New Direction CEO Bill Humphrey Talks Real Estate Investing for Retirement on RE/MAX of Boulder Podcast

Patricia McCrystal

July 14, 2015

Monday, July 13^th 2015 – In a podcast hosted by RE/MAX of Boulder, New Direction IRA’s CEO Bill Humphrey gave a rundown of the history of self-directed IRAs, and the benefits investors can glean from real estate investing for retirement. Podcast host Duane Duggan is a Broker Associate with Boulder Property Network, and was one of the attendees at New Direction IRA’s very first public continuing education meeting in Denver back in 2003. There was a familiar air between Humphrey and Duggan that allowed dialogue to flow easily and remain accessible for viewers and listeners of all knowledge bases.

Left to Right: Duane Duggan and Bill Humphrey

Duggan kicked off the podcast with a nod to New Direction’s growth since its conception in 2003, as the company now boasts $1.14 billion in account assets under its roof. Humphrey explained this number is indicative of self-directed IRA account growth in general, as more investors become disenchanted with the securities market and seek to invest their retirement savings into a more tangible asset market that they know and understand – such as real estate. In fact, Humphrey pointed out, “self-directed IRAs are the fastest growing segment of the retirement industry as a whole”.

So what kind of IRA does one need to take advantage of real estate investing for retirement? One that you’re in control of (Humphrey). Employer-provided retirement accounts such as 401(k)s typically only allow for securities investments. However, a Traditional IRA, Roth IRA, SEP IRA, SIMPLE IRA, Individual 401(k) and Checkbook IRA can be self-directed. With a self-directed IRA, investors can capitalize on their personal knowledge and experience of the real estate market to purchase real estate, fund fix-and-flip projects, purchase notes, deeds, and partner with other IRA accounts to finance a real estate purchase. You can even use self-directed Health Savings Account (HSA) to invest in real estate.

“Real Estate investors are finding that the IRS doesn’t define what account holders can invest in,” Humphrey explained, “the IRA administrator does.” In other words, the scope of investments your IRA is legally allowed to make is nearly limitless – the only investing limits an account holder may run up against are those exacted by the account administrator. A self-directed IRA administrator like New Direction IRA specializes in the bookkeeping for alternative asset investing so that account holders can invest in anything they desire, as long as it follows IRS guidelines (no life insurance or collectibles). “Any investment you’ve ever made is probably one that you can make through your IRA” (Humphrey). In fact, New Direction IRA was conceived because Co-founder and President Catherine Wynne was interested in investing retirement funds in real estate, and believed there should be a better market for self-directed IRA administrators.

What are the advantages of investing IRA money? Humphrey explained that the IRS made a deal with IRA holders – you can save money in your account and watch your IRA’s real estate investments grow on a tax deferred basis, as long as you as the account holder (along with other disqualified persons) don’t directly benefit from the funds or assets while they’re in the account. Once the account holder reaches legal distribution age, they can access their tax-deferred funds and/or take possession of their assets as a distribution.

“One of the aspects that turns real estate investors to self-directed IRAs is the spectacular market growth" (Humphrey). Your IRA can buy real estate and take advantage of market appreciation – something many Coloradans (particularly those living in the Boulder area for the past 20 years) can appreciate. Tenants from rental properties can send cash directly to your IRA account, which you can direct New Direction to either save in your account, or put toward more investments for your IRA. As far as depreciation goes, your IRA can benefit from depreciation as long as the property is debt leveraged. However, depreciation will not effect your personal finances, because the IRA owns the property, not the IRA account owner.

What is New Direction IRA’s role as a self-directed IRA administrator? New Direction does all the bookkeeping and administrative services for your IRA that is required by the IRS in order to keep a buffer between the IRA account holder and the IRA’s funds/assets. Because your IRA is the owner of all real estate investments made with the IRA funds, New Direction signs all contracts on behalf of your IRA, and sends checks from your account at the direction of the account holder. New Direction does not endorse or recommend any assets or asset providers: “We’re not here to tell people to not buy ocean front property in Arizona,” Humphrey joked, “we’re just here to make sure the paperwork is done right.”

You can watch the full podcast on Boulder Property Network’s YouTube site, and read RE/MAX of Boulder's blog about the podcast here. Visit New Direction IRA.com to learn more about how to start investing in real estate with your self-directed IRA today!

