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A general overview… The Basics |
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The rules governing allowable investments by IRAs preclude an IRA’s investment in life insurance, collectibles (e.g., artwork, antiques, metals, gems, and most coins) and S corporations.
All other types of investments are permitted, and thus the range of possible investment choices is nearly unlimited. Consequently, an IRA can purchase any form of real estate.
Real estate IRA investing opens up a huge range of alternative investments for individuals who are knowledgeable about real estate investing or who work with knowledgeable advisors, sponsors, or brokers. Investing in real estate for your retirement may serve as a means to diversify your retirement portfolio to hedge against the cyclical changes in the stock market, economy and bank and government-based investments.
For many who are experienced with real estate investing, real estate investments hold the potential to protect against the loss of principal while generating better than market rate returns through income production and capital gains. When real estate investments are not leveraged, both income and capital gains can flow back to IRAs tax-deferred (or tax-free if the IRA is a Roth IRA).
If you have your IRA purchase real estate from an unrelated party and pay cash for it, and you do not use the real estate for personal reasons while it is in your IRA (i.e., you treat it strictly as an investment), there are no special issues.
If your IRA invests in real estate through a down payment and leveraging, there are some significant issues:
- You cannot personally guarantee a loan for your IRA;
- It may be difficult to get a bank to allow an IRA to be the debtor without a personal guarantee. However, there are now some banks that specialize in loans to IRAs. Currently, the minimum IRA down payment for such loans is 30%, although the exact amount is up to the lender;
- Your IRA will pay tax on UDFI (Unrelated Debt Financed Income), which is the income and/or capital gains attributable to the leveraged portion. (UDFI is taxed at the trust tax rate because an IRA is treated as a trust for this purpose.)
As a consequence, although it is perfectly legal, it may not be desirable to have an IRA carry debt in a real estate investment transaction if there is any significant risk that the IRA will be unable to pay the mortgage payments.
What you can’t do in an IRA with real estate
- Your IRA cannot directly or indirectly buy real estate from a “disqualified person”. Who is a disqualified person?
- The IRA owner;
- the IRA owner’s spouse, descendant (e.g., son), or ascendant (e.g., mother);
- spouse of a descendant of the IRA holder;
- a fiduciary of the IRA or person providing services to the IRA (e.g., the trustee or custodian);
- an entity at least 50% of which is owned (or at least 50% of the beneficial interests are held) by a combination of the above (e.g., if you and your spouse own 50% of an LLC, that LLC is a disqualified person with respect to your IRA); or
- a 10% owner, officer, or director or highly compensated employee of such an entity.
- You cannot have your IRA enable an investment for yourself or another disqualified person. In other words, if the IRA’s investment is deemed essential to accomplishing a transaction in which both you and your IRA invest, then the transaction would be considered a prohibited transaction.
- Your IRA cannot purchase a real estate asset and then have a disqualified person use it while it is in the IRA. For example, you cannot buy a vacation home and use it partly for personal use, even though you might rent it to unrelated persons the rest of the year.
What you can do in an IRA with real estate
Buying real estate from an unrelated party (i.e., one who is not a disqualified person) with cash is the simplest way of investing in real estate with your IRA. Your IRA can buy raw land, commercial property, residential (e.g., rental) property, real estate options, as well as extend loans (e.g., first and second mortgages), secured by real estate with your IRA, to unrelated parties.
As discussed above, your IRA can also buy property through leveraging, provided the loan is not guaranteed by the IRA owner (or any other disqualified person) and that the IRA has enough liquidity to support the mortgage and expenses. Generally, most custodians will have limits on the amount of leverage they will permit. Also, as previously mentioned, leveraging can result in income taxes on UDFI that must be paid by the IRA. Generally, these taxes are higher than would be paid on income generated from a property that you buy and finance personally. In addition, the UDFI taxes must be paid from funds from the IRA and, therefore, there has to be enough liquidity in the IRA to cover these taxes. See IRS Form 990T and its accompanying instructions for details.
There are a variety of ways, however, that an IRA can participate in a real estate investment without a full cash capital investment. For example, your IRA can co-invest with other parties. You could also have your IRA, and other parties participate in real estate investing by becoming members of an LLC that buys and sells property.
Examples of real estate investments that can be made using IRA funds
Example I
John’s IRA has purchased a single-family home from an unrelated seller. John now wishes to have the IRA sell it to his sister with a first mortgage that his IRA will hold.
The purchase of a single family home from an unrelated party is not a problem. John pays $300,000 cash and his IRA holds the grant deed from the sale to his IRA by the third party. John’s IRA later sells his sister the property and takes back a first mortgage and a down payment in exchange. His IRA gives her a market rate loan for 15 years and receives a 10% down payment. Since this is a $280,000 debt owed to the IRA and not by the IRA, there is no concern about the potential liability of the IRA. John’s IRA has a fixed income investment and is protected because it holds the trust deed in the event his sister defaults on the loan. The transaction may also have the incidental benefit of allowing John’s sister to purchase the home more easily than she could have on the open market.
