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.

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.

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.