With the economic downtown, savvy investors are looking for investment opportunities in real estate and may consider using a self directed IRA or real estate IRA. After all, real estate has long been considered the number one way to building wealth – and what better way than to build wealth tax-deferred or tax-free using a self directed IRA?
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.
Regardless of the reasons, I think there are three items which do not bode well for commercial real estate prices in the next few years. First and perhaps most overlooked, investment or income producing properties, during the boom years, where purchased more for appreciation, rather than “income”. In other words, many deals were justified by investors who were willing to forego a rate of return (income), for future price appreciation. But as its name suggests, this is not what “income producing property” is all about. If it doesn’t give you an income stream in good times, it sure won’t be able to in bad ones. Only a “flipper” can make money on appreciation, and the trick is to know when to get in and when to get out. Second, the credit crisis has reduced the chances of obtaining loans, and also the leverage previously afforded owners/purchasers. Less money means less deals, and more cash out of pocket. This can only lead to lower prices. Third, we are for now in a “new” economy (although Americans often prove to be driven by fads and can be short sighted), where we will consume less, which should mean less need for commercial space. If there is one truth that history makes clear over and over again, it’s that most sectors of the economy will move in conjunction with one another, not in spite of one another. No doubt prices are tied to supply and demand issues, but too much of a swing invites change. So when prices double and triple in one sector while the rest of the economy isn’t going in that direction, chances are some force will snap that imbalance back into its proper place in the overall economy. And that change can be from social, economic, and/or political means.
Those are great points to consider for any real estate investment in an IRA.
• Residential and commercial real estate markets and opportunities can be very different depending on the geographical region. In areas where properties are currently priced below market value, there has been considerable interest in purchasing real estate within an IRA both for cash flow and upside capital appreciation rather than flipping.
• If your IRA does not have sufficient funds to purchase a property, any IRA lending must be done with a non recourse loan, and the loan criteria is different. Rather than looking at your current income an IRA lender will usually look at the funds available in your IRA and evaluate the property you would like to purchase.
• Though property condition, location and income potential are all factors to consider in any real estate transaction, one should also consider the economic factors. It is recommended that you consult with your tax or legal professionals when contemplating a real estate transaction in an IRA.