Real estate and your IRA

Lets say this to begin…’You cannot buy real estate with your basic IRA – you need to open a self-directed IRA’.

Few people realize that they have the option to self direct their IRAs and other retirement plans into real estate. Most investors believe that their only IRA investment options are bank CDs or the stock market and mutual funds. The reason? Most custodians do not offer truly self directed IRAs. They will only allow you to invest in their approved list of investment options. If you have an IRA at a bank, you will probably be limited to CDs; at a brokerage firm, to stocks, bonds and mutual funds.

The types of real estate investments that you can make with your self-directed IRA include single family homes, apartments, commercial real estate and raw land; essentially, any form of real estate.

Using your IRA to purchase real estate

If you have your IRA purchase real estate from an unrelated party and pay cash for it, and you do not use the real estate for personal reasons while it is in your IRA (i.e., you treat it strictly as an investment), there are no special issues.

If your IRA invests in real estate through a down payment and leveraging, there are some things to be aware of:

1. You cannot personally guarantee a loan for your IRA
2. It may be difficult to get a bank to allow an IRA to be the debtor without a personal guarantee
3. Your IRA will pay tax on Unrelated Debt Financed Income (UDFI), which is the income and/or capital gains attributable to the leveraged portion. (UDFI is taxed at the trust tax rate because an IRA is treated as a trust for this purpose.)

Your IRA cannot directly or indirectly buy real estate from a "disqualified person" - the IRA owner, the IRA owner's spouse / descendant / ascendant (e.g., mother or an entity where at least 50% of which is owned by a combination of the above).

If the IRA's investment is deemed essential to accomplishing a transaction in which both you and your IRA invest, then the transaction would be considered a prohibited transaction. You cannot have your IRA enable an investment for yourself or another disqualified person.

Also, your IRA cannot purchase a real estate asset and then have a disqualified person use it while it is in the IRA.

Buying real estate from a non-disqualified person with cash is the simplest way of investing in real estate with your IRA. Your IRA can buy raw land, commercial property, residential property, as well as extend loans – secured by real estate with your IRA – to unrelated parties.

Provided the loan is not guaranteed by the IRA owner or any other disqualified person, and the IRA has enough liquidity to support the mortgage and expenses, your IRA can buy property through leveraging. However, leveraging can result in income taxes on UDFI that must be paid by the IRA. Generally, these taxes are higher than would be paid on income generated from a property that you buy and finance personally. In addition, the UDFI taxes must be paid from funds from the IRA and, therefore, there has to be enough liquidity in the IRA to cover these taxes.

There are a variety of ways, however, that an IRA can participate in a real estate investment without a full cash capital investment. For example, your IRA can co-invest with other parties. You could also have your IRA, and other parties participate in real estate investing by becoming members of an LLC that buys and sells property.

As an alternative to borrowing, the IRA can purchase the property with other parties, all of whom pay cash. When this is done, there is no UDFI and there are no issues associated with the financing.

There are not any downsides per se, but there are certain types of transactions that you cannot perform through an IRA. Basically, the IRS prohibits “self dealing,” which are investments in which you or your family members of lineal descent have prior ownership.

Additionally, no investment (aside from FDIC-insured deposits) is guaranteed and real estate investing is not for everyone.

There are four main differences between purchasing real estate for yourself and for your IRA:

1. Title
   a. When purchasing an asset for your IRA, it is titled to your IRA.
2. Funding
   a. When purchasing an investment for your IRA, funds must come directly from your IRA and be sent directly to the title company/closing agent/attorney, per your instructions.
3. Expenses/Income: Any expenses associated with your IRA investment must originate in your IRA account and any income must be remitted to your IRA account.
4. Signatures: Documents pertaining to your IRA investments must be signed by the custodian on behalf of your IRA.

Purchasing a property with your IRA

In general, IRA investments should be bought outright, as any use of debt financing might incur the production of unrelated business income tax.
If debt financing is used, it must be in the form of a non-recourse loan, meaning that, if your IRA fails to make payments, the only collateral the lending institution can come after is the property itself, and not the IRA. IRAs may purchase an undivided (and proportionate) interest in a property, which would eliminate the occurrence of UBTI.

All income generated by a property owned by your IRA must return to your IRA, in order to retain the tax-deferred or tax-free status of the investment. Rental payments are remitted to the custodian for the benefit of your IRA. Once received, the checks or money orders are deposited into your account. As your IRA owns the investment, all rental checks must be made out to the IRA with proper titling.

You may not purchase a property or interest in a property, which is presently owned by a disqualified person or entity. Nor may you live in or work in a property that your IRA owns (e.g., personal residence, retirement home, office).

You may use funds from your IRA to renovate property in order to sell it at a higher price? However, your IRA must pay all expenses associated with a property that it owns, including the renovation of the property. Further, all proceeds associated with the sale of your IRA’s investment in a renovated property must be remitted to the custodian for the benefit of your IRA.

Investments in newly-formed private entities are not prohibited under the IRC, with the exception of Subchapter S corporations.

The foregoing is a general discussion and is not intended, as an opinion or advice on any legal, tax or investment aspects of IRAs. An IRA owner considering an IRA investment in real property should consult with his or her own advisor.