Example II
Allison wants to form an LLC that will buy property that will be developed. She wants to make her IRA the primary investor. She expects to have other investors in the LLC.
Allison’s IRA can participate in the formation of the LLC provided Allison and related persons and parties do not already own 50% or more of the LLC in aggregate. If she is just starting the LLC, then the IRA can own something less than 100% (e.g., 90%). The LLC is considered a real estate operating company and, therefore, the assets are not considered plan assets unless there is 100% ownership by the IRA. If the company’s assets are deemed plan assets, then a transaction between the company and the IRA owner is considered a transaction between the IRA and a disqualified person (such as the IRA owner) and is therefore possibly a prohibited transaction. Because of some recent legal rulings involving self-dealing, we recommend that you consult with a competent attorney if you intend to have a personal role in any entity in which your IRA is an investor.
If the LLC was not a real estate operating company or other type of operating company (for example, if it was a hedge fund), then the aggregate ownership of all IRAs and employee benefit plans would have to be less than 25% in order for the LLC’s assets not to be considered IRA assets. (The interest owned by the IRA owner is disregarded for purposes of calculating the relevant percentage.)
Example III
Howard wants to have his IRA purchase a $400,000 rental property with a 50% down payment. Is this possible and are there any special considerations?
Yes, it is possible, but there are special considerations such as:
-Disqualified persons (such as the IRA owner and his or her spouse) cannot personally guarantee the loan for the IRA. The loan must be supported by the property itself or some other property that the IRA owner owns;
-The IRA will be subject to tax (UDFI or UBIT) on any income and/or capital gains attributable to the leveraged portion of the investment;
It should be noted, as an alternative to borrowing, that the IRA can purchase the property with other parties, all of who pay cash. When this is done, there is no UDFI and there are no issues associated with the financing.
Conclusion
In summary, the tax laws (1) require that the investments in an IRA not benefit the IRA owner or other “disqualified persons” and (2) prevent “self-dealing” between the IRA and the IRA owner or other disqualified persons. However, by properly structuring an IRA investment in real estate, an IRA can obtain the benefits of real estate investment in a manner that complies with applicable tax laws.top
(The foregoing is a general discussion. It is not intended, and should not be relied upon, as an opinion or advice on any legal, tax or investment aspects of IRAs. An IRA owner considering an IRA investment in real property should consult with his or her own advisor.)
Top 10 Questions for Self-Directed IRAs and… 
With all the questions related to self-directed IRAs…..with some of them being answered here….more people who “fit the box” should be seriously considering a self-directed 401(k) rather than a self-directed IRA.
As mentioned in a previous blog, if an individual enters into a prohibited transaction within their IRA , the plan as nationally-recognized tax expert, Tim Berry, states, “blows up.” In this parlance, it simply means that the individual will face full distribution on the first day of the calendar year which the prohibited transaction occurs, incur early distribution penalties (if they apply) and taxes. Yikes, that doesn’t sound user-friendly to me.
But, let’s not digress and…..now for the Top 10 list (courtesy of www.pgiselfdirected.com):
1) What is a Self-Directed IRA?
Legally speaking, a self-directed IRA is no different than any other IRA. Having a self-directed IRA simply means that you are allowed to direct the investments of the IRA. Many custodians claim that they allow you to self-direct your IRA investments but then turn around and restrict what you can invest in. A truly self-directed IRA allows you to make the decisions without restriction.
2) Why Haven’t I Heard of This Before/Is It Legal?
Congress passed ERISA in the Securities Act of 1975. As a result of this passage, banks and brokerage houses found that this was an ideal time and market to bring IRA and 401(k) plans to individuals and employers and sell the products they wanted to sell….stocks, bonds and mutual funds. Nothing in the IRS code states that you can only invest with a brokerage house…let alone in stocks, bonds and mutual funds. But this IS what 97% of the population believes. Banks and brokerage houses have a vested interest in having you invest in stocks, bonds and mutual funds - not real estate, businesses and other non-traditional investments.
As investors have become more disillusioned and frustrated with traditional investment choices, they have begun looking for alternatives. After the steep stock market decline, corporate scandals and corruption (e.g. Enron, ImClone, Worldcom) and many investors seeing their retirement accounts cut in half, they are ready to take control of their own investments. They often want more tangible investments such as Real Estate.
However, when they ask their current custodians / brokers, they are typically told that such investments are illegal, too complicated or that it can’t be done. But those are ignorant and self-serving responses. Although those custodians / brokers may not allow it, it can be done. It is just likely you can’t do it through your current custodian so they financially suffer if you make a move.
