How to partner with your IRA to buy Real Estate

Q - It is possible, supposedly, to "partner with your IRA". You put in, say, half the money and the IRA puts in the other half. The partnership does a fix and flip. The net profits would then be split 50/50.
Is this true? I thought you could only do this if you start the business with the IRA as a partner. But if your business already exists, you cannot use funds from your IRA for a flip. Is that not right?

U.S. Department of Labor ruling 2000-10 allows you to partner with your IRA but there are special circumstances under which it is allowed. Otherwise it's self-dealing and a prohibited transaction. Here are the basics for partnering with your IRA.

Your IRA can partner with another person, entity or IRA. In partnering, as you may know, the IRA would own only a percentage of the property and the remaining portion would be owned by someone else. You may partner your IRA with personal funds and/or disqualified persons, but some restrictions apply.

One major restriction is when your IRA partners with disqualified persons, the ownership percentage must be kept constant throughout the life of the investment, and all expenses and income must be split according to that ratio. Each bill must be paid according to the ownership ratio. 

For instance, if you and your IRA each pay half of the cost for a real estate investment, any renovation or fix-up costs must also be split in half. Conversely, any income from the property must also be split in half.

Although these restrictions require an active investor to properly manage the investment, a good self-directed IRA provider can smooth the edges and make your investment and management process easier. Partnering with your IRA has worked for some of our clients and can be a valuable tool to increase retirement funds and acquire lucrative real estate assets.

And, contrary to popular belief, you don’t need to start an LLC when partnering with your IRA to purchase real estate. You can also partner with non-disqualified persons to your IRA such as your siblings or cousins to set up a more flexible investment plan.

Best practices for Real Estate IRA investing

How to manage your Real Estate IRA Investments

For those with a penchant for real estate investing, IRAs are a potent vehicle indeed. Outside of a tax-advantaged account, such as an IRA or a SEP IRA, rental income is taxable every year, as you receive it, and passive activity rules restrict your ability to claim losses from real estate. If you use a self-directed IRA, or a real estate IRA, however, you can accumulate all that rental income tax-deferred, or tax-free if you hold the asset in a Roth IRA. If you have the patience, liquidity and know-how to be a successful real estate investor, it can make perfect sense to leverage these skills in a self-directed IRA or other retirement account as well.

That said, there are some things that you need to be aware of that are unique to using an IRA or other retirement account for real estate investing, because if you don’t comply with certain rules and regulations, you risk exposing yourself to unintended penalties and taxes.

Watch Your Cash Flows

Paying attention to cash flow is critical with real estate IRA investing. Remember, the law limits the amount of new money you can contribute to an IRA each year to $5,000 (or $6,000 if you are over age 50.) As any veteran property owner knows, property repairs and renovations can easily exceed many times this amount.

This means you can’t intervene in your IRA-owned property with a massive cash infusion from outside your retirement accounts, no matter how badly your property needs the repairs. For anything over the max $5,000 annual contribution, you will need to pay for it from liquidity you have in the IRA itself, roll the money over from another eligible retirement account, or have your IRA borrow the money.

For this reason, it’s generally best to have some liquid reserves – cash, cash equivalents, reasonably stable securities, or a line of credit your IRA can tap for this purpose. Your checking account won’t do you much good when you have to pay for a $30,000 roof.

Set Aside Cash in Your IRA

Outside of an IRA, the tax code provides a natural means for investment property owners to set aside some reserves. This is part of the logic of depreciation deductions – you’re supposed to set aside the savings to pay for expected repairs, maintenance, upkeep and eventual replacement. But you don’t get a depreciation deduction in an IRA. You need to set aside reserves from operating income within your IRA or be prepared to transfer assets from elsewhere.

Understand Prohibited Transactions

Remember, you can’t lend money to your IRA personally. If your IRA needs to raise cash in a hurry, you can’t be the person to provide it, beyond allowable contributions and rollovers. The same applies to your descendants, your parents and grandparents, and any of their spouses. Ditto for any business entities they control. (The law does not specifically rule out your brothers and sisters, though).

