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.

Unrelated Business Income Tax (UBIT): What is it and Why you should embrace it

UBIT may be an indicator of investment profits

If there ever was a subject that will stop an accountant is his or her tracks it is UBIT, which stands for unrelated business income tax. Many investors shy away from certain IRA investments out of fear that UBIT will take out a big chunk of their earnings. But the truth is that these investors are misinformed about the tax.

To start, UBIT was initially placed on some taxpayers to “level the playing field” for certain businesses. The best example of how UBIT is used is for the competition between a non-profit and a for-profit enterprise. The college bookstore sells books to students and others within the structure of their “non-profit” umbrella. The college bookstore, because it is non-profit, is not taxed the same way as a for-profit enterprise. A non-profit does not pay taxes on most operations and therefore can afford to sell books at a lower cost than the for-profit store across the street. Since both the college bookstore and the for-profit bookstore are competing for the same customers, the college bookstore has the advantage of being treated differently for tax purposes and the advantage of this preferential tax treatment may allow the college bookstore to sell their books for less, thus attracting customers away from the for-profit store.

This is where UBIT comes into play. The government has placed a tax burden on the non-profit enterprise for running a business, i.e. selling books, under the main business of running a college. This same philosophy and set of rules is applied to an IRA’s investment in real estate when there is debt related to the purchase of that real estate. So what is bothering the accountants among us?

• The tax rate for UBIT is high, ranging from 26% to 34%.
• Calculation of this tax is, for those not familiar with the rules, complicated.

These issues are resolved, however, when the investor realizes that the tax allows for greater for overall gains because the account is allowed to use debt-leverage. A good Self-Directed IRA provider will be able to clear up any questions about calculating UBIT and make the process easy.

When debating the pros and cons of using leverage within an IRA to purchase an income property, the questions should never be “How do I avoid UBIT?” but rather “How much will the IRA grow using debt leverage and paying UBIT?” and “What is the resulting rate of return within my IRA?” The other due diligence items such as physical condition of the property as well as questions on the ability of the cash
stream to service the loan and pay expenses, including UBIT, should also be taken into consideration.

Dismissing an investment because of the potential payment of taxes should never be a deal killer. Consult with your legal and tax advisors regarding investments involving potential UBIT within your IRA.

For information or videos about UBIT and other self-directed IRA issues, visit www.newdirectionira.com.

Purchasing a vacation home with your IRA/401k plan

Summer vacations are the perfect time to find a dream home in the perfect location. Today’s investors sometimes need clever solutions for affordability, so it’s important to be aware of all of the available investment tools. One such tool is the self-directed IRA. Did you know that your IRA/401k funds can be used to buy real estate? Let’s look at some of the options available for purchasing a second home with IRA funds:

1.    Vacation home is purchased and held in a self-directed IRA for investment purposes only.

This scenario is the simplest. Existing IRA or 401k funds are used to fund the investment account. The IRA directly owns the property and receives special tax treatment by the IRS.

PROS:  If you love this home and this area, chances are others will too. Vacation homes in desirable locations can be valuable investments. The property may be rented out to vacationers and earned income grows tax-deferred or tax free in the IRA. Many investors also enjoy holding hard assets like real estate in addition to or instead of paper assets as part of their portfolio.

CONS:  You cannot personally use any real estate owned by your IRA account. This second home would be purely for investment purposes. The IRA must pay all expenses associated with the vacation home.

IMPORTANT CONSIDERATIONS:
Compare the return on investment for the vacation home, whether from rental or resale to the return on investments currently held by your retirement account. If cashflow and/or returns on the vacation home are higher, it is probably worth looking at the investment as a potential option for your IRA/401k plan. 

2.    Buy the property now and plan to live there after you retire.

Up to age 59 ½ this option would work identically to Option 1 above. At age 59 ½ you can elect to take a percentage (up to 100%) of ownership in the IRA-owned property in lieu of cash distributions from the IRA. Once you have distributed 100% ownership, you are permitted to use the property as a vacation or primary home.

PROS: Purchasing the property now protects your ability to own the property at retirement. As real estate in popular resort areas continues to rapidly rise, you will have locked in your price at today’s cost.

CONS:  This strategy requires patience. You cannot personally use the property until you have distributed 100% ownership after age 59 ½.

IMPORTANT CONSIDERATIONS:
Taking the property distributions can take time. Talk with your advisors and make sure that you are willing to wait the necessary time.


3.    Secure a mortgage using your IRA and make mortgage payments via IRA distributions using the 72t exemption, which eliminates the 10% early withdrawl penalty.

This scenario is the most complex and will require consulting with a team of professionals to execute properly.  Essentially, the IRA invests in an annuity or other investment with guaranteed payments or stable cashflow.  As money flows into the IRA account from the annuity or other investment, payments are received as a distribution (without penalty) by the IRA holder. These distributions are used to pay the mortgage on the second home, which is held directly by the individual, NOT by the IRA account. Contact our office for a follow-up consult or for a report on 72t exemptions or visit 72t.NewDirectionIRA.com

PROS: You can begin using the property immediately as it is owned directly by you. This strategy provides investment capital for investors with IRA balances that are larger than personal cash savings.

CONS: Investor must be 59 ½ or older in order to take advantage of a 72t exemption. Since the property is owned directly by you and not the IRA, you lose all of the tax advantages of IRA-owned properties.  As a result, taxes apply to the sale of the property as well as the rental income. Income tax is paid on the distributions used to pay the property mortgage.

IMPORTANT CONSIDERATIONS:
You must already have enough wealth to create the annuity providing guaranteed payouts substantial enough to pay the property mortgage.

Buying property using an IRA/401k not only provides critical investment capital, it also has associated tax advantages.

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.