3) What Can My IRA Invest In?
Well, the real question should be what CAN’T my IRA invest in? Now, that being said, there are some very strict IRS regulations that must be followed, but the IRS does not provide an all-inclusive list of possible investment options
but rather excludes and stipulates what you CANNOT invest in: life insurance contracts and collectibles
The following list is an EXAMPLE of some permissible investments with your self-directed IRA:
Residential Real Estate
Commercial Real Estate
Raw Land
Trust Deeds / Mortgages, and Mortgage Pools
Private Notes and Loans
Private Stock Offerings
Limited Liability Companies (LLC)
Limited Partnerships (LPs)
Tax Certificates
Receivables
Stocks, Bonds, Mutual Funds
Annuities
Options
Currency
Futures
Commercial Paper
4) What is ERISA?
ERISA stands for the Employee Retirement Income Security Act. It more or less passed along the responsibility of an employee’s retirement plan from the employer (company sponsored pension) to the employee. As a result of this act, the IRS only excludes what can be invested in. These two prohibited investments are: life insurance contracts and collectibles.
5) What Types of Retirement Accounts can be Moved into Self-Directed Status?
Traditional IRAs;
Sep IRAs ;
Roth IRAs;
401(k)s;
403(b)s;
Coverdell Education Savings (ESA);
Qualified Annuities;
Profit Sharing Plans;
Money Purchase Plans;
Government Eligible Deferred Compensation Plans;
Keoghs
6) How Do I KNow This is Legal?
Well, first of all, be prepared to be told by many accountants and CPAs (and possibly yours) that this is not legal or is very dangerous to do. Neither is true. First of all, as mentioned before, this is legal as a result of the ERISA Security Act passed over 30 years ago. It is more of a question of whether an individual SHOULD do it (see question #7).
Find out for yourself by going to the Internal Revenue Service’s website www.IRS.gov. Request Publication 590. On pages 40-41 you will see what investments are not allowed (see below – collectibles, life insurance, s-corporation stock, etc.). Real Estate is NOT mentioned as a disallowed investment just like stocks, bonds, mutual funds are not mentioned as a disallowed investment.
7) Should Everyone Do This? How do I Know it is Right for Me?
Of course you know the answer to this question is NO. Not everyone should do this and not everyone will. It really depends on a person’s interest level to self-direct. Some folks would rather bury their heads in the sand and just hope that everything turns out okay for retirement. Others have done well with the brokerage accounts
and have not diversified into real estate. However, the best aspect of a truly self-directed plan is that you can invest in non-traditional assets (e.g., real estate) and STILL invest in stocks, bonds and mutual funds.
Are There Certain Investments Disallowed?
Of course. As previously mentioned, IRS Code does exclude one from investing in Life Insurance Contracts and Collectibles. These are referred to as “prohibited transactions”. Prohibited Transactions are defined in IRC 4975(c)(1) and IRS Publication 590.
The biggest concern at times is for the Manager (you) of the IRA self-directed account to REMEMBER that any and every transaction that the SD IRA engages in is for the exclusive benefit of the retirement plan. An individual cannot “self-deal”. Self-dealing occurs when an IRA owner uses their individual retirement funds for their personal benefit rather than to benefit the IRA. As an IRA owner, if you violate these rules, your entire IRA could loose its tax-deferred or tax-free status.
9) What Are Prohibited Transactions?
Prohibited transactions as noted by IRC 4975 (c) (1), identifes prohibited transactions to include any DIRECT or INDIRECT:
- Selling, exchanging, or leasing, any property between a plan and a disqualified person;
- Lending money or other extension of credit between a plan and a disqualified person;
- Furnishing goods, services, or facilities between a plan and a disqualified person;
- Transferring or using by or for the benefit of, a disqualified person the income or assets of a plan;
- Dealing with income or assets of a plan by a disqualified person who is a fiduciary acting in his own interest or for his own account.
- Receiving any consideration for his or her personal account by a disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.
10) Who Is a Disqualified Individual?
As it related to IRC, the following would constitute disqualified individuals for entering into any investment or arrangment with, directly or indirectly.
- The IRA holder and his or her spouse;
- The IRA holders ancestors, lineal descendants and their spouses;
- Investment advisors and managers;
- Any corporation, partnership, trust or estate in which the IRA holder has a 50% or greater interest; and,
- Anyone providing services to the IRA such as a trustee or custodian.
Please note that too many individuals are playing games with the disqualification provision of an IRA holder who has 50% or greater interest in an investment. A word to the wise, do not play games with this provision by placing the IRA holder as a 47%, 48% interest in the endeavor. This is dangerous grounds to walk on for reasons to be examined later….but caution if you are advised to do this.