Unlike stocks and other passive investments, real estate is a tangible asset that can provide real value to an investor. This article will explore the rules on using a Self-Directed IRA to buy real estate and will also cover, what, if any, benefit, the IRA owner can gain from the IRA-owned asset.

What is a Self-Directed IRA?

When IRAs were created in 1974 by ERISA, the Act did not distinguish between an IRA that invested in stocks and other traditional investments, and a Self-Directed IRA that invests in alternative assets. Essentially, a Self-Directed IRA is an IRA that can invest in almost any asset without restriction. Generally, traditional financial institutions will place limitations on the types of investments you can make. However, when working with the right plan administrator/custodian, such as IRA Financial, no such limitations are in place. Therefore, you can invest in anything you choose, so long as it is not prohibited by the IRS.

For the most part, the only things you can’t invest in are collectibles, life insurance, and transactions involving a disqualified person, which we will discuss below.

Self-Directed IRA Prohibited Transactions

The IRS has always permitted alternative investments to be held inside IRA accounts. However, IRA providers have the option to only offer investments they so choose. Real estate is arguably, the most popular Self-Directed IRA investment. However, there are specific rules that need to be followed to make sure your plan remains compliant with the IRS.

What is a Disqualified Person?

The term “disqualified person” includes virtually anyone having a direct or indirect relationship to the plan other than as a participant or beneficiary. Under Internal Revenue Code (IRC) Section 4975, the principle categories of disqualified persons are:

• The IRA participant (holder)
• The IRA’s participant’s ancestors and lineal descendants (spouse, mother/father/daughter/son)
• Spouses of the IRA participant’s lineal descendants (son/daughter’s spouse)
• Fiduciaries of the plan (custodian or trustee)
• Investment managers and advisors
• Any corporation, partnership, trust, or estate in which the IRA holder has a 50% or greater interest
• 10% or more shareholder, highly compensated employee, or director of an entity that is 50% or more owned by a disqualified person.
• 10% or more owner of an employer with a 401(k) plan

Siblings, aunts, uncles, cousins, friends, neighbors, coworkers etc. are not included in the definition of disqualified persons.

What is a Prohibited Transaction?

IRC Sections 4975 & 408 prohibit fiduciary and other disqualified persons from engaging in certain types of “prohibited transactions,” which are any direct or indirect:

• sale or exchange, or leasing, of any property between a plan and a disqualified person;
• lending of money or other extension of credit between a plan and a disqualified person;
• furnishing of goods, services, or facilities between a plan and a disqualified person;
• transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
• act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interests or for his own account; or
• receipt of any consideration for his own personal account by any 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.

Fiduciary prohibited transactions appear to be the most common in the Self-Directed IRA context. The IRA owner is a fiduciary to the plan and cannot use his or her IRA to directly benefit him or herself.

Investing in Real Estate with a Self-Directed IRA

The two most common ways to purchase real estate with a Self-Directed IRA is either having the IRA custodian purchase the asset directly or via the use of an LLC where the IRA owner serves as manager, which then owns the real estate.  In both cases, the IRS prohibited transaction rules under IRC Section 4975 apply and dictate what level of activity the IRA owner or any disqualified person can have in relation to the IRA asset.

Using Real Estate Owned by a Self-Directed IRