Here are the basics to help you get started and understand how it works.

Find an IRA Custodian

Locate an IRA custodian, preferably a bank or trust company, which accepts real estate in a self directed IRA or real estate IRA. It’s best to use a custodian rather than an administrator. Administrators use the services of a third party to custody your IRA investments which creates an extra layer that can lead to problems. Custodians are regulated by a state or federal authority, while administrators are not subject to any regulatory oversight.

Likewise, if you use a facilitator or middleman to assist you in finding a property, make sure they either work with or recommend an IRA custodian.  Many new firms offering self directed IRAs and real estate IRAs have entered the market in recent years promoting the LLC-structured concept of “checkbook control” IRAs.  Under this scenario, the IRA owner has full control over the use of their IRA funds– something that seems to contradict the IRS rules and many IRA custodians consider a gray area. Even some regulators, including the SEC and FDIC, have recently become concerned with the checkbook control concept and fear it may mislead an investor into a prohibited transaction which could lead to disqualification of the IRA and result in taxes and possible penalties.

Funding the Purchase

Once you find the property you want to purchase, you can either use cash from your IRA to purchase the property outright, or you can locate a lender to finance the purchase.  If your purchase will be financed, the lender must use a non-recourse promissory note.  This limits the recourse the lender would have to only the underlying property (and not other IRA assets) in the event of default.  No other IRA assets or personal assets can be used to collateralize the loan. If your IRA purchase uses debt financing, you should be aware that this would generate Unrelated Business Taxable Income (UBTI) and discuss this with your tax professional.

Starting the Transaction

It is also important to remember that the purchase offer and contract must identify the named purchaser as your IRA custodian for benefit of your IRA account (i.e., Self Directed IRA Services, Inc., Custodian FBO John Doe IRA).  In addition, all funds, including the earnest or escrow deposit must be paid directly from the IRA rather than out of your personal pocketbook.  Also, a closing date should not be set until the IRA is established and funded with your custodian.

Spare Funds Needed

Keep in mind that all expenses related to owning, maintaining or improving the property owned within an IRA must be paid by the IRA. This includes maintenance, repairs, taxes, insurance and improvements, as well as any mortgage payments if debt-financed. The way this usually works is that once you receive a bill or invoice for the expense, you would sign it as approved and send it, along with payment instructions, to your IRA custodian. The custodian then issues the payment from your IRA.

Income-Producing Property

If the property generates any income through rental or lease of the property, the income must flow back into the IRA. So whether you have residential, commercial, raw land or vacation renters, any tenant of the property would need to write checks to the IRA rather than to you personally. Or, you may need to use a third party property manager to handle the process and remit the income to your IRA.  Your custodian will provide the specifics for how this should work.

Keep it Arms-Length

Now, let’s address the questions we hear most often—

• Can I use the property for a vacation home?
• Can I lease the property to my son/daughter to use for their business?
• Can my IRA buy a property that I/my parents currently own?

These questions fall under the rules about prohibited transactions and self dealing under Internal Revenue Code § 4975. A prohibited transaction most commonly results when your IRA engages in a transaction with a disqualified person, primarily:

• The IRA owner and their spouse,
• The IRA owner’s ancestors (parents and grandparents) or lineal descendants (children and grandchildren) and their spouses,
• Any entity in which the IRA owner has a combined ownership of 50% or more.

In general, you cannot have any direct use or benefit of the property owned within your IRA.  Likewise, you should not engage in a transaction with a family member.  This means your IRA cannot lease a property to a disqualified person, nor can it buy or sell a property from a disqualified person.  As a general rule, if you follow the guidelines set forth, your IRA transaction should be okay.

Selling the Property

The property can be sold at any time to an unrelated party and the proceeds from selling an IRA-owned property roll back into the IRA without facing capital-gains taxes.

You can then invest the proceeds in another property or any other asset within your IRA. When you eventually withdraw funds from the IRA, the profit would be taxed at ordinary income rates when withdrawn from a traditional IRA— or tax-free if in a Roth IRA.

Summary

Given the uncertainty in today’s mainstream investments, real estate is gaining a great deal of interest as an investment option in self directed IRAs. It’s easy to see why. After all, most people prefer to invest in what they know and understand.

Knowing the rules associated with owning property in your IRA is essential, so do your homework and consult with your tax advisor so they may cover the details relating to the investment you are considering.

Whether your retirement strategy is to retain properties or buy and sell for gain, real estate investing through your IRA can yield astonishing profits toward your potential retirement.

To learn more about holding real estate in a self directed IRA, see our Real Estate IRA Investing information.