Using Your IRA to Buy Real Estate: Critical Compliance Rules to Avoid Costly Mistakes

“One mistake basically completely wipes out your IRA. You’re going to have probably penalties and interest and everything that goes along with that.” — Daniel Roccanti, CPA

In this episode of the Real Estate Industry Update, Daniel Roccanti and Kyle Paxton break down the opportunities and hidden risks of using your IRA to buy real estate. While these accounts can offer powerful tax advantages, improper structuring or IRS noncompliance can lead to severe penalties and disqualified accounts.

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Full Episode Transcript

[00:02] Daniel Roccanti: Hey, welcome to another episode of the Real Estate Industry Update. I’m Daniel with here with Kyle again hosting. Today we got a pretty interesting topic that I think comes up a lot in the real estate space and that is self-directed IRA. These can be a powerful tool especially for real estate. It provides a lot of tax-free deferral and growth but the rules can be pretty unforgiving and I think that kind of gets glossed over a lot of time. So a lot of normal real estate habits actually can turn into a compliance nightmare.

[00:32] Kyle Paxton: Yeah, absolutely. And when Daniel and I were prepping for this, I said, “This is my classic like the Instagram screenshot I get from the client, right?” These are advertised everywhere. Real estate investments and investments in general through self-directed IRAs are something we see a lot. It’s a hot topic and seems to be everywhere, particularly in the social media space. It’s a topic Daniel that I deal with frequently and on the surface seems pretty simple. You make an investment within an IRA. But there’s a lot of traps, things you need to look out for and most mistakes we see with this are not due to malicious intent or just truly not understanding the rules and being intentional on the front end and setting these investments up correctly.

[01:16] Daniel Roccanti: Yeah, I see this get kind of sold to a lot of people in the real estate space sometimes way too early on, but eventually at some point in your real estate career, this is going to come up, okay? And a lot of the pros get discussed, but not always the cons. So you really need to understand what really is a self-directed IRA. And so today we’re going to cover how it works, the big traps, basic structuring and reporting to make sure that you don’t get in any kind of trouble with the IRS.

[01:49] Kyle Paxton: Yeah. So go ahead and take us through a little bit of the core concept. What is a self-directed IRA and what exactly can you do with it?

[01:59] Daniel Roccanti: So the main thing we need to understand with self-directed IRA is the core concept. It’s not some special act or anything. It’s just an IRA. Yeah. Standard IRA rules, but there’s just one big thing that’s different and that is considered self-directed because you have more abilities to basically invest in things, okay? So just your normal traditional IRA, your Roth IRA, but now you just have a wider range of things you can invest in.

All right, these IRAs still have to be held by qualified custodians. Normal ones that everyone are used to is like Vanguard, Fidelity, these are your normal IRA custodians. They limit what you can invest in so that you won’t mess it up. All right? They don’t want you to make mistakes. And so by limiting your choices, it’s almost impossible for you to mess it up.

But there’s other custodians out there that are willing to basically do these self-directed IRAs. All right? And this just gives you more control so that you can invest in things like real estate or private companies and limited partnerships or precious metals and things like that. So that’s what it basically does.

Custodians, they’re just the administrator, okay. And they’re giving you more control over your IRA so you can invest and have more options. And it also gives you more control to mess up.

[03:23] Kyle Paxton: Yeah. And with more control comes a lot more risk. And to Daniel’s point, there’s only certain custodians who offer this. And they don’t always put the proper guardrails around the investments on the front end. It is important to kind of bring your full advisory team. We come to you from the tax side and from the accounting consultant. It’s important to have legal involved in these conversations as well as your wealth management team all under one roof when making these investments to make sure everything is done above board. You’re hitting all the ongoing compliance requirements and all that good stuff.

So let’s talk about a little bit kind of the nuts and bolts here. So in these investments, that self-directed IRA is the buyer, the owner and what’s funding the operation. The buyer of, we’re using real estate as our primary example today, right? The buyer of the real estate should align with the IRA’s ownership format through the custodian. The IRA itself is the owner of the investment. It’s separated from Kyle Paxton personally. Kyle Paxton is not an owner. It is Kyle Paxton’s IRA that owns this investment. That distinction is very important.

Closing funds come from the IRA. The ongoing expenses come from the IRA. Rents received go to the IRA. It’s important to have a cash buffer within the IRA to fund those expenses on an ongoing basis. But you see the point I’m making here. Everything occurs in and stays within the IRA. And that’s really the ultimate kind of operation here is make an investment within the IRA. All of that activity stays within the IRA and it’s fully separate and it’s tax-free to me as Kyle Paxton the individual over the life of the investment.

So it’s very important to draw that distinction between personal and then the IRA vehicle itself.

[05:11] Daniel Roccanti: Yeah, I don’t think some people understand the legal definition of actually what an IRA is. It’s actually a separate tax entity, technically a trust, okay. And so you are the account owner, the beneficiary of this. All right? And so you got to really keep it separate from you personally. So when you’re doing a self-directed IRA and you’re going to go invest in real estate, you got to realize that IRA owns the real estate, not you, okay? You can’t be titling it to yourself or anything. And then what’s going to run the operations? It’s that IRA, the money going in and out, paying the bills and everything.

That’s really you got to really understand here that okay, I’m buying real estate, it needs to be in the IRA’s name. All income and expenses related to the property must go to the IRA. You can get yourself in trouble when it’s not or the whole like I’ll fix it later and basically just playing with fire. And so there’s a lot of issues there and we’re going to go into that a little bit later.

But let’s talk about a little bit of what are the common ways to kind of invest in real estate with your self-directed IRA. All right, there’s three main ways. Direct ownership, okay, the IRA simply owns the real estate, okay. This, there’s a lot of pros. Basically it’s the simplest way to do it, okay. Fewer moving parts. The con is just it’s a lot slower execution because the custodian has to be involved a lot.

All right. So the most common way we actually see when someone wants to invest directly into real estate is actually they own an IRA owned LLC, okay? And what this does is it just lets the account owner basically have checkbook control. All right? So instead of having to go through the custodian and everything, I open a bank account in this IRA owned LLC. So an LLC that’s fully owned by my IRA and now the LLC is the one that actually buys the real estate. It kind of cuts out that total middleman and you basically have control.

Now that comes with great benefits. I can do my deals faster when I’m dealing with real estate and I have a lot of transactions come in and out. I can pay my vendors easier. But there’s also issues here because now again I’m putting more of that risk back on me where I’m going to be non-compliant. And so you got to make sure you understand the rules and create strict boundaries for yourself.

The last way is just basically passive investment. This is syndication. I go and I invest in a real estate fund. They’re giving me a K-1. All right. Just like you can do it yourself. Your IRA can do that as well. It’s pretty passive. So the easy part about that is you’re not really managing the property. You’re not doing anything. You’re just getting the K-1. You put your funds in which just come directly from the IRA and then you get your K-1 at the end of the year.

A lot of the cons with that is it’s really easy to actually create a taxable situation or extra tax reporting. And so we want to make sure we understand when we invest in these funds if they use things like leverage, it could actually create a taxable situation for us. And this actually happens a lot of times and the account owner doesn’t understand.

[08:31] Kyle Paxton: Yeah, I see this a lot in the syndication space as we’re talking about here where fund managers push these investments through the self-directed IRAs and the classic setup I see is typically the IRA owned LLC. That’s usually how these things are set up. And in a lot of those scenarios, to your point, you have some surprise reporting on the back end because the partnership that you’re investing in via the IRA owned LLC are generating unrelated business taxable income and there’s additional reporting both on the fund side for the partnership itself that gives the IRA partners the information they need to file these returns and then the IRA itself could have a tax return reporting requirement around these investments.