The same people who can’t lend to your IRA also can’t borrow from it, for the same reason (though you can use your self-directed IRA to lend money at interest to whomever else you like.)

Likewise, you can’t do business directly with your IRA, nor can any other disqualified individuals, nor can their spouses or any business entities they control. Some people try to open a property management company, or construction company, and have their IRAs compensate their companies directly for services rendered. This is prohibited by the IRS.

Understand Long-Term Tax Ramifications

If you hold a real estate investment outside a retirement account, and sell it at a profit, you pay tax at capital gain rates. If you held it for more than a year, your capital gain tax will be less than your income tax. However, if you hold the property in a tax-deferred retirement account, you will need to eventually pay income taxes on any gains, rather than the lower long-term capital gains rate. To avoid this, consider using a Roth IRA to hold real estate or capital assets in an IRA. You don’t get a current year tax deduction, and you can’t take depreciation deductions in either case. But any gains are tax free. Additionally, you sidestep the eventual problem of taking required minimum distributions when you get older, which can be a challenge if your retirement portfolio is in illiquid holdings such as real estate.

Don’t Stay in the Property

Ordinarily, rental properties allow you to spend a couple of weeks per year in them without jeopardizing their status as investment properties. This is not true for IRA-owned real estate. You can’t live in the property, even if you’re paying rent. You can’t even stay overnight in the property. What’s more, you can’t let your children, grandchildren, parents, grandparents, or their spouses stay overnight either. If you do, the IRS could consider it a distribution, and impose a tax equal to 100 percent of the amount involved.

Be Careful With Borrowing

Many people are confused by IRS prohibitions on lending to or borrowing from your IRA personally, or pledging your IRA as collateral for a loan, and think that you cannot borrow money for your IRA at all. In fact, your IRA can borrow money. But understand that it’s your IRA that’s borrowing the money – not you. This distinction is crucial. Your IRA can only borrow money from non-disqualified individuals and entities on a non-recourse basis. This means that if the loan should default, the lender can only come after the IRA to collect. Only assets held within the IRA can serve as collateral for the loan. You cannot pledge anything outside the IRA as collateral, nor sign a personal guarantee of any kind.

Beware of Taxes

Taxes? In an IRA? Alas, yes. While your IRA can defer income tax and is generally exempt from capital gains tax, you still have to pay property taxes if you own real estate in your IRA. Additionally, if your IRA employs leverage – as is common for real estate investing – your IRA may be subject to unrelated debt income tax, or unrelated business income tax, depending on the situation. New Directions IRA does not give tax advice, so you should retain the services of a qualified tax advisor, such as a CPA, tax attorney or enrolled agent, for advice specific to your situation.

5 little known facts about Real Estate IRA investing

1. An IRA can secure a loan in order purchase an asset. If you have a property in mind but don’t have the funds in your account to purchase it outright, the IRA may be able to secure a non-recourse loan. Keep in mind that not all lenders make this type of loan, and, because the lender cannot rely on personal assets as collateral, it is common for them to require a down payment of 30% to 40%. Also, an asset secured using a loan may be subject to Unrelated Business Income Tax (UBIT). This may sound like a negative, but needing to pay UBIT means that the investment is making money.

2. Real Estate has always been an allowable asset in an IRA. This fact, however, is not widely known. In fact, the IRS received so many inquiries, IRS.gov issued this statement, “…IRA law does not prohibit investing in real estate, but trustees are not required to offer real estate as an option.” Because IRA providers are not required to offer real estate, it is up to the IRA holder to establish an account with a provider that will perform the administration and bookkeeping necessary for that asset.

3. While an IRA holder can provide brain power for his/her Self-Directed IRA, he/she is not allowed to perform physical services for the real estate assets the IRA owns. It is relatively well known that an IRA holder can’t live in real estate that his/her IRA owns, it is less well known that sweat equity is not allowed. Many people would like to be able to have their IRA purchase a rental property and then act as the property manager, including making repairs and performing maintenance. Unfortunately, the IRA holder can only contribute some brain power/strategy to the operation of an IRA-held property. When the IRA holder goes over to the property to paint a room, do some light plumbing, or some other physical service, he/she is stepping into a prohibited activity.

