IRA owner is the manager of the LLC. The LLC opens a bank account, and the IRA owner writes checks from that account to make investments and pay expenses — without routing every transaction through the custodian.

This structure is legal (the IRS has not prohibited it, and several Tax Court cases and DOL advisory opinions support it), but it creates significant compliance risk. Every check you write from the LLC is a transaction that must comply with the prohibited transaction rules. There is no custodian reviewing the transaction before it happens. If you inadvertently write a check to a disqualified person — paying your son to manage the property, for example — you have triggered a prohibited transaction with no custodial guardrail to stop you. The checkbook-control structure is powerful for experienced real estate investors who need transactional speed (closings, repairs, tenant security deposits), but it is a compliance minefield for anyone unfamiliar with the prohibited transaction rules.

When a self-directed IRA does not make sense

• You lack expertise in the alternative asset. The custodian provides no due diligence. If you do not know how to evaluate a rental property, a private placement, or a cryptocurrency position, the SDIRA wrapper does not protect you — it just makes the loss tax-advantaged.
• The account balance is too small for real estate. If your total IRA balance is $40,000, you cannot buy a property and maintain adequate cash reserves for expenses. You are one furnace replacement away from a prohibited transaction (paying personally because the IRA is out of cash).
• You want depreciation deductions. Real estate inside an IRA generates no depreciation deduction. If you are in a high tax bracket and need current-year deductions to offset other income, a taxable account with depreciation may produce better after-tax results than an SDIRA.
• You expect low returns relative to traditional assets. The fees on an SDIRA (custodian fees, transaction fees, legal setup for checkbook-control LLCs) add 0.5–1.5% per year to the cost structure. If the alternative investment does not materially outperform a low-cost index fund, the fee drag eliminates the advantage.
• Liquidity risk at RMD age. Traditional SDIRAs require minimum distributions starting at age 73. If the IRA holds an illiquid asset (real estate, a private company stake), meeting the RMD may force a sale at an inopportune time or require an in-kind distribution with complex valuation requirements.

Key takeaways

• A self-directed IRA is a standard traditional or Roth IRA held at a specialized custodian that permits alternative investments — real estate, cryptocurrency, precious metals, private placements, and more. The contribution limits, tax treatment, and distribution rules under IRC 408 are identical to any other IRA.
• The prohibited transaction rules under IRC 4975 are the single greatest risk. Any transaction between the IRA and a disqualified person (you, your spouse, your parents, your children, or entities you control) disqualifies the entire account — triggering full taxation plus a 10% penalty if under 59½. There is no partial disqualification or correction mechanism.
• The custodian does not evaluate, vet, or approve your investments. Due diligence is entirely your responsibility. The SEC and FINRA have issued fraud alerts specifically warning SDIRA investors not to rely on custodial oversight.
• Real estate inside a traditional SDIRA trades the depreciation deduction and favorable capital gains rates for tax deferral. The trade-off favors the SDIRA when the time horizon is long and the expected appreciation is large. It favors the taxable account when current-year deductions are valuable and the investor’s distribution-year tax bracket will be high.
• A Roth SDIRA eliminates the rate-conversion problem entirely: qualified distributions are tax-free, no RMDs apply during the owner’s lifetime, and all appreciation — including illiquid alternative assets that may appreciate substantially — escapes taxation permanently.