And so it does create additional compliance considerations and things of that nature that can complicate these and a lot of people don’t understand that when they enter these deals. And so that’s one of those traps we’re going to talk about more here.

And so before we get into that a little bit, I want to talk about really kind of what types of real estate work in these vehicles. And so oftentimes the cleanest is those truly passive rentals where you have a third-party property manager. And so again, you’ll notice the theme as we keep talking here. There is clear separation from Kyle Paxton as a person with these investments through my IRA because a big theme we’re going to talk about is that personal use can overlap here.

And so any portion of this where the IRS looks and sees you’re either running a business or providing services related to this real estate in any way muddies the line and gets riskier. So when we’re talking about these types of investments, the best is truly those passive investments where you have very little to no activity in the investment itself and you’re able to either fully delegate those management opportunities or in the syndication we’re using, you’re truly kind of a limited partner in the investments. Again, just drawing that line in the sand and separating activity.

[10:43] Daniel Roccanti: Yeah. So let’s kind of move on to the compliance traps, okay. If you are thinking about getting a self-directed IRA or if you already have one, this is where you need to know. You need to know the rules like the back of your hand, okay, because this is where it’s really easy to mess up and unfortunately the penalty is pretty significant if you do.

So when we’re talking about the compliance traps, it really comes down to there’s rules about prohibited transactions. All right. So in these self-directed IRAs, you can’t do some improper uses that basically are done by the owner or the beneficiaries or what we call a disqualified person. All right.

If it does happen in these prohibited transactions, the consequence is severe because what it actually does is the IRA ceases to be an IRA on the first day of that year, that taxable year. So January 1st, it’s no longer an IRA. And then the fair market value of your IRA is distributed to you, to the account owner and the beneficiary. So that has to be included in your income, okay.

[11:55] Kyle Paxton: Bad news bears all around.

[11:57] Daniel Roccanti: And now you’re going to have probably penalties and interest and everything that goes along with that. So one mistake basically completely wipes out your IRA. All right? So you need to understand and a lot of times it’s really easy to just make this mistake and not even know it, okay? And so if you ever get audited by the IRS or anything, they’re going to be looking at these self-directed IRAs. Did you mess up? Did you do a prohibited transaction? When did it happen? And we’re going to go all the way back to the year it happened and wipe your IRA.

So pretty strict and that’s why, I’m not trying to scare anyone but it can be a very serious situation. So the first prohibited kind of transaction is you can’t be dealing with any related party or disqualified person, okay. And so what is kind of related party or disqualified person? It’s basically if I’m the account owner and the beneficiary then I can’t deal with myself, okay. And I can’t deal with basically my family members, okay.

And then there’s going to be some other disqualified persons, but that’s mainly it. All right. The related people, the people closest to me. But the one who actually people mess up the most is they deal with themselves, okay? And they forget that like, hey, this is a whole separate entity. I can’t be doing self-dealing, okay?

We mentioned this before, but related entities as well. That’s another one people forget like they own a business, they own other things and they’re doing dealings with that, okay? You got to remember you cannot deal with it. A big one is that when you’re buying property or selling property, you can’t do it to any of these related parties or disqualified people, okay? I can’t buy it. I can’t sell it from them. So I can’t buy my own property. I can’t sell my own property. Can’t buy my family members’ properties or sell it to my family members. That’s all prohibited transactions.

And so when you’re looking at it saying, “Hey, can I buy this property from my parents or my kids or sell it to my kids or can I lend money to my business or my spouse’s?” No. Any of those actions is a prohibited transaction and your IRA is basically dissolved the moment that happens. So pretty big stuff here right off the bat.

[14:10] Kyle Paxton: Yeah. So without a doubt if the IRA has any relation whatsoever to another individual involved in a real estate transaction, you should really approach it as assuming it’s prohibited. You can structure these investments to where you can co-invest with a disqualified person. But the key there is that the benefits cannot shift between the IRA and the disqualified person. And really approaching the transaction with assume it’s disqualified unless you have good counsel around you that can really help you structure these deals is really important.

