Real Estate IRA Investing FAQ

Can I buy real estate in my Retirement Plan?

Yes, the IRS actually places very few limits on what you may buy with your IRA retirement funds. It is your IRA custodian who has put those limits on your retirement account. Truly self-directed IRAs allow you, the investor, to choose your investments.

Can I borrow funds to buy real estate in my IRA? Can my IRA get a mortgage?

IRAs can invest in all types of real estate!

Yes, many banks have discovered the demand by IRA owners to finance real estate purchases in their IRAs. Banks continue to develop products specifically for IRAs and other plans. You’ll need a non-recourse loan, which tend to have higher down payment requirements than those for personal homes, but these loan types are available at many banks.

Do I need an LLC to purchase real estate with my IRA?

An LLC may be used to purchase real estate, but it is not required. Your IRA can purchase a property in the very same way as you would personally. This is the most common way real estate is purchased and in this situation the property is simply titled to your IRA.
 
Do I need to use a special broker and title company?

No special broker or title company are required—you can use the same ones you used to buy your current home or any other broker. However, using a broker that is familiar with this process may be helpful buy it is not required.
 
Can I repair the property myself?

You may not personally do any work on the property and neither can any other disqualified persons (IRA holder, his spouse, his parents and grandparents, children and grandchildren, their spouses, certain fiduciaries and any entity owned or operated by a disqualified person. Work can be done by anyone else and you still have control over what you want them to do. For instance, you can’t personally paint the walls but you can tell the painter how you want the house painted.
 
Can I partner my IRA with my personal funds? Who else can I partner with?

If you cannot afford the investment property you are interested in you have many options. One option is to partner with yourself. For example your IRA can own 50% and you can personally own 50% (note: even if you personally own 99% of the property you are still prohibited from living in it or using the property.) You may also partner with someone else’s personal or IRA funds; the disqualified persons rule does not apply here so you may partner with your spouse, parent, child, friend, or whomever. There is no limit to how many people you can partner with. The percent of ownership cannot be changed once the investment is made.
 
Do I have to pay capital gains taxes if I sell the property?

Because the property is owned within a tax deferred (Traditional IRA) or tax free (ROTH IRA) plan no capital gains taxes need to be paid.

Can I take property as a distribution and then live in it?

Yes, after you reach 59.5 years of age you may choose to take the property as a distribution from your IRA. Once the property is 100 percent in your possession, you are free to use the property as you wish.

Can I be the property manager for my IRA-owned real estate?

Many self-directed investors who call our office ask, “Can I act as the property manager for my IRA owned real estate?” The answer is yes, but there are several rules that must be followed in order to comply with IRS guidelines.

1. Do not handle the finances of your IRA owned real estate personally.

Example: Pay bills or expenses out of pocket, have rent checks made out to you personally, etc.

Facts: When investing in real estate with your IRA, you are not the investor. The IRA (a legal entity) is the real investor and title to the real estate is most likely held in the name of the IRA (Example: NDIRA, Inc. FBO Client Name IRA). This is a tough concept for some investors to grasp because it can be difficult to conceptualize who is really investing.

2. You are allowed to be the decision-maker.

Example: Selecting contractors, choosing fixtures, screening tenants, etc.

Facts: You are ultimately the decision-maker for all investment related decisions. However, IRS code prohibits you from personally adding sweat equity to the property. This means that you are not permitted to perform repairs or upgrades; they must be done by a non-disqualified person and paid for by the IRA. To the IRS, value-added services that are personally rendered constitute a contribution that cannot be taxed and are therefore disallowed. The bottom line is that your IRA must have access to an adequate cash buffer necessary to pay all expenses related to the property.

3. A disqualified person or entity cannot be hired by the IRA to manage the property.

Example: IRA Holder says, “Well, since I can’t personally manage the property for a fee, can the IRA pay a property management company that I own and manage myself?”

Facts: The short explanation here is that your IRA cannot employ an entity that is managed or controlled by you or your direct lineal ascendants or descendants. The IRS logic here is to keep all IRA transactions completely arms-length and not co-mingled with any personal benefit. To truly understand this rule, you need to continue reading more about “Disqualified Persons” under Section 4975 of the Internal Revenue Code.

4. You cannot take a personal commission as a real estate professional for brokering your IRA’s real estate transaction.

Example: As a real estate agent by profession, you’d like to help yourself by brokering the transaction and taking the commission for the deal.

Facts: As mentioned above, IRA transactions need to be made as arms-length investments, separate from any personal benefit. You are not permitted to immediately benefit from your IRA investments; rather, you are investing for the future. You can negotiate a change in the purchase price of the property that may reflect your services, but you may not take a commission personally.

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.

Real Estate IRA Tax Rates

Question: When you receive an IRA distribution of cash that was made from the sale of real estate, it is taxed at ordinary income tax rates. Isn’t this rate much higher than the capital gains rate you would pay on the sale of real estate outside of the IRA?

Yes, Traditional IRAs give you a tax deduction for contributions and you pay taxes on distributions. Both are at ordinary income rates which are higher than capital gains rates. This is true for any IRA asset, not just real estate.  Even if your IRA invested in securities like stocks and mutual funds instead of real estate, distributions of any gains will be taxed ordinary income tax rates.

If your goal is to minimize taxes at distribution you may wish to convert your existing Traditional IRA to a Roth IRA.  Distributions from Roth IRAs are generally tax-free.  Conversion may be done at any time; income tax at ordinary income will be due on the converted amount. Many investors feel the Roth IRA is a much better long term plan as the taxes are effectively prepaid on the money.  Both contributions and the income and profits are withdrawn tax free.

Recently, much of the appeal of real estate investing is the positive cash flow it can generate. For IRAs owning real estate, generating income can make it an attractive option even without the potential for appreciation. The tax your IRA may incur at the end of an investment is only one factor to consider. Smart investors can generate significant revenue from rent. Cap rates of 4 to 10% are not uncommon and, when compared to returns from other assets, can be very enticing for investors in today’s economy.

In many cases, income generated from real estate assets can cover any Required Minimum Distributions (RMDs) required for Traditional IRAs at age 70 ½ .

Remember, the point of owning real estate or any asset in an IRA is to increase the total value of your IRA.

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.

Can I live in my Real Estate IRA property?

Question: Is it true I can’t live in or vacation in my IRA-owned real estate?

Benefiting personally from any asset owned by your IRA is prohibited by the IRS. It’s called self-dealing. Furthermore, you can’t let any of your lineal relatives benefit from the asset either; this includes your parents, grandparents, children, grandchildren, spouse and fiduciaries. None of you can live in or lease or vacation in real estate owned by your IRA.

Additionally, you can’t put any personal funds or sweat-equity into the property. New Direction spends the majority of its educational efforts on the rules regarding self-dealing.  Unlike having your IRA own shares of IBM or some other security, the temptation and ability to influence a real estate asset is very real.  Using personal funds or time (“sweat equity”) to benefit the property is strictly prohibited.

Think of it this way: Your IRA is taking advantage of IRS rules that allow it to grow tax-free or tax-deferred. The assets that you purchase with your IRA are not yours, and shouldn’t be viewed as such. We tell our clients that they should think of the IRA as a separate entity (we call it Uncle IRA to illustrate this separation). 

The client’s job is to make good decisions related to the investment, but not have transactions with Uncle IRA or his assets.  These rules are the same for any asset owned by the IRA, but like we mentioned, the temptation to influence real estate owned by your IRA is much greater than other assets. 

When it comes time to distribute the asset, you can certainly take it out of your IRA and live in it then.  It becomes your personal property after distribution. Smart investors will have maximized the investment before then, however, by renting it to tenants or buying property that has increased in value over the years.

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 we receive. New Direction IRA is committed to providing you with the best education so you can self-direct your IRA successfully.

How to manage a Real Estate IRA

Question: How do I manage expenses and cash flow in an IRA, particularly when I reach retirement age and have to take Required Minimum Distributions (RMDs)?

Planning for investment cash flow needs is critical for any investment strategy, particularly illiquid assets like real estate. Annual contribution limits vary from over $50,000 with 401k and SEP-IRA plans down to $3,150 for Health Savings Accounts (all of these plans may be self-directed and are available at New Direction IRA.) The investor needs to determine how much cash will be needed and how much will be available.

When you reach retirement age, you need to take RMDs. This is sometimes tricky for people who only have real estate in their IRA—they’re faced with the prospect of distributing a massive asset, which may incur a lot of tax, to meet the RMD requirements.

Many of our clients choose to own more liquid assets in addition to real estate, such as cash, securities or other alternative assets. Clients also sometimes set up a reserve for unexpected expenses. This allows them to be more flexible, particularly when it comes time to distribute their assets yearly. It is also possible to take incremental “in-kind” distributions of the property itself to satisfy the RMD requirement. This is done by re-titling the real estate each year showing an increasing personal ownership. Although this option may seem complicated it is done.

In addition, real estate is unique in that it can generate cash flow for your IRA. By renting the property to tenants, some clients can generate enough income to offset their RMD requirements.  

Don’t forget that RMDs apply to Traditional IRAs and regardless of what type of asset you hold, it’s only smart to have a plan for how to accommodate these distribution requirements.

If you come across a situation where your IRA cannot afford any incurred expenses, then you should make plans to sell it, bring in other investors, liquidate other assets or make contributions. It is important that you only use IRA funds for all expenses associated with the property including taxes, repairs and insurance. You are not allowed to use personal funds to cover these costs; if you do, your IRA may be disqualified by the IRS.

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 we receive. NewDirection IRA is committed to providing you with the best education so you can self-direct your IRA successfully.