By Adam Bergman

The Internal Revenue Service (“IRS”) permits retirement accounts, such as an IRA, to invest in real estate and other alternative types of investments. As a matter of fact, IRS rules permit one to invest retirement funds in almost any type of investment, aside generally from any investment involving a disqualified person, collectibles, and life insurance, in the case of an IRA.

There are several advantages of using a self-directed IRA or Solo 401(k) plan to buy real estate. The first is tax deferral or tax-free growth. For example, if one purchased a piece of property with retirement funds for $80,000 and later sold the property for $300,000, the $220,000 of gain appreciation would generally be tax-deferred. Whereas, if you purchased the property using personal funds (non-retirement funds), the gain would be subject to federal income tax, and in most cases, state income tax. Second, a self-directed IRA can allow you to invest in hard assets you know and understand, such as a rental property or piece of land. Lastly, having the ability to invest in alternative assets is believed to be a good source of investment diversification.

Before using a self-directed IRA to buy real estate, there are five important items to consider:

  1. Do Your Research. Real estate can be a complex investment that involves various components. Therefore, it is important to do your research and diligence on the real estate asset your IRA will be purchasing. You should be familiar with the specific real estate asset your IRA will be purchasing, its locality, as well as understand the costs involved.

  2. Price Matters. Unlike stocks or mutual funds, which typically do not involve ongoing costs, the purchase of real estate often involves ongoing costs, such as repairs and taxes. Thus, it is vital that you make sure you are purchasing a real estate asset that your IRA can afford. It is good practice to keep a reserve of at least 5-10% of the value of the asset in case of emergency.

  3. IRA Custodian Options. Most traditional banks and financial institutions do not allow IRA holders to buy real estate with their IRA since it does not generate any profit for the institution. However, there are a number of special self-directed IRA custodians throughout the United States that allow their clients to make alternative asset investments, such as real estate, using retirement funds. Hence, when purchasing real estate with a self-directed IRA, an IRA holder has generally two options: (i) “Custodian Controlled” Self-Directed IRA or (ii) “Checkbook Control” Self-Directed IRA.
     
    With the “Custodian Controlled” self-directed IRA, the IRA holder will direct the IRA custodian to invest the IRA funds into traditional, as well as alternative asset investments, such as real estate. Whereas, with a “Checkbook Control” Self-Directed IRA, a special purpose limited liability company (“LLC”) is established that would be wholly owned by the IRA and managed by the IRA holder through a local bank account. The use of the LLC allows the IRA holder to act quickly when the right investment opportunity presents itself cost effectively and without IRA custodian delay.

    The “Custodian Controlled” self-directed IRA option is often used by IRA investors looking to make alternative asset investments that do not involve a high frequency of transactions, such as raw land or an investment fund. While, a “Checkbook Control” Self-Directed IRA is popular for IRA investors interesting in making real estate investments involving a high frequency of transactions, such as rental properties, fix and flips, tax liens, and hard money loans.

  4. Understand the IRS Prohibited Transaction Rules. The Internal Revenue Code (“Code”) does not describe what a self-directed IRA can invest in, only what it cannot invest in. Code Sections 408 & 4975 prohibits “disqualified persons” (as defined under Code Section 4975(e)(2)) from engaging in certain types of transactions. In general, as long as the self-directed IRA does not purchase life insurance, collectibles, or engage in a transaction directly or indirectly benefiting the IRA holder or a lineal descendant of the IRA holder (“disqualified person”) then the investment can be made.

  5. Using Leverage Can Create Tax Issues. The IRS prohibited transaction rules prohibit an IRA holder from personally guaranteeing a loan associated with his or her IRA. However, if an IRA holder is able to secure a non-recourse loan (a loan which is not personally guaranteed by the IRA holder) to purchase real estate with an IRA, the unrelated business taxable income (“UBTI”) rules could be triggered and a tax rate reaching as high as 37 percent could apply. Note – an exemption from this tax is available for 401(k) plans pursuant to IRC 514(c)(9). If the UBTI tax is triggered and tax is due, IRS Form 990-T must be timely filed.

Using a self-directed IRA to buy real estate continues to grow in popularity, but IRA holders seeking to use retirement funds to invest in real estate must be mindful of the five items outlined above and should consult with a tax professional for further guidance.
 

Adam Bergman is a tax partner with IRA Financial Group and president of IRA Financial Trust Company. Contact him via email at [email protected] or call him at 800-472-0646 Ext 12.