Let’s jump into trap two. So this again a common theme, right? Personal use. In this context I’m talking about personal use of the actual real estate. So the easy example here is a vacation home, right? You got that beautiful beach house you want to acquire and you’d love to spend just a weekend, nothing too crazy there. That in itself, a quick stay, storing personal items, letting other family use the property can blow the investment and disrupt the IRA.

And so the personal use component of this is very serious and it really gets back to you are truly passive, a real estate investment and you are not benefiting personally by making that investment through that self-directed IRA.

[15:41] Daniel Roccanti: I see this get messed up a lot. Hey, it’s my property, my IRA, and again, though, hey, does it really matter if I stay there? Even if it’s just like I’m just storing equipment or some personal items or I’m letting family. I’m not using it, but this goes back to the related parties and it just falls under that. I can’t let family use it.

Personal use is one that probably gets done a lot. And so really got to realize, hey, I’m buying real estate. I’m putting it in my self-directed IRA. It’s an investment. There’s zero personal use. There’s no vacation home. There’s no letting my family use it. You truly need to separate yourself out and kind of realize like, hey, as the account owner, I’m really kind of like the fund manager, okay? Like this is an investment. I don’t use this. I’m just a high-level fund manager.

And so a lot of times with this, you want to realize if you’re going to have any kind of personal use, you don’t want to buy with your IRA. All right? You need to buy it personally. You need to structure it a different way. IRAs are strictly for investment, no personal use. If you’re considering personal use, you’re not doing it in your IRA.

[16:47] Kyle Paxton: Yeah. And that extends, Daniel, even to paying expenses personally. We talked about having that reserve in the IRA to make sure you can cover the expenses. Having that separate cash account that’s held within the IRA. We talked about the LLC so you have autonomy there. Property manager actually managing the income and expenses and removing the individual from that.

And a classic thing we see all the time in real estate is that sweat equity, right? A lot of our real estate investors love getting in there, getting their hands dirty and flipping the property, making improvements, all that kind of stuff, doing the landscaping. I mean, simple stuff, small things objectively can jeopardize these transactions. And so again, I’m going back to our theme over and over, any personal use of actually benefiting from the real estate yourself or performing activities that increase the value of the real estate personally can jeopardize these investments.

And so it really is creating a third-party framework around all of these activities to where Kyle Paxton as the person is not in any way receiving benefits from or providing benefits to the real estate investment.

[17:59] Daniel Roccanti: Yeah, this is called self-dealing. All right, this one comes up as a common mistake made and it’s because it goes against the core of what real estate and real estate investors are about with real estate. I want to buy an asset that I can control and I want to go in there and fix things up, find ways to basically cut my cost, be more efficient. We want to have control and we want to do it ourselves, okay?

But the problem is your labor, your actions are being basically seen as a benefit to the account, as a benefit to you. You’re self-dealing. All right? You or any of your related party or disqualified people cannot provide services to the property, okay. They can’t pay for things. We’ve talked about how income and expenses need to run through the IRA. You can’t pay for it, okay, the IRA has to. All right, and you can’t do the repairs. You can’t manage the properties.

You are the fund manager. You only are at the very top level. So when you’re really doing real estate, you got to really, this is you have to basically use property management. You have to use independent contractors because you can’t do it yourself. And so a lot of people mess up because they just don’t even know. They’re like, this is what I do for all my normal real estate properties that I own personally or through my businesses and not understanding that the rules are completely changed. You have to remove yourself from the actual activities into it.

And so like Kyle was saying that when you’re dealing with this self-dealing it’s just so easy. Think less me more third party contractors. All right. I am the oversight. I’m the highest level possible. I can’t do any of the work, okay.

[19:51] Kyle Paxton: The traps are adding up, Daniel. Tell us about leverage a little bit, right? I mentioned it briefly before. Take us through the basics high level of just like how debt and guarantees enter these deals and what the impact is to the IRA.

