When investing in real estate, most investors will be subject to capital gains taxes when they sell and profit on a property, as well as possible income tax on the rental income that they receive.
But imagine if you could still profit on your real estate deals and not have to pay a percentage of your gain or income to Uncle Sam. And, what if these funds could then go into an account and continue to earn tax-deferred or tax-free returns. This is what you can do if you invest in real estate through a self-directed IRA.
Having real estate in your portfolio can help you to diversify much more than only owning stocks, bonds, mutual funds, and / or CDs. In fact, as many real estate investors already know, owning property can provide you with a hedge against the volatile stock market.
Just about any type of real estate can be purchased inside of a self-directed IRA account. Because of this, it can allow those who choose to purchase and sell property the opportunity to multiply returns, due to the tax related advantages that are offered through IRAs.
Locating and researching property for purchase through your self-directed IRA account is technically no different than researching and purchasing any other type of investment property – other than having to follow the IRA rules with regard to incoming and outgoing funds that are related to the property. Likewise, the actual process of purchasing rental real estate in a self-directed IRA is quite similar to the regular process that is followed, with a few exceptions.
If you do not use cash to purchase property for your self-directed IRA account, it may be necessary to obtain funding. If this is the case, you can borrow funds through your IRA. When you do so, however, the borrowed funds must be from a “non-recourse” loan. When borrowing through this type of loan, the funds are not borrowed by you personally, but rather by your self-directed IRA account.
A non-recourse loan is one that is typically secured by collateral rather than by the borrower’s credit. In the case of financing investment real estate, the non-recourse loan would be secured by the property.
In this situation, if the borrower defaults on making the loan’s re-payments, the lender can seize the property, and then liquidate it, in order to help with covering some or all of the amount of the default. The lender cannot, however, seek out the borrower for any compensation.
In order to help with covering its potential downside risk, the lender on a non-recourse loan will oftentimes require a higher amount of down payment as compared to financing with a recourse loan.
Here, the down payment would typically be between 30 and 50 percent of the property’s purchase price. Also, the interest rate on a non-recourse loan will usually be higher as compared to that of a recourse loan.
It may also be required that the borrower keep a certain amount of cash available in order to ensure that there is money for any of the property’s expenses. In this case, the liquid cash will need to be in the self-directed IRA account, as any of the income and expenses that are related to the property you purchase must come and go through the IRA.
Depending on the lender, it may be required that you keep an additional 20% of the loan value available in cash within the IRA account. This figure is in addition to the amount of money you would need for the down payment and other closing costs.
When you own a property inside of a self-directed IRA account, it is essential that you keep the amount of your income and your expenses proportional if the property was purchased using any borrowed funds.
According to the IRS, for a debt-financed property, “the unrelated debt financed income is that amount which is the same percentage – not to exceed 100% – of the total gross income that is derived during a taxable year from such property as the average acquisition indebtedness regarding the property is of the average adjusted basis of the property.”
What this means is that the amount of the funds that are taxable would be in proportion to the amount that you financed to purchase the property. As an example, if your self-directed IRA borrowed 70 percent of the purchase price of the property, then 70 percent of the income that the property generates could be subject to UDFI taxation. The reason for this is because the amount of the purchase that was financed from an outside source is not considered tax-deferred money.
However, the annual rental income that is received from the property would also be taken into consideration when figuring the amount of UDFI-related tax. For instance, if the property took in $10,000 in annual rent, then the IRS would assess UDFI tax on roughly $7,000 of the profit. This is because 70% of the income generated came from leverage.
When figuring the amount of UDFI tax, the average indebtedness over the past 12 months is considered, and then divided by the adjusted basis in the property (which is usually the original purchase price).
Therefore, as the total amount of the mortgage is paid down every year, the amount of UDFI tax will also be reduced – and, a year after paying off the mortgage in full, there will no longer be any UDFI tax obligation.
Just like purchasing property outside of an IRA account, when you buy property within your self-directed IRA, you are allowed to do so in conjunction with partners. If you decide to purchase real estate with a partner, your self-directed IRA account can buy an undivided interest in the property.
In this case, all of the income and expenses that are related to the property must come and go via the IRA account. However, when a partner (or partners) is involved, you will also need to make sure that all income and outgo is proportional to your share of the property.
For example, if you and a partner invest 50 / 50 on a property, then 50% of the property’s expenses must come from your IRA, and likewise, 50% of the income that is derived from the property must go into your IRA account. And, when the property is sold, your IRA account should receive the portion of the proceeds that match the percentage of your IRA’s investment in the property.
When investing with partners via your self-directed IRA, you will often enter into the transaction together as tenants-in-common. Tenancy in common allows two or more people or entities to have ownership interest in a property. In this case, each of the owners will have the right to leave his or her share of the property to any named beneficiary upon that owner’s death.
Each investor will appear on the property’s deed (which is the legal document that gives title to the property) as a percentage owner, based upon each investor’s contribution towards the full purchase price of the property.
For instance, if you purchased a property with partners for $100,000 and your self-directed IRA contributed $10,000 towards buying the property, then the grant deed would specify that your IRA account is a 10% owner.
If there is not enough money in your self-directed IRA account to fully purchase a property, and you do not wish to work with a partner or to finance part of the transaction, you may be able to combine your personal funds with your IRA funds in order to make an all cash purchase.
One way to do this is to use a tenancy-in-common structure. This would work similarly to the tenants-in-common approach when purchasing property with partners, except that your IRA could contribute some of the funds, and you personally would contribute the rest.
