Learn How to Perform Due Diligence in Investing and Protect Your SDIRA
Self-directed IRAs provide a great deal of freedom, giving you control over your retirement funds and the unique ability to choose your own assets. However, the responsibility of performing due diligence in investing also falls on your shoulders, as well, and it is critical to the overall success of your investments.
Key Takeaways
Due diligence is one of the most important tools investors can use to protect their wealth, especially when using a self-directed IRA. In this article, you’ll learn how to verify the legitimacy of an investment, avoid scams and prohibited transactions, and evaluate whether an asset aligns with your risk tolerance and diversification goals. These six steps—and the pro tips provided—can help you confidently navigate the due diligence process and safeguard your SDIRA’s long-term success.
Understanding Due Diligence in Investing
What is due diligence? It goes beyond an initial cursory review of an investment. It involves validating facts, identifying risks, and confirming that each opportunity fits your overall retirement strategy. With a self-directed IRA, this becomes even more vital because you are responsible for determining the legitimacy and compliance of every deal. You don’t have a third-party fund manager with a fiduciary responsibility because, in essence, you are the fund manager with all the responsibilities that title implies.
Whether you’re looking at extending a private loan, exploring a real estate investment, or considering investing in a startup, proper due diligence equips you with the knowledge you need before moving forward.
Why Does Due Diligence on Investments Matter?
Due diligence helps you avoid fraud.
No one is safe from scams and fraud, but self-directed investors can potentially be vulnerable because you manage your own investments. You must go the extra mile to discern the viability of each opportunity. Proper due diligence in investing is key. Investigate every potential asset and the people involved. These tips to spot investment fraud can help:
- Request documentation
- Verify credentials
- Cross-check claims of ROI/performance
The more you can verify before you invest, the better your chances are of avoiding scams and detecting fraud.
Pro Tip: When applicable, access trusted financial databases, state licensing boards, and the SEC’s Investment Advisor Public Disclosure tool to confirm an advisor’s or a firm’s legitimacy.
It helps you avoid prohibited transactions and disqualified persons.
The IRS prohibits certain transactions in your SDIRA, and it also regulates transactions with disqualified persons. Violating the rules can trigger tax implications, hefty fines, and even impact the tax-sheltered status of your account. Due diligence helps you determine who you can deal with when buying or selling investments.
For example:
- Your IRA cannot buy assets from or sell assets to yourself, your spouse, your lineal descendants, or lineal ascendants. Other disqualified persons this rule applies to include investment advisers, managers, fiduciaries, and anyone else providing services to your IRA.
- Dealings with corporations, partnerships, trusts, or estates in which disqualified persons have a 50 percent or greater interest are also not allowed.
- Certain investments, like life insurance and collectibles (including art, antiques, most coins, and stamps), are off-limits in SDIRAs.
Pro Tip: When in doubt, consult a professional familiar with Internal Revenue Code 4975 for guidance. You can also read IRC 5975 to learn more about prohibited transactions and disqualified persons.
Due Diligence in Investing Is a Key Factor to Determine Risk and Diversification.
Beyond avoiding fraud and prohibited transactions, thorough due diligence includes examining how each investment fits your portfolio and enhances your investing strategy.
Ask yourself:
- What are the liquidity and exit options if I decide to sell for any reason?
- How stable are the asset and its market, and does that impact ROI and exit strategy?
- Is this helping me diversify or is it leaning too heavily into one investment type?
Pro-Tip: Learn to think like a portfolio manager. If an asset doesn’t strengthen your diversification strategy or mitigate risk, it might not belong in your IRA.
Checklist: 6 Ways to Perform Due Diligence on Investments
1. Research the investment thoroughly.
Make sure the asset is real, viable, and not a grand Ponzi scheme someone’s peddling or oceanfront property that doesn’t even exist. Ask questions. Request financial information for private equity, hedge funds, multifamily real estate syndications, or other options that should have statistics for review. Find out who else is involved, if possible.
If anything seems sketchy—politely decline participation and move on.
2. When performing due diligence on investment real estate, explore the property.
Is it a parcel of raw land in an area that is under consideration for eventual development? Or is it a swamp that will only benefit the alligators? Is that piece of rental property in an area that generally attracts consistent, reliable tenants? Or is it located in an undesirable area where many homes are vacant, run-down, or riddled with crime?