4. An IRA can partner with other investors, with other IRAs, or even with the IRA holder’s personal funds to purchase an asset. In this scenario, the IRA purchases a percentage of the asset and the partners purchase the balance. It is important to note that all income and expenses need to be divided along the percentage of ownership lines. For example, if in a partnership, the IRA buys 50% of an apartment building, then 50% of all of the income and expenses come to and are disbursed from the IRA. So, if your IRA does not have enough money to purchase 100% of a real estate asset, and you don’t want your IRA to secure a loan, it may be a good idea to think about using a partnership to acquire the asset you want.

5. A real estate asset held in a traditional IRA does not have to be sold in order to be distributed to the IRA holder. While it is certainly allowable for an IRA to sell a property and then distribute the proceeds, there is another alternative. The physical asset itself can be distributed, with the obligatory tax on its value. In addition to a complete distribution of the asset, a percentage of a property can be distributed in a given year. The way that works is that the real estate is re-titled to reflect a new percentage of ownership between the IRA and the IRA holder. The IRA holder would then pay the taxes on the value of the percentage distributed in that year. In this manner, the tax burden could be spread out over a period of years while still holding on to the physical property.

Real Estate IRA: How the IRS treats Prohibited Transactions

When it comes to owning real estate assets in an IRA, it may be tempting to live in the property or work on the property before it is distributed out of the IRA. However, these are prohibited by the IRS and can result in steep penalties and a distribution of the account.

At New Direction IRA, we hear a lot of questions from investors asking what they can and can’t do with their IRA property according to IRS rules. Here’s a few of those questions and some basics about how the IRS treats prohibited transactions within real estate IRAs.

The Basics

IRS audits are extremely thorough. If you break a rule and your IRA is audited, you’re affairs better be in order. The penalties can be extremely damaging to an IRA. On top of that, unlike within our Judicial System, the accused is guilty until proven innocent – not the other way around. The burden of proving innocence falls on the accused taxpayer.

The IRA prohibited transaction rules can be found section 4975 of the IRS code. In respect to buying real estate within an IRA, you (and your direct lineal relatives) cannot use the asset that your IRA owns. Additionally, your IRA cannot have transactions (buy/sell) with you or your direct lineal relatives. If your IRA owns a property, there is no way for you to use the property or benefit from the property in any capacity. 

Likewise, if you own an asset personally there is no way to move it into your tax-deferred IRA.

“How would the IRS know if I use the property?”

SDIRA administrators and providers can help account holders avoid prohibited transactions, but their purpose isn’t to babysit investors and make sure they follow the rules. If your IRA owns real estate and you haven’t distributed that real estate, you cannot live in or physically work on that property. It is prohibited to do so and could result in the distribution of that asset.

The IRS is not likely to monitor an IRA holder’s investments, so the agency relies on administrators to report prohibited transactions. At New Direction IRA, we won’t process a prohibited transaction and illegal distributions are reported to the IRS so they can be properly taxed and penalized. And, if your IRA is audited, the IRS may be able to determine if you lived in or worked on the property.

“What if I sell my personally owned property to my friend and then buy it back with my IRA? How would the IRS ever know?”

Buying the property with your IRA from your friend is not directly a prohibited transaction; however, the arrangement of selling something you own to the friend and then buying back with the IRA is most definitely a prohibited transaction.

The IRS doesn’t just look at transactions on paper, they also look at the circumstances involved. The IRS has seen just about anything an investor could propose or scheme. They can recognize these prohibited structures and declare them as a prohibited transactions.

Other investors suggest using an LLC to get around the IRS rules. LLCs can sometimes be useful in structuring real estate investment. However, they are not magical entities that make all the rules disappear. If your IRA invests in an LLC, then the rules apply to the IRA now apply to the LLC as well, but now the onus is on you to maintain proper bookkeeping for the account in case of an audit.