Become a First-Time Homeowner, Thanks to Your IRA (Even if You’ve Owned a Home Before)

Patricia McCrystal

July 10th, 2015

There’s no time like this summer to buy your first home. The market is booming, and you’re ready to stop shelling out cash to your landlord and invest in a long-term asset that will belong to you. Plus, you’ll finally be able to paint the walls!

If you have a Traditional IRA account, you may be able to use your retirement funds to finance the down payment of your first home. The distribution age of your Traditional IRA account normally isn’t until you reach 59.5 years of age; withdrawing assets or capital gains before that age can result in taxation and a substantial penalty.

However, IRA account owners are permitted to withdraw money before distribution age, penalty-free, in certain circumstances – in this case, IRA owners can withdraw up to $10,000 for qualified acquisition costs on a home, without paying the 10 percent penalty for early distribution. Qualified acquisition costs generally cover buying, building, or rebuilding your first home, as well as funding most settlement, financing and closing costs.

Since all contributions into your Traditional IRA account are deposited “pre-tax”, you will have to pay ordinary income taxes on the money you take as a distribution. This could potentially bump you up into a higher tax bracket. Additionally, you will no longer benefit from the compounding interest on your account’s lump sum.

Despite these caveats, there are more perks involved with this exemption: you can take distributions from your IRA account for home buyers other than yourself, including persons who are otherwise disqualified to interact with or benefit from your Traditional IRA in any way. Your distributions can be used to cover home buying/building expenses for your children, grandchildren, spouse, parents, mother in law, etc.

Additionally, you can qualify as a first-time home buyer even if you’ve owned a home before. As long as you haven’t owned a home dating back two years prior to (what will be) the closing date of your new home, according to the IRS you’re technically a first-time home buyer.

Using your Traditional IRA account to finance your first home (or in some cases, your second) can be a fabulous perk to regularly and sensibly investing in your IRA. Consult with your trusted financial adviser to weigh the costs and benefits of taking an early distribution to fund your first home. And as always, happy investing!

Titling Your IRA Real Estate Investment: Avoid Missteps to Save Time & Money

To Enjoy IRA Real Estate Tax Benefits, be Mindful of Costly Titling Mistakes.

Patricia McCrystal

June 25, 2015

That modest country cabin nestled down by the lake at your favorite vacation spot has finally been put on the market. It’s a regular fixer-upper, but you know a little love and hard work could transform the property into a beautiful modern getaway for renters year-round.

You plan to use your self-directed IRA to fund the investment so you can enjoy future gains on a tax-deferred basis. You understand this means you (and your family members who count as disqualified persons) will not be able to stay in the lake house; at least not unless you decide to keep the property after you reach the distribution age of your IRA account (for a Traditional and Roth IRA, that’s age 59.5), in addition to paying taxes on the property at distribution.

You contact your self-directed IRA administrator, New Direction IRA, to inform your client representative about your exciting investment opportunity, and to learn more about IRA real estate tax benefits. Although no disqualified people are allowed to be directly involved in the renovation process of the property, you have a friend from college who owns and operates a construction company who you think will be a perfect fit for the job.

In this fast paced market, you need to act soon before you’re outbid. But before you start signing papers, there are specific investment-titling rules that all real estate investors should keep at the forefront of their minds before initiating any transactions. Remaining conscious of the following guidelines will help you avoid common missteps and save yourself a lot of time and money when using your self-directed IRA to invest in real estate.

To start off, your self-directed IRA account must be opened and funded before a transaction can be initiated. You can fund the account with either a transfer, rollover, and/or a contribution. 

Always remember:  you and your IRA are NOT the same thing. Your IRA is a completely separate legal entity from you and your personal finances. By extension, you cannot pay any of the IRA’s expenses, and you cannot sign on behalf of your IRA.

When investing with retirement funds, all paperwork for that investment must reference the IRA as the buyer, not the IRA holder (you) as the buyer. If a form needs a signature, you should write “Read & Approved” in the margins, and then sign next to or beneath this note (also in the margins). You will then upload/email/fax the form to New Direction IRA, who will sign as the buyer or investor of the property. NDIRA also accepts e-signatures from companies like DocuSign and Adobe.

New Direction cannot fund your investment if these guidelines are not followed, and the investment ends up being titled under your personal name and/or social security number. You are a disqualified person, therefore trying to transfer the title of a contract from you to your IRA is a prohibited transaction. Once this mistake occurs, there is no way to change the titling from your name to your IRA, so be diligent in following the proper procedures for IRA investment-titling.