Whether you’re looking at commercial or residential real estate, determining these elements is critical to the success of your return on investment.
3. Ensure the parties you are working with are legit.
Due diligence in investing goes beyond verifying the investment. You should also fully vet the parties involved in any investment opportunity. From the bank to the realtor to the broker to the individual seller—get access to their credentials. Is the attorney involved reputable? Is the realtor respected? How experienced is the broker? Are they listed in good standing within their industries?
Answers to these questions and more can help you avoid becoming a victim of fraud.
4. Seek the advice your own trusted CPA, realtor, attorney, or financial advisor.
Your own research when performing due diligence in investing may prove the persons facilitating an investment are legitimate. But you should still enlist the help of your own trusted advisors to help perform due diligence on investment options. These people may have solid knowledge (good or bad) of the others you’re dealing with. And if they don’t know, they have better access to get reliable information on people within their industry.
Perhaps they have merely heard whispers of negativity within their peer groups about the asset and people involved—which may help you determine whether you buy in or not.
5. Ask other investors for their opinions.
Joining investment clubs and attending investor networking events is beneficial in many ways. Meeting others whose interests are in line with yours increases your resource base of knowledge. All share secrets and tips, success stories and failures to help each other out. If you have a particular asset in mind, broach the subject and get the opinion of others. You never know—someone in one of these groups could possibly have experience with the asset you’re considering, and the people involved.
Any news helps arm you with the information you need to move forward or step away from the opportunity.
6. Commit to Ongoing Monitoring and Performance Review after You Invest
Due diligence doesn’t end once you’ve purchased an investment, especially for self-directed investors. It’s important to stay engaged. Monitor financial statements and investment reports and track ROI to review how it meets the initial projections. Take the time to perform yearly reviews of the investment’s overall performance to decide if it’s a keeper or time to deploy your exit strategy.
Don’t ignore red flags like poor communication, changing deal terms, or anything else that feels off. You must stay proactive long after the deal closes to protect the integrity of your portfolio.
Common Due Diligence Mistakes to Avoid
Even experienced investors sometimes overlook key steps. Common mistakes include:
- Believing promotional claims without proper documentation
- Skipping background checks on relevant individuals, entities, etc.
- Assuming every alternative investment is eligible in your SDIRA
- Overlooking title verification and/or skimming legal documents
- Failing to continue monitoring an asset’s performance once you’ve invested
- Ignoring red flags like “guaranteed” returns or pressure to “invest now.”
The Role of Your Self-Directed IRA Company
When you self-direct, your self-directed IRA custodian or administrator plays an essential but limited role. They facilitate transactions, maintain compliant account records, and file required IRS reports on your behalf. They do not sell investments or give investing advice, and they do not vet the legitimacy of your investments. That is your responsibility as the account holder.
Always vet your investments independently or with the help of qualified professionals, such as attorneys, tax professionals, or investment advisors before submitting paperwork to your SDIRA custodian or administrator.
Treat Due Diligence as a 3-Step Process
Performing due diligence isn’t a single step or a one-time event. It’s a three-phase process that strengthens decision making and improves risk management:
- Preliminary screening: Determine if the investment fits your goals and risk tolerance.
- Detailed analysis: Assess legitimacy, performance potential, and regulatory compliance.
- Ongoing review: Track performance and spot red flags after investing.
Closing Thoughts on Performing Due Diligence in Investing
Self-directed retirement plans offer account owners great freedom and flexibility in choosing alternative assets to build income in their portfolios. However, as the saying goes, freedom is not free—so, you must do your part to perform due diligence on investment opportunities.
Sometimes it’s easy; other times it can be exhausting. In any case, it’s worth your time. The success of your financial future depends on it.
Due diligence is an investment in itself—one that protects your account’s tax-sheltered status, preserves your hard-earned wealth, and helps secure a successful financial future.
If you have questions about due diligence in investing or wish to learn more about self-directed retirement plans, please contact Advanta IRA.
This article was initially published in 2018 and has been updated for accuracy.
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