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Other Articles
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Real Estate Investment
How to Hold Real Estate In a Self-Directed IRA or Qualified Plan - Part 2
By Joe Maas, CLU, ChFC, CFP
Principal, Synergy Financial Management, LLC
Part II: Using Your IRA
For many years now, people have been using non-directly owned real estate in their IRAs
and other retirement plans. These intangibles are investments like REITs and real estate
mutual funds. But most people did not know that they could use their retirement plans to
purchase directly owned real estate such as raw land, commercial building, condos,
residential properties, empty lots, trust deeds, or real estate contracts.
In general, the internal revenue code (IRC) section 408 does not prohibit the holding of
real estate in an IRA, provided the transaction is not prohibited under IRC Section 4975.
Code section 4975 covers what transactions are prohibited between an IRA or retirement
plan and a “disqualified person.” Generally, “disqualified persons” are defined to be the
accountholder, other fiduciaries, certain family members, and businesses under the
accountholder’s control. In essence, the prohibited transaction rules prohibit an IRA or
qualified retirement plan from owning a piece of property which will be purchased from
or used personally by the accountholder, family members, or businesses under the
accountholder’s control. Simply put, the property must be used for investment purposes
only and cannot be used personally while maintained in the IRA. In addition, properties
that are individually owned outside of the IRA cannot be transferred or purchased by
one’s individual IRA.
Remember, the IRS will not let you use your IRA to purchase your home or a vacation
home. Nor will they let your business lease property from your IRA. Remember you
cannot have personal use or benefit from the property. If you did, it could cost you plenty
in taxes and penalties.
However, it may make sens e to take the property out of the IRA as a distribution and live
in it during retirement. Make sure not to move in until the distribution is complete. The
distribution would need to be at the current market value as of the date of distribution and
taxes would be due unless your account was a ROTH IRA. This may be a good reason to
convert your IRA to a ROTH. Furthe r, if you were under the age 59½, a 10% penalty
may also apply.
Example: Convert your IRA to a ROTH IRA and pay the income taxes now. Once the
conversion is complete, use your new ROTH IRA to purchase a residential rental
property in a location you may want to retire in. Rent the property until retirement. When
you are ready to retire, take the property out of the ROTH IRA as a tax-free distribution,
assuming you follow the rules, and then you may live in the property.
OK, for those of you who stopped reading and immediately called your basic IRA
provider so that you could get started investing in real estate right away, you probably
were told that you were not allowed to do so and now think I am crazy. So, now that you
are back, let’s find out how you go about doing this.
The first key step to investing tax-deferred or tax-exempt in real estate is to open a selfdirected
IRA with any one of the dozen or so independent IRA custodians that allow real
estate investments. Remember, just because it may be OK with the IRS does not mean
that your local bank, stockbroker, or insurance company with provide this service.
A self-directed IRA is simply an IRA where you are in control of your investment
options and are not limited to just stocks, bonds, mutual funds, and other traditional
securities. In a self-directed IRA, you have access to all of these traditional investments
plus real estate and even other alternative asset classes.
Because fees and other services may vary, it is a good idea to check out a few of the
independent IRA custodians to find the one that fits best with your needs.
Now that you know how to open an account, let’s discuss how to fund the account. In
2005, the IRA and ROTH contribution limits are $4,000 or $4,500 for individual over the
age of 50 and making catch up contributions. We all know that four or five thousand
dollars is not enough to buy a rental house, so how else can we fund the IRA?
One very popular way, if eligible, is to roll over your 401(k) plan into a new self-directed
IRA or use a self-directed 410(k) that is allowable by both the IRS and the IRA
custodian.
In many scenarios, the IRA holder will have sufficient funds to cover the real estate
purchase, but what if you find a great investment property for your IRA, something really
valuable, and your retirement account simply doesn’t have adequate funds? Luckily,
there are a number of ways in which you can make the purchase and still keep the
transaction both legal and profitable.
We will review three ways in which you may want to pursue real estate investing with
your IRA.
Loans
Tenancy- in-Common (TIC)
Limited Liability Companies (LLC)
Loans
Yes, you can use debt financing to purchase real estate in a self directed IRA. However,
to do so legally, you must use the IRA-purchased property, not the IRA itself, as security
for the loan. This type of permitted borrowing is called non-recourse lending. A nonrecourse
loan is not like the loan on your personal residence. In fact, it is very different.
Here unlike your home loan, if the loan isn’t paid back as promised, the lender may take
the IRA-owned property used to secure the debt, but may not take recourse against any
other of your assets. Because of its unique nature, not very many banks or lending
institution offer these types of loans, but they do exist, and your self-directed IRA
custodian may be able to point you in the right direction.
Like other loans, non-recourse loans do have a monthly payment and some type of
amortization schedule, which will need to be adhered to. Therefore, your IRA property
will need to be able to make the loan payments from its cash flow, its annual IRA
contributions (within the limits – $4000 or $4500 for 2005), or some combination of the
two. Simply put, you need to have more money coming into your IRA than is going out.
This also means that you need to have sufficient liquidity in your IRA for other real estate
related expense like property taxes, insurance, and other repairs and maintenance.
Remember, the IRA itself must pay all expenses.
Let’s look at a simple example:
| Loan Information: |
| Present Value of Loan |
$100,000 |
| Term (amortization period) |
30 year Fixed |
| Annual Interest Rate |
7% |
| Monthly Payment |
$665.30 |
| Annual Payment |
$7,983.62 |
| Taxes: |
Annual Property Tax |
$1,500 |
| Insurance: |
Annual Insurance Premium |
$400 |
Repairs and
Maintenance: |
Annual Repairs |
$150
|
Total Annual Cost of Property:
| Payment |
$ 7,983.62 |
| Taxes |
$ 1,500 |
| Insurance |
$ 400 |
| Repairs |
$ 150 |
| Total |
$ 10,033.62 |
The amount of $10,033.62 is the amount of money going out each year, and so your
property would need to have more than this amount coming in each year. So, for a person
under the age of 50, you could subtract the $4,000 annual IRA contribution from the
$10,033.62 annual expenses and you would need ($10,033.62-$4,000=$6,033.62)
$6,033.62of cash flow from the property.
In addition to annual operating expense, in accordance with Section 511 of the Internal
Revenue Code, if your IRA property has debt, or if a mortgage was incurred with its
acquisition, you must pay annual taxes on any income produced. This special tax is called
Unrelated Business Taxable Income (UBTI). Please note that this tax does not apply to
every property purchased with an IRA but only to those that have related debt. Here is an
example of how it works. Please be advised that I am not a CPA and that the following
calculations are for illustrative purposes only. I advise you seek tax advice from your
own CPA when it applies to your individual situation.
First, your income is taxed only after deductions are made for expenses and for other
items that are deductible. Then, the first $1,000 of your net income from the property is
not subject to tax.
Using our previous example you will remember that we had a loan of $100,000. Let’s
also say that you put down $100,000 so that the total purchase price was $200,000.
Finally, let’s say you found some good renters and your net income after expenses is
$1,500.
Since the first $1,000 is not subject to tax, only $500 will be used in the UBTI
calculation. ($1,500-$1,000=$500).
The tax is based on the relationship between the average amount of debt on the property
during the preceding twelve months and the property’s average tax basis. Here tax basis
is the purchase price, increased by improvements or decreased by depreciation, during the
same period.
In our example our ratio looks like this.
Debt: $100,000
Basis (purchase price): $200,000
Ratio equals: $100,000/$200,000= 50%
We then apply the ratio to the income that is subject to the UBTI tax.
$500 x 50% = $250
The $250 is then taxed at the current rate for trusts. The trust tax rates like other tax rates
are a moving number
.
Here we will use a trust tax rate of 37.5%.
$250 x 37.5% = $93.75
The $93.57 is your tax liability.
You should notice that as the debt is reduced, the UBTI tax is decreased proportionately.
Tenancy-in-Common (TIC)
For people who identify an attractive property that costs more money than they have in
their IRA or more than they can (or are comfortable) borrowing, then tenancy- incommon
may be a solution.
Tenancy- in-common is a form of concurrent ownership in which two or more persons
each have an undivided interest in the entire property, but no right of survivorship.
Because each person’s interest, or share, is undivided, each can sell his share at any time
without the consent or agreement of the others. So, how does this help you? Let go
through an example:
Let’s say tha t you and two of your friends find a good property to invest in, and that the
purchase price is $100,000. With a tenancy- in-common arrangement, you can buy the
property together, with each person putting in the amount of money he or she has
available. Each will own a certain percentage of the property, the income generated from
its operation, and, eventually, a percentage of the profits when the property is sold.
| Owners: |
Contribution amount |
% ownership |
| You |
$60,000 |
60% |
| Tom |
$20,000 |
20% |
| Rob |
$20,000 |
20% |
| Total |
$100,000 |
100% |
A tenancy- in-common arrangement also allows use of both IRA funds and non-IRA
discretionary funds to buy a single investment. It is not a requirement that the each of the
owners use the same type of funds as the others.
Here is what I mean:
| Owners: |
Contribution amount |
Contribution Type |
| You |
$60,000 |
50% IRA money/50% Cash |
| Tom |
$20,000 |
100% IRA money |
| Rob |
$20,000 |
100% Cash |
| Total |
$100,000 |
100% |
Your IRA has a current balance of $40,000 but you do not want to use the entire $40,000,
so you use $30,000 from your IRA and $30,000 from your bank account. Your total
contribution amount is $60,000, and you’re a 60% owner of the property.
Tom’s IRA has a current balance of $20,000. He is comfortable using the entire amount,
and he will fund future property expense inside the IRA with his annual IRA
contributions.
Finally, Rob does not own an IRA, so he will use some of his savings account to
contribute his $20,000.
The possibilities are endless.
Limited Liability Companies (LLC)
The limited liability company is another flexible option if your IRA does not provide
sufficient funds for the purchase, and neither loans nor tenancy- in-common ownership
provides a solution you are looking for.
I am going to skip the long version of what an LLC is and leave that to your attorney, but,
briefly defined, an LLC is a form of business entity that offers both limited liability for its
owners and certain tax benefits.
When using LLCs, it is similar to investing in a real estate investment trust (REIT) in that
your IRA may be invested in limited interests which is kind of like investing in shares of
stock. The difference here is that LLCs are private, and there are usually only a few
investors that are limited members and a developer that is the managing member.
Here is one way a LLC may be used.
You know a developer who is getting ready to start a new project in your local area. He
has used $1,000,000 of his own money to purchase the land and now is trying to raise
capital to develop the property. Once the project is finished and the condos are sold, he
expects to realize a large profit. He is willing to give up some of his profit in exchange
for the needed capital.
The name of his company is ABC Construction Company, LLC. After your attorney has
reviewed the proper agreements and you have done your due diligence, you may instruct
your self-directed IRA custodian to purchase the units of ABC Construction Company,
LLC that have been agreed upon with the developer.
This is a simple version, and there are many more detailed points to be considered and
understood when using LLCs; but I hope it gives you some food for thought.
Now we are ready to talk about how to actually purchase the property. When using your
IRA to purchase property, the steps in buying real estate are really no different than if
you were not using your IRA. There are a few things to be aware of, and we will review
them now.
The basic steps are:
The Purchase and Sales Agreement (the offer)
The Acceptance
The Inspection
The Closing
The purchase and sales agreement is where it all starts and is probably the most
important. Each self-directed IRA custodian will have their own set of rules and
procedures, so you need to review their real estate processing checklist well in advance of
actually making an offer.
You need to make sure that the purchase is made by your IRA custodian and not you,
personally. This means that you will need to set up your self-directed IRA prior to
making an offer. If you are under the gun and did not have time to open your IRA, and if
the person making the offer is not a disqualified person, you may make the offer in the
following way: “John Doe and or assigns”. Adding the phrase “and or assigns” will allow
you to assign the contract to the IRA custodian once the account opened.
In addition, if you put up earnest money with your personal funds, you will need to make
sure you include that amount in the total due so that the title company can reimburse you
upon closing.
Some IRA custodians will require that they hold the original recorded title to the property
in safekeeping. The title should reflect the name of your IRA custodian for your benefit,
such as, XYZ Trust Company, Custodian FBO John Smith IRA.
In conclusion, I hope you now realize that there are some interesting and creative ways to
invest in real estate and that they can be done in your IRA or other types of retirement
plans. This topic is very complex and by no means has it been all covered in the article,
but I hope it was a good start.
Please remember that this type of investing is best utilized when using a team of
professionals that can help you navigate the potential hazards. Please seek the advice
from the following professionals as needed: an Attorney, CPA, IRA Custodian, CFP,
Real Estate professional, Mortgage Broker, Registered Investment Advisor or other
competent Financial Advisor.
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