If you are an investor in real estate, you have heard about the self-directed IRA—an option that gives you the flexibility to invest in real estate for your retirement. It’s a popular choice that allows real estate investors to invest in something they understand and trust, while producing tax deferred or tax free income toward their retirement.
It seems like a win-win for real estate investors, but it’s a little more complicated than that. IRAs can become complex when dealing with investments outside of normal stocks, bonds and mutual funds and can even produce taxable income in certain situations. Due to the complexity, the Internal Revenue Service (IRS) requires that the IRA assets are held on behalf of the IRA owner by a qualified trustee or custodian.
What is a self-directed IRA?
A self-directed IRA is a type of traditional or Roth IRA that allows for investment into non-standard investments such as real estate. It also requires more responsibility. While all IRAs follow the same rules, most custodians provide only standard IRAs that limit the type of investments and activity in which the IRA can be invested. This limited responsibility protects the account holder by making sure he or she only chooses eligible investments that don’t produce complex issues.
Self-directed IRAs are much more likely to create potentially complex tax issues, such as prohibited transactions and unrelated business income tax (UBIT).
There are many advantages to self-directed IRAs that have increased their popularity. Probably the most prominent reason an individual invests in one is because it allows the account holder to invest in real estate, an avenue that provides a potentially higher return on investment (ROI) and more control. Popular real estate investment strategies include rental properties, wholesaling and flipping properties.
The cost of this ability, however, is increased complexity. Any transaction involved with real estate must be at arm’s length, with no self-dealing and no personal use. The IRA account holder operates as the fund manager. He or she can make decisions, negotiate and execute contracts, select vendors and conduct the financial transactions associated with deploying the IRA capital for investment. However, the account holder cannot furnish services to the investment property for a fee, such as repairing a house or providing lawn care services.
As an example, you can act as manager of a rental property without compensation but not as the paid or unpaid contractor for a property you own in your IRA. You cannot perform any of the labor on the property. This is of special note to real estate flippers that do any of the actual work on the properties.
Some investors use a structure called a self-directed IRA LLC, which is wholly owned by the self-directed IRA. The added layer of the LLC gives the investor checkbook control, allowing him or her to make transactions quickly while also maintaining accountability. The investor must comply with IRA rules—for example, any expenses related to IRA-owned properties must be paid from the IRA, while any income generated must be returned to the IRA.
Another popular way to invest in real estate in a self-directed IRA is with private lending. Real estate investors are always in need of financing. When conventional methods don’t work, they will look for private lending or hard money lending.
Being on the lender side of real estate deals can be lucrative for the account holder without all the hard work; the investor benefits from offering higher interest rates, and the borrower gets more flexibility than what he or she would have with a financial institution. This can be a real win-win situation for all parties. Of course, private lending comes at a risk too. Lenders should always do their due diligence when evaluating potential borrowers.
Self-directed IRAs follow the same rules as traditional or Roth IRAs. To understand them, we must know that certain transactions are prohibited for all IRAs. These restrictions relate to the people involved in the IRA—the account holder, the beneficiary and the trustee. The parties filling these roles (along with their linear family members) are called disqualified persons, and there are certain transactions that they’re not allowed to perform with IRA funds.
Such prohibited transactions include:
- The sale, exchange or leasing of any property to or from a disqualified person
- The lending of money or other extension of credit to a disqualified person
- The furnishing of goods, services or facilities to a disqualified person
- The transfer of the IRA’s income or assets to (or use by or for the benefit of) a disqualified person
- Any other act by a disqualified person, who is a fiduciary, dealing with the income or assets of an IRA in his or her own interest or for his or her own account (i.e. self-dealing)
(To read more on disqualified persons and prohibited transactions check out this IRS page.)
When dealing with a self-directed IRA, the account holder has to understand which transactions are prohibited. If such a transaction does occur, the IRA ceases to exist on the first day of the tax year, resulting in a distribution to the owner at fair market value. This in turn could produce a taxable event and consequently subject the account holder to interest and penalties.
Unrelated Business Income Tax
Real estate usually requires large quantities of capital to invest, and investors commonly find themselves using debt to secure it. However, using debt financing in an IRA will produce unrelated business income tax (UBIT) on a portion of the profits.
Activities such as flipping and wholesaling, if done on a “regular and repeated” basis, could be considered trade or business income and exposed to UBIT. If UBIT in excess of $1,000 occurs, it is taxed at trust tax rates and an IRS Form 990-T must be filed.
Required Minimum Distributions
Another potential pitfall of investing in real estate with your traditional self-directed IRA is required minimum distribution (RMD) rules. Traditional or tax-deferred IRAs are required to start distributing funds to the beneficiary once the beneficiary reaches age 70 ½. If cash reserves are not enough in the IRA, liquidity could be a problem—forcing the account holder to sell off real estate investments held by the self-directed IRA. This does not apply to Roth IRAs, which do not require minimum distributions during the owner’s lifetime.
A self-directed IRA is a great way to invest in real estate in your retirement portfolio. However, the rules around them are complex and must be understood well; a mistake can potentially require your entire IRA to be distributed and taxed in a single year.
For this reason, it’s important to contact a real estate CPA when considering a self-directed IRA. He or she can help you stay within the complicated rules while you watch your retirement portfolio grow.
The information in this article is for IRAs only. Any other retirement and qualified plans, such as self-directed 401(k) plans, have different rules that are not reflected in this article.
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