Penalties

The penalties for prohibited transactions can be extremely harsh. Each case is judged on a case by case basis. An IRA that committed a prohibited transaction will almost certainly lose its tax-deferred status (the IRA would be immediately distributed to the account holder). This can create an unexpected tax liability as well as penalties if the account holder is under the age of 59.5. On top of that, the IRS will most likely impose a 15% prohibited transaction penalty. There have been extreme cases when the prohibited transaction resulted in 100% loss of the IRA. Prohibited transactions are not to be taken lightly.

The bottom line: your IRA receives special tax treatment from the IRS. IRAs have built in tax-deferred growth. In order to maintain that treatment, it is important that the IRA investments are just that--investments. If you want to use the IRA funds or benefit from the IRA funds then you should take a distribution, pay the tax and then do whatever you like with the funds. However, while they remain in the IRA you (and your direct lineal family members) should not benefit from what the IRA is doing.

Step-up in basis of Real Estate IRA assets

Question: If I die before the sale of my investment property, will my heir be able to benefit from step-up in basis and pay fewer taxes?

Step up in basis at death is not available for a Traditional IRA’s assets, including any real estate it owns.  Normally, if you die before the sale of investment property, your heirs would get a step-up in basis, meaning they could sell it immediately and pay no tax. If it is in an IRA, there is no step-up in basis and they would pay taxes on the amounts distributed from the IRA at their ordinary tax rate.

However, the goal for any retirement plan is to maximize its value.  If real estate assets achieve a higher return than any other investment available, then that should be the investment of choice.  

Alternatively, this issue can be solved by converting the Traditional IRA to a Roth IRA.

Step up basis is not a concern for Roth IRA owners who invest their IRA in Real Estate because their taxes will have already been paid, either in the year of contribution to the Roth or at the time of conversion from Traditional to Roth. Plus, those benefits pass to the beneficiaries of the account.

The recent relaxation of Roth conversion rules has led to a surge of account holders electing to pre-pay their future income retirement income tax by converting from Traditional to Roth IRAs. This legislation is beneficial to investors who believe they will pay fewer taxes by converting their IRA now than they will upon distributing their Traditional IRAs at retirement age.

Like all investments, due diligence is required to decide what will work best for your IRA and its investments. New Direction IRA can help with the administration and bookkeeping of your IRA, and will ensure your transactions and/or conversions are done according to IRS code.

Browse our website for more answers to the most common questions and concerns about self-directed IRAs. New Direction IRA is committed to providing you with the best education so you can self-direct your IRA successfully.

Real Estate IRA Valuation

Question: Do I have to get my IRA-owned real estate appraised every year and how much will that cost?

If you own real estate property, you have to submit a valuation to your administrator every year to ensure proper tax reporting by your IRA administrator. A fair market valuation is used to establish or change the value of a real estate holding.  All IRA custodians are required to provide a year-end value for IRA accounts. A qualified real estate professional who is not a disqualified person to your IRA may provide a comparative market analysis to meet this requirement. 

When you reach retirement age, the IRS requires you to start taking Required Minimum Distributions (RMDs) from your IRA. The RMD amount is based on the value of your IRA assets as of Dec. 31 of the previous year.

Formal appraisals for the annual valuation are generally expensive and they aren’t required, though they are acceptable. You can instead get a valuation which is usually much cheaper, and sometimes free.  Although an appraisal is a valuation, they are not one and the same. We understand that real estate agents may not provide appraisals, but they are qualified to determine the market value of a property.

Like all investments, due diligence is required to decide what will work best for your IRA and its investments. New Direction IRA can help with the administration and bookkeeping of your IRA, and will ensure your transactions and/or conversions are done according to IRS code.

Browse our website for more answers to the most common questions and concerns about self-directed IRAs. New Direction IRA is committed to providing you with the best education so you can self-direct your IRA successfully.