The IRA may partner with another person, entity, or IRA. In partnering, your IRA would own 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 restrictions apply. See NDIRA's website for more details.

When partnering with disqualified persons, the ownership percentage must be kept constant throughout the life of the investment. All expenses and income must be split according to that ownership ratio, and each bill must be paid according to that ratio as well.

Unrelated Business Income Tax (UBIT) applies to profits made as a result of using leverage (loans) to invest in your property. It is your responsibility to calculate, report and pay this tax. However, your CPA or tax preparer may be able to help with the calculation. (Our sister company, IRA Tax Services, can assist as well. Visit www.irataxservices.com for more information on UBIT.)

There are no restrictions on the types of real estate you invest in, where the property is located, or the price and/or market value of the property. In order to have sufficient time for required compliance review and processing, New Direction IRA needs to have all completed paperwork 3 full business days prior to funding.

Although these guidelines are a great introduction into the procedures every investor must follow when investing in real estate with their self-directed IRA, they are far from exhaustive. A complete comprehensive guide to these policies and more details about IRA real estate tax benefits can be found on New Direction IRA’s website. Happy investing!

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.

Land in an IRA

More and more investors have been turning to real estate as a way to diversify their retirement portfolios.  Everything from pre-construction condominiums and rental properties to rehabs and lease options are being held inside of IRAs and 401(k) plans. With larger contribution limits and more than $3 trillion currently in retirement plans, investors are now able to look outside the realm of stocks and mutual funds into assets such as real property. Though investors continue to become more sophisticated in their real estate transactions, undeveloped land remains a clear-cut favorite among IRAs and other retirement plans. The simplicity of raw land provides investors with the opportunity to diversify into real estate, without the headaches of upkeep. 

The obvious upside to adding real property to a retirement plan is diversification.  Real estate has long provided investors a way to offset fluctuations in the securities market.  Over the years, millions of investors have utilized this diversification strategy in their personal portfolios, yet only recently have they started implementing this method within their retirement plans.  One of the reasons why less than 3% of all retirement funds are being invested in real property is the “idea” that managing the asset is difficult.  An attractive attribute to land, is its simplicity.   Land truly provides investors with opportunity to take part in the real estate market, without the headaches of upkeep and unforeseen expenses. 

Keep in mind that when a retirement plan holds a piece of real property, all the expenses involved must be paid for by the plan. Simply put, if an IRA owns a rental property, then the IRA must pay for all of the repair and upkeep of that unit. Investors who self direct their retirement plans into assets like real estate will have to be more involved than those who just turn their accounts over to a Brokerage house. 

However, raw land offers a low maintenance way to invest in real estate.  Land has only one relatively predictable expense in annual property taxes. Of course you could lease out your land to a farmer or a timber company and there may be additional expenses.  But for most parcels of land, property taxes are the only expense.  An investor can diversify part of their retirement portfolio into a parcel of a land and not have to worry about any unexpected repairs or cost. 

Any economist or financial advisor will tell you appreciation is driven by supply and demand.  There is a simple truth when it comes to land—there is only so much. The supply is somewhat fixed, especially when it comes to desired land around mountains, waterways and growing metropolitans.

The goal of a retirement plan is to build up your own nest egg through wise investments.  Diversification is the key to any successful portfolio.  Understanding all of your investment choices will only make you a smarter investor.  When it comes to diversifying into real estate, raw land is about as close to a mutual fund as you will find.  It’s an asset that can be purchased and held for the long term, without the worry of unexpected repairs or expenses.  Whether it’s a lot in a planned development near Destin, Florida or a large track of farm land outside of Topeka, Kansas; land provides a simple way to diversify a stock heavy portfolio. 

Living in your IRA-owned real estate

“I have an IRA invested in Real Estate. Now how do I take that real estate to live in, when I’m retired?”

Hopefully, that rental property has served your retirement plan well, not only appreciating in value over time, but also providing regular monthly cash flows over a number of years.

But what if you’ve decided you really want to retire and live in that house?

If the house was purchased by your Roth IRA, and you’ve held the Roth IRA for 5 years and turned 59 ½, it’s yours to distribute to yourself, with no tax or penalties.

But what are your options if your real estate assets were held in a Traditional account?