[20:10] Daniel Roccanti: Yeah. And we’ve already mentioned several traps and we’re still not even close to done. You could go all day, my friends. Right. This is why self-directed IRAs, we just want to make sure that everyone is informed, okay? And so after you get the self-dealing, now we’re having to deal with debt and guarantees and things like that, okay?

When you add leverage, it just creates complexity. All right? There’s two ways to kind of have the complexity you have to look at. First is if you’re doing any kind of lending of money and borrowing it, you can’t do it with related parties. I can’t lend money to my IRA. I can’t do it the other way around. Same things with my relatives and things like that. So you really got to understand that hey this is another prohibited transaction. Can’t be lending and borrowing from myself or my relatives, okay.

And also personal guarantees. Forgot about that. So if I’m going to get some loan in it and I’m going to personally guarantee it can’t do that either. Also prohibited transaction even though it’s not technically in my name. I’m guaranteeing it, okay.

And then the second level of this that I think really gets overlooked, I don’t think this gets talked about enough is basically your self-directed IRA could technically actually create taxable income. It’s called UBIT, unrelated business income tax or UDFI, which is unrelated debt financing income.

[21:38] Kyle Paxton: All the acronyms.

[21:40] Daniel Roccanti: All the acronyms I know. I’ve almost messed that one up. And so when you add leverage, you add debt, which is very common. If I buy real estate, I mean, there’s some people going out there and buying real estate in cash, but most people are using leverage. All right? Because it can basically increase your ROI, give you that chance to invest into more real estate, okay?

Well, now you got to understand the rules of normally investing in real estate have changed now that we’re doing it through an IRA. All right. The first one is if I’m using any kind of leverage, okay, that debt financing basically for my real estate inside my IRA. Now, any part of that finance portion may be subject to this unrelated business income tax, okay? And so that’s important. I’m using debt now to fund because like let’s say I have $100,000 in my IRA and real estate I want to buy is a million dollars, okay? I don’t have enough money to buy it.

So I need to get a loan for the rest of it because I can’t fund it myself and I have to get a loan. The moment you’re doing that, okay, you’re basically creating yourself a taxable situation. And because of the tax entity doesn’t mean it’s not subject to potentially any income tax unless it’s doing certain activities.

And so what you have to do is you have to file a 990-T in these scenarios and you actually have to report and pay taxes. So 990 is a tax exempt entity tax return. So any kind of nonprofit has to file a 990. All right. 990-T is the unrelated business income portion. That’s all you have to file for it. But it’s still understanding, hey, I thought this was going to be tax exempt. I didn’t think I had to do it. Now I’ve just created by investing in real estate using leverage. I actually now have to go back to filing a tax return and like, all right, well, I’m not getting the benefits that I was hoping of creating all this tax-free wealth through real estate. Now I’m still filing taxes. I’m just filing a 990-T instead of on my personal tax return.

[23:42] Kyle Paxton: And Daniel, that filing threshold is low. So you have probably $1,000 of taxable income allocated to you, the reporting requirement kicks in. So to your point, it’s a surprise and a trap that a lot of people fall into.

[24:01] Daniel Roccanti: Yeah. It’s like it’s only $1,000 and technically and this is one where we should probably mention this right now is if you invest in these syndications, these funds, okay, you don’t have control. If they go use leverage they just created a taxable situation. When you get that K-1 now I have to report it. Now I have to do the 990-T.

I see this is where a lot of mistakes are made. Well I’m not doing it. Doesn’t matter because you’re investing in the syndication or partnership that is using leverage. That leverage because of your ownership, you directly technically own part of it. And so now you have it and now you need to be reporting it. And even if it’s a loss, you probably should be reporting it so that you can get your carryovers because at some point it’s going to sell and you’re going to have a gain. So if you’re not reporting your losses, you’re not getting your carryovers to offset the gains in the future.

And then we can go on for days on the filing compliance here. But you just need to make sure you understand you’re doing anything in real estate, it’s really easy to trigger actually a tax compliance requirement.

[25:11] Kyle Paxton: Absolutely. And then again, we’ll add another trap, shall we? So let’s talk liquidity problems here. So big one, the IRA. We’ve talked about already how you have to make sure you have the cash reserve for the expenses, ongoing expenses both the IRA itself and any fees that you need to pay to the custodian, taxes on the real estate, repair maintenance. Real estate is an illiquid asset. It is hard to get cash out of real estate, right?

So having a good solid liquidity plan before entering one of these investments is huge because the IRA at some point is on top of all those ongoing expenses we just rattled off is going to be subject to required minimum distributions at age 73. And so making sure that the IRA has actual proper liquidity to be able to fund those required distributions is paramount and super important.

This is very important and again get back to bringing all of your teams together, the legal, the accounting team, your wealth management team so all these angles are getting looked at. I mean through these traps we touched on all three buckets time and time again and so it really is important. Do you have a good plan on what the holding period of this real estate might look like? How would you exit? What does an exit look like? And making sure everything’s lined up to that you’re handling that correctly.

And then to Daniel’s point, if you have a potential taxable event within the IRA at some point, are you doing the filing up to that point so that you can potentially mitigate it? Because a lot of times in real estate, you have loss, loss, loss, loss, loss, loss then income. And so making sure all of that is properly structured is very important.

[26:55] Daniel Roccanti: Yeah. And I’ll just add to this, the liquidity problem is a big one because remember, you have to pay everything out of that IRA. All right. So when that rental property needs a new roof, you have to pay out of the IRA. If you don’t have enough money in the IRA, now I got to get a loan, which then creates tax compliance because now I have unrelated business income tax. So you can see how it can easily go wrong.

And I’ll mention this shortly, the RMDs. All right, required minimum distributions. All IRAs have it and self-directed IRAs have it. But the problem is you don’t have the cash in the IRA if you’re investing in real estate. So you got to realize that I’m at that RMD age, which is like 72 and a half, around there that I might have RMDs and I got to be prepared for that. So big issues kind of up there.

And then kind of just rounding this out here, okay, is just make sure that if you’re the owner of the IRA or any of your relatives, you’re not getting any kind of indirect benefits, okay? Like we’re talking about staying in the property, using it, personal loans, even just renting it for below market value, things like that can be considered indirect benefits. You just really want to make sure that you truly understand the prohibited transactions just because unfortunately the consequences are severe and by just making one small mistake, you blow up your whole IRA and now you don’t even have your IRA anymore and you have to pay all the taxes and the penalties that go with it. No good at all.

All right, Daniel. Now let’s take this home here. So we talked a lot about the traps here. I want to be clear, we don’t want to be negative all along here. These are great ways to invest in real estate and it’s another tool in our toolbox as we do kind of holistic planning with any one of our clients on does this make sense for your personal retirement goals, cash flow needs, everything else.

So I want to take this back and I’m a big fan of investing in real estate. We see this all the time with a lot of our clients, but it really gets back to making sure you do the intentional planning and set these things up correctly for them to be successful.

[29:07] Daniel Roccanti: I agree. I mean, make sure this is your risk and what you want to do. I don’t discourage this. It’s just make sure you understand the rules and understand that it’s going to go against what your nature is of how you’ve done real estate before. If you’ve never really done real estate before, I probably won’t recommend it. If you’re an experienced real estate investor and you want to get into this, great. Let’s go over the rules. Make sure you understand that you’re not doing prohibited transactions. You’re documenting. You’re using more third parties to do everything. Just make sure you understand the rules.

And this can be a great benefit to you and the generational wealth that you’re building just like normal real estate but now you’re doing it in your retirement account which comes with tax benefits of basically tax-deferred or you’re doing it through your Roth, nothing when you distribute it at the end.

[29:52] Kyle Paxton: Daniel, thanks for another great REIU. Appreciate you all joining us and join us again next time.

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