– Adapted from an article reported on CNBC 2/27/12
Most people mistakenly believe that their IRA must be invested in bank CDs, the stock market, or mutual funds. Few Investors realize that the IRS has always permitted real estate to be held inside IRA retirement accounts. Investments in real estate with a Self-Directed IRA are fully permissible under the Employee Retirement Income Security Act of 1974 (ERISA). IRS rules permit you to engage in almost any type of real estate investment, aside from any investment involving a disqualified person.
In addition, the IRS states the following on their website : “…..IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option.” This means that real estate is always allowable as in IRA investments, but most trustees/custodians will not offer it as an option because the process of managing a real estate investment is much more extensive than other investments such as stocks, mutual funds, etc.
In order to use IRA funds to invest in real estate you must roll over your retirement funds to a trustee company that will allow you to invest in real estate as well as the traditional retirement options.
Advantages of Using a Self-Directed IRA LLC to Purchase Real Estate
Income or gains generated by an IRA generate tax-deferred/tax-free profits. Using a Self-Directed IRA to purchase real estate allows the IRA to earn tax-free income/gains and pay taxes at a future date (in the case of a Roth IRA the income/gains are always tax-free), rather than in the year the investment produces income.
With a Self-Directed IRA, you can invest tax-free and not have to pay taxes right away – or in the case of a Roth IRA – ever! All the income or gains from your real estate deals flow through to your IRA tax-free!
This means if you have a rental property that is producing monthly income, that income will build in your IRA tax free and build your retirement account faster. Also if you sell a property for a capital gain, the gain will not be taxed and will build your IRA nest egg.
Types of Real Estate Investments
Below is a partial list of domestic or foreign real estate-related investments that you can make with a Self-Directed IRA:
Real estate notes
Real estate purchase options
Tax liens certificates
Investing in Real Estate with a Self-Directed IRA is not complicated!
Purchasing real estate with a Self-Directed IRA is essentially the same as purchasing real estate personally.
- Set-up a Self-Directed IRA with a Self-Directed IRA custodian. (Call us for a list of the top companies that offer Self-Directed IRAs)
- Identify the investment property.
- Purchase the investment property with the Self-Directed IRA – Your Custodian company will place the ownership of the property inside the IRA and the property will be owned by your IRA.
- Title to the investment property and all transaction documents should be in the name of the Self-Directed IRA. Documents pertaining to the property investment must be signed by the Custodian/Manager.
- All expenses paid from the investment property go through the Self-Directed IRA. Likewise, all rental income checks must be deposited directly in to the Self-Directed IRA bank account. No IRA related investment checks should be deposited into your personal accounts.
All income or gains from the investment flow through to the IRA tax-free!
Structuring the Purchase of Real Estate with a Self-Directed IRA
When using a Self-Directed IRA to make a real estate investment there are a number of ways you can structure the transaction:
1. Use your Self-Directed IRA funds to make 100% of the investment (Ex: Cash Buyer)
If you have enough funds in your Self-Directed IRA to cover the entire real estate purchase, including closing costs, taxes, fees, insurance, you may make the purchase outright using your Self-Directed IRA. All ongoing expenses relating to the real estate investment must be paid out of your Self-Directed IRA bank account. In addition, all income or gains relating to your real estate investment must be returned to your Self-Directed IRA bank account.
2. Partner with Family, Friends, Colleagues
If you don’t have sufficient funds in your Self-Directed IRA to make a real estate purchase outright, your Self-Directed IRA can purchase an interest in the property along with a family, friend, or colleague. The investment would not be made into an entity owned by the IRA owner, but instead would be invested directly into the property.
For example, your Self-Directed IRA could partner with a family member, friend, or colleague to purchase a piece of property for $150,000. Your Self-Directed IRA LLC could purchase an interest in the property (i.e. 50% for $75,000) and your family member, friend, or colleague could purchase the remaining interest (i.e. 50% for $75,000).
All income or gain from the property would be allocated to the parties in relation to their percentage of ownership in the property. Likewise, all property expenses must be paid in relation to the parties’ percentage of ownership in the property. Based on the above example, for a $2,000 property tax bill, the Self-Directed IRA LLC would be responsible for 50% of the bill ($1000) and the family member, friend, or colleague would be responsible for the remaining $1000 (50%).
Isn’t partnering with a family member in a Real Estate Transaction a Prohibited Transaction?
Likely not if the transaction is structured correctly. Investing in an investment entity with a family member and investing in an investment property directly are two different transaction structures that impact whether the transaction will be prohibited under Code Section 4975. The different tax treatment is based on who currently owns the investment. Using a Self-Directed IRA to invest in an entity that is owned by a family member who is a disqualified person will likely be treated as a prohibited transaction. However, partnering with a family member that is a non-disqualified person directly into an investment property would likely not be a prohibited transaction. Note: If you, a family member, or other disqualified person already owns a property, then investing in that property with your Self-Directed IRA would be prohibited.
3. Borrow Money for your Self-Directed IRA LLC
You may obtain financing through a loan or mortgage to finance a real estate purchase using a Self-Directed IRA. However, two important points must be considered when selecting this option:
Loan must be non-recourse – A “prohibited transaction” is a transaction that, directly or indirectly involves the loan of money or other extension of credit between a plan and a disqualified person. Normally, when an individual purchases real estate with a mortgage, the traditional loan provides for recourse against the borrower (i.e., personal liability for the mortgage). However, if the IRA purchases real estate and secures a mortgage for the purchase, the loan must be non-recourse; otherwise there will be a prohibited transaction. A non-recourse loan only uses the property for collateral. In the event of default, the lender can collect only the property and cannot go after the IRA itself.
It should be noted that real estate income using leverage (loan) inside an IRA may be subject to taxes. It is advised to consult an accountant when making these choices.
Contact Us for more information on setting up a Self-Directed IRA, locating and purchasing properties, or general real estate investment questions.