Certainly, you can distribute the house once you’re 59 ½, without paying any premature withdrawal penalties. But you’ll have to pay taxes on the dollar amount (in this case, property value) of your withdrawal, as though that amount was some cash added to your income in the year you take it. Naturally, since we’re talking about thousands of dollars, this may be costly. However, you have a few options:

1) You can distribute your IRA’s holdings a little bit at a time.

For example, at age 59 ½, you could begin distributing 10% of the property from your IRA each year. If you distributed 10% in year one of such a program, this would result in the property being owned 90% by your IRA and now 10% share is owned by you. You’ll need to arrange with the title company so that the ownership share is properly reflected accordingly each year. You’ll still be constrained from using the property personally until it is entirely distributed from the IRA. This will allow you to spread the tax burden from distributions over a 10-year period.

Keep in mind, this will change your monthly cash flows. You will personally be entitled to a direct 10% of income and responsible for 10% of expenses. These proportions would need to be honored since there are now two investors: you and your IRA.

2) You could consider converting a portion of your IRA (including that real estate asset) to a Roth IRA.

Yes, you’ll pay income tax on the amount you convert, but this may make sense for you, if you anticipate a number of years more of income to sock away, and for your IRA’s value to grow, before reaching age 59 ½. The point here is you may be paying some tax now on a smaller amount, instead of paying tax on a potentially larger amount down the road at retirement.

You could also convert a fractional share from your IRA to a Roth IRA each year so that at some point in the future your Roth IRA owns the entire property. Then, if you’ve reached age 59 ½ with 5 years in that Roth IRA, it’s available to withdraw free from penalty or tax.

3) You may elect to begin distributing shares of your property before retirement age by using the 72T method.

The IRS grants the 72T method (substantially equal payments) as an exception, which enables one to avoid the penalty for early IRA withdrawals.

The 72T exception offers a choice of methods, which you can use to tailor the timeline of your distributions. All are based on your life expectancy (or, if you elect, on the joint life expectancy of you and your beneficiary), and whichever method you choose must be continued for at least 5 years or until reaching age 59 1/2.

How to help a cousin buy a home with your Real Estate IRA

One of our New Direction IRA client representatives recently spoke with a prospective client who asked us to frame some ways for his IRA to help a cousin buy a home. The cousin has a good job, but he wasn’t sure about his credit rating nor did he have the money for a down payment. We spent some time talking about the ways that IRAs can participate in real estate and the IRS rules associated with that participation. Below is an excerpt that was sent to the cousin to get the ball rolling. If you are in a similar situation, perhaps this may help you get your thoughts together.

Scenario 1 – My IRA buys the house (the property would literally be deeded to the IRA). It secures a non-recourse loan to do this. Typically, a lender will want 30-40% down. So our max purchase price would be about $150K I am guessing. You would pay rent to the IRA or we can set up a rent-to-own agreement. This set-up, depending on the purchase price might leave me with little cash; so, you may need to pay for any unexpected repairs, which of course, would come off the rent or be recognized in some way. The advantages to this method is that you would not have any initial cost and would not have to qualify for financing. And, you could buy my IRA out whenever it was feasible for you.

Scenario 2 – We buy the house as tenants-in-common. My IRA and you are the deed holders, each owning a percentage of the house. This can be kind of fluid but the basic idea might be that I put in the ~$50K, and you come up with the rest. If you need financing for your part, the collateral for the loan would have to be something other than the house. It would also be helpful for you to let me know what your exit strategy might be. In this set-up, I really just contribute the IRA money in exchange for a percentage ownership in the house, but from that point, pretty much all the financial burden would fall on you.

Scenario 3 – I can simply loan you the money that I have available and we can set up the rate, term, and such in a way that is financially possible for you. Like interest only for several years, with a balloon payment down the road or some such. This set-up would mean that you are the deed holder, and the financing would be whatever you can work out.

Because you are a non-disqualified person to my IRA, we have a good deal of flexibility in how we set this up. In part, it will come down to how you want to play it and what your financial options are. One thing that I will mention is that my IRA’s participation always needs to be titled as the IRA. The important thing is to not put just my name on an offer or any type of legal document.

As a point of clarification, disqualified persons to an IRA include the IRA holder, their spouse, and lineal ascendants and descendants (and their spouses). However, the sides of the family tree, siblings, aunts and uncles, cousins, etc. are not disqualified persons.

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.

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.