Yet another way to invest in real estate through your self-directed IRA account is to do so by way of a lease option. Typically, a lease option will include the following steps:
- Entering into a lease through your IRA account. This lease would include a sub-lease, as well as the option to purchase the property for a set price in the future.
- Subleasing the property through your IRA account to a third party.
- Having the third party rent the property, and then purchase the property at a set amount in the future.
In this case, when the property is sold, any amount of profit should be returned to your self-directed IRA account.
Regardless of how you structure your property purchase and the financing, it is important to work with knowledgeable legal and / or accounting professionals when enacting these types of strategies, as you will want to be sure that you are properly following of the rules. Otherwise, you could leave yourself and / or your IRA account subject to potential penalties.
As previously discussed, you may opt to go the route of an IRA LLC. If this is the case, your LLC (Limited Liability Company) is considered to be a distinct legal entity. Because this type of self-directed IRA structure provides you with easy access to your funds, you will be able to act more quickly if a competitive real estate deal comes along.
If you use the IRA LLC structure, then you will also be allowed to join forces with others in making investments. This is possible because technically, you are dealing with the company, and not with the underlying members.
With an IRA LLC, you will have a bank account that can be used only by the LLC. Because of that, you will be able to make your real estate purchases directly, and without having to obtain custodial approval.
When you purchase property within an IRA LLC, it is important that the following requirements are met:
- The LLC must ensure that all of the IRS and Department of Labor rules and requirements are properly followed;
- If the LLC finances a property in the IRA account, then the LLC must pay any of the required UDFI taxes that are due;
- The LLC must distribute dividends to LLC owners (if applicable), based upon the percentage of ownership of each.
Unlike investment property that you own under your own name or through a business, you are not allowed to personally receive rental income on property that you own in your self-directed IRA account. Rather, this rental income must go directly into the IRA account when it is received.
In some cases, if you are working with an IRA custodian, the tenant(s) may send their rent checks directly to the custodian for deposit into your IRA account. Alternatively, the checks may be received by you or by a property manager, who in turn, will forward the funds to the IRA custodian (if applicable), or directly to the IRA LLC.
Likewise, when there are any expenses that are used for the investment property – such as maintenance and / or repairs – the funds must come directly out of your IRA account, rather than from your own personal account.
If you do place rental income in a personal account and / or you use your personal funds towards the property’s expenses, it can be considered as “co-mingling” of funds, which in turn, may be considered a prohibited transaction. This could cause the self-directed IRA to lose its tax-advantaged status.
Depending on how involved you intend to be with your real estate investment(s), it will oftentimes make sense to hire a property manager to handle the many duties that are affiliated with owning rental real estate. There are some instances where you as the IRA account owner may not be allowed to manage the property.
The activities of a property manager will typically include the following:
- Advertising the property for rent
- Screening potential tenants
- Checking information and references on the rental property applications
- Obtaining a security deposit
- Receiving monthly rent from the tenant(s)
- Making necessary repairs to the property
- Ensuring that all of the day to day maintenance is taken care of
When you are in the process of hiring a property manager, be sure that they are professional, and that they also have experience in working with properties that have been purchased via a self-directed IRA account. This can help you to better ensure that all of the specific rules are followed as they relate to self-directed IRAs.
Jeff had $75,000 in his self-directed IRA LLC account. After finding a suitable property to be used as a rental, Jeff was able to purchase the property in cash for $60,000. After paying closing costs of $2,000, Jeff had $13,000 remaining in his IRA account that could be used as a “buffer” in case any emergency expenses for the property came up.
Jeff was able to rent out the property for $600 per month, and he had his tenant make out her monthly rent check to his IRA LLC. After factoring in property taxes of approximately $50 per month and monthly maintenance of another $50, Jeff made a profit of roughly $500 per month on his investment.
- Decide whether the property will be purchased directly, or via an IRA LLC.
- Locate appropriate real estate investment(s) for your account, based on your specific goals.
- Submit a purchase offer in the name of your IRA.
- Complete an investment authorization form from your IRA custodian (if you are not purchasing the property via an IRA LLC) which indicates the property that you intend to buy, and the amount of your deposit.
- Consult with an attorney and / or title company in order to close on the property.
- Obtain approval from your IRA custodian (if you are not purchasing the property via an IRA LLC), and forward the signed paperwork to the attorney or title company prior to closing.
- Have the attorney or title company prepare any additional documents that may be needed, such as the 1) Finalized purchase contract; 2) Escrow statement, which outlines all of the costs, and the net amount that is due from your IRA account upon closing; 3) A preliminary insurance report; 4) Evidence of property insurance; 5) Instructions for funding; 6) Any additional required documents.
- Obtain a non-recourse loan, if the purchase will require financing.
- Have your IRA custodian sign the mortgage note.
- Obtain property insurance, and pay the premium through your IRA
- Hire a property manager for the property (if applicable).
- Have your IRA custodian send the necessary proceeds for closing from your IRA account to the title company or attorney who is handling the closing (if you are not purchasing the property via an IRA LLC).
- Ensure that all of the documents are properly titled (for instance, the property will be owned by the IRA account, so it would be titled as:
- Have the attorney or title company pay the funds for the down payment, closing costs, and any other necessary expenses out of the escrow.
- Have the deed to the property issued to your IRA custodian or IRA LLC.
- Ensure that all of the income and the expenses that are related to the property come and go via the self-directed IRA account.
One way to invest in real estate through a self-directed IRA account is to do so by way of a lease option. List the following steps that are typically included in this process.
• Subleasing the property through your IRA account to a third party.
• Having the third party rent the property, and then purchasing the property at a set amount in the future.
• In this case, when the property is sold, any amount of profit should be returned to the self-directed IRA account.