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Using Self-Directed IRAs for Investment Real Estate Purchases

Written by: Kristy Welsh

Last Updated: August 10, 2017

Self-Directed real estate IRAs have been around since 1974, but many investors are unaware of this option. Investments with a Real Estate IRA are fully permissible under the Employee Retirement Income Security Act of 1974 (ERISA), which modified rules to allow investors to diversify their holdings to include non-traditional investments, including real estate. Real estate has been permitted to be held inside IRA retirement accounts since that date, yet the means to do that — the Self-Directed IRA — remains one of the least known and unheralded investment vehicles in the vast financial marketplace.

In this article, we will focus strictly on real estate investments, which might include raw land, houses, condos, commercial properties, mortgage notes, options, tax liens or deeds and deeds of trust. Investment real estate is quickly becoming one of the more popular options for using a Self-Directed IRA, otherwise known as a Real Estate IRA or Self Directed IRA LLC.

Why It's a Good Idea

Why would an individual select real estate as an investment asset within their IRA? There are a number of good reasons:

  • Real estate is an excellent long term strategy. Despite the recent plunge in real estate values, real estate has historically been an investment that offers the potential for both income and appreciation. With the recent housing bubble, and subsequent ongoing market correction, many areas of the country offer unprecedented buying opportunities. For investors willing to hang on to a property for five years or more, residential real estate today presents a tremendous opportunity to do just what investors ideally do -- buy low and sell high.
  • A good alternative to stocks and mutual funds. With the dismal performance of the stock market in the forefront of many investors minds, many retirement savers are uncomfortable with their nest egg tied up largely in stocks. History dictates that the stock market looks out six months to a year, and even those who have been in the business for years are unable to predict how long it will take for financial markets to regain levels seen only last year. Diversification, or not restricting all your eggs to one basket, is an appropriate analogy.
  • Buy and sell real estate with less tax impact. Proceeds from selling an IRA owned property are rolled back into the IRA directly without facing capital gains taxes. An investor who buys and resells a property within a year with non-retirement funds will face a significant capital gains tax on the proceeds.
  • Steady income generation. Especially for those in or near retirement, buying a property that produces rental income that's likely to increase with inflation is a sound a long term investment.

Selecting and Setting Up a Self-Directed Real Estate IRA

You can't buy real estate with a basic IRA, so the first step will be to open a self-directed IRA. Read this article for more information on setting up a self-directed IRA.

A number of financial institutions such as banks, insurance companies and brokerages can assist you in opening a self-directed IRA, but most likely your investment options will be limited to the products they sell and service. To buy real estate with your IRA you will need to find a specialized independent administrator to serve as a trustee or custodian. Some examples of well-known established companies that handle this sort of IRA include Entrust, Equity Trust, Sterling Trust, Guidant Financial, Pensco Trust, and Trust Company of America. When selecting a company to administer the IRA, consider that experience is key. You'll want to ensure you fully understand the fees involved, but ask hard questions to ensure they are well versed in the requirements involving real estate investments.

Many companies/administrators do not even take on real estate contracts, as the complexities are numerous.

It should be obvious that you cannot use your IRA to purchase your own residence, condo or any property in which you or your family live or work. In fact, there are a significant number of IRS rules, regulations, and restrictions regarding these transactions so it is an absolute necessity to utilize an adviser familiar with these IRAs and their rules. See the end of this article for more information regarding prohibited transactions.

Self-Directed IRA is Set Up - What's Next?

Here are the steps for purchasing investment real estate with an IRA:

  1. Select an administrator as the trustee of your account.You will select an administrator when you set up your Self-Directed IRA. The administrator will help take funds out of your IRA and purchase the property on your behalf. He or she will will properly document the transaction.
  2. You must go out and find the real estate to invest in.You will not get help or advice from your administrator in selection of the property. You are completely responsible for the due diligence on the selected property. This means determining if this will give you good returns, if it's too expensive to maintain, etc. If you pick the wrong property and it results in a loss to you, you are responsible, and not the administrator.
  3. Bring your accepted real estate contract to your administrator.He or she can assist you in the transaction.
  4. If you need additional financing, you must secure it.This would occur if you do not have sufficient funds in your IRA to pay the full purchase price of the property or if you wish to only invest a portion of your funds in the property.
  5. Once purchased, any fix-up funds must come from the IRA.You cannot work on the property yourself if it increases the value.
  6. Making money from your investment Here are your choices once you've purchased the property:
    • You can fix and flip or buy and hold and hope the property will increase in value.
    • You can turn it into rental/income property. All rental income must be made payable to your IRA and deposited into your account through the custodian (your administrator or trustee).
  7. When you sell the property all proceeds must go back into the IRA.

Commonly Asked Questions

Once I select a property to purchase within my IRA, does the custodian or trustee have to approve it? No, as long as the transaction does not violate IRS rules relative to the IRA. See the end of this article for more information regarding prohibited transactions.

How will the title or deed to the property be held? When you purchase real estate in your IRA, it can be held simply in the name of your IRA or you can pool your funds with other investors and invest through an LLC. Custodians handle all the paperwork with title companies, and the deed will read in the custodian's name "for the benefit of" the account holder.

My IRA doesn't have that much cash. Can I co-invest with my friends and relatives?
Yes. You can combine your IRA and personal funds with your wife's or husband's savings, her or his IRA, funds from your friends, children or other relatives (or any other combination) in order to enter into the transaction together as tenants-in-common. Each investor appears on the grant deed (the legal document giving title to the property) as a percentage owner, based on the amount of each investor's contribution towards the full purchase price. For example, if your IRA contributed $10,000 towards the purchase of a $100,000 parcel of land, the grant deed would specify that your IRA was a 10% owner.

What kind of property can I buy?
Your IRA can purchase raw land, rental properties, commercial property, condominiums, mobile homes, boat slips - really, anything. Of course, all of these have to be handled strictly as investments and cannot be used personally.

What are the typical costs for a custodial firm to manage a real estate IRA? A custodial firm's costs can range from almost negligible to about 1% a year, depending on the service level you desire. Lower-cost custodians make up some of the discounted cost with small transaction fees for cutting expense checks or transferring rental income periodically into mutual fund and stock investments. Higher-cost custodians, such as Pensco trust, offer a wealth of educational information among other benefits and may provide such services at no added cost.

If I decide to rent out the property, what are my options as far as managing IRA-owned rental properties? The most cost-effective approach to managing an IRA-owned rental property is to handle it yourself, but you must be careful to ensure you follow the rules. For instance, account holders can arrange for work to be done on the property, but payment for labor and materials should be issued by check from the custodian directly to contractors and suppliers. When self-managing the property, account holders can screen and select tenants and collect rent checks, but they must be made out to the deed-holder, i.e. "XXX Custodian Firm FBO Your Name."

If you don't have the time or inclination to self-manage, hiring a property management firm is another option. Fees range from 10-15% of monthly rent, along with a month's rent or more each time they screen and sign up a new tenant. Most firms will handle everything including securing tenants, collecting rents, and overseeing maintenance and repairs.

A third option is for account holders to create a limited liability company (LLC) that will give them "checkbook control" as the manager of the self-directed IRA account. This option, which also protects the accountholder from personal liability for any claims or lawsuits, tends to only be cost-effective for IRAs holding multiple properties. Many advisory firms will handle all paperwork and filings required to set up an LLC for fees ranging from about $2,500 to $5,000.

Who pays the state property tax, mortgage or home insurance?
Anything expenses incurred by the property should come from the custodian. Payment should be issued by check from the custodian.

Can I do any of the work required on my investment property myself? IRS rules on allowable work are somewhat unclear on the degree to which a Self-Directed IRA account holder can do minor work on a property themselves. The only permissible scenario is account holders can perform maintenance work that does not increase the property's value. This may include examples such as maintaining the landscape, a minor plumbing repair, doing shingle repair on a leaky roof or painting a few rooms between tenants. If you are a licensed contractor for instance and capable of major remodeling projects as your trade, this would be considered adding value to the property and would risk IRS action.

When I sell the property, do the proceeds go back into my IRA? Yes, as do all proceeds from rent(s) if applicable.

If I do rent out the property, who collects the rent? Rents can be collected by the account holder or property management company, but all rental income must be made payable to your IRA and deposited into your account through the custodian.

How does the process for purchasing property with my IRA differ from a standard real estate transaction? Funding a real estate purchase through your IRA is not significantly different - simply that there is an additional party involved (your IRA custodian), and there are important titling differences (your IRA, or LLC will be the owner). The purchase phase and closing process mirror that of a traditional purchase. Once you have identified a property you wish to purchase, you will request earnest money from your custodian. As these deposits must be paid from your IRA funds, request that your custodian issues this payment expeditiously, while assisting you with any specific forms required. As with earnest money, all closing costs, property taxes and insurance premiums must be paid by your IRA account.

Can I use IRA funds for a down payment, and get a traditional home loan to fund the remainder? Yes, you can use the funds in your IRA to borrow additional funds to complete your purchase. This is called a non-recourse loan, and can only apply to a first mortgage. Custodians generally have limits on financing when using non-recourse loans, so check with your particular custodian for their guidelines. The typical down payment requirement is 30% of the sales price.

Rules Involving Self-Directed IRAs for the Purchase of Real Estate

Although we can't go into all the potential rules and regulations involved in real estate investments in self-directed IRA's, there are some primary considerations involving prohibited types of transactions and disqualified persons that are key issues, as follows:

A disqualified person in accordance with (IRC 4975(e)(2)) is defined as:

  • The IRA owner
  • The spouse of the IRA owner
  • Lineal Descendants (such as daughters, sons, grandchildren)
  • Spouses of Lineal Descendants (such as a son or daughter-in-law)
  • Lineal Ancestors (Mother, Father, Grandparents)
  • Fiduciaries (those providing services to the plan)
  • Investment advisors
  • Any business entity in which any of the disqualified persons as defined above has a 50% or greater interest.

Prohibited Transactions:Defined in IRC 4975(c)(1) and IRS Publication 590, these rules were established to maintain that everything the IRA engages in is for the "exclusive benefit of the retirement plan". Often referred to as "self dealing" transactions, this section of the code identifies prohibited transactions to include the following (either direct or indirect):

  • Lending money or other extension of credit between a plan and a disqualified person. For example, you cannot personally guarantee a loan for a real estate purchase by your IRA.
  • Selling, exchanging, or leasing, any property between a plan and a disqualified person. For example, your IRA cannot buy property you currently own from you.
  • Dealing with income or assets of a plan by a disqualified person who is a fiduciary acting in his own interest or for his own account. For example, you should not loan money to your Financial Advisor.
  • Furnishing goods, services, or facilities between a plan and a disqualified person. For example, you cannot use furniture from your primary residence to furnish your IRAs rental property.
  • Transferring or using by or for the benefit of, a disqualified person the income or assets of a plan. For example, your IRA cannot buy a timeshare condo you or your family intends to use.
  • Receiving any consideration for his or her personal account by a disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan. For example, you cannot pay yourself income from profits generated from your IRAs rental property.

For a complete explanation of the requirements, refer to the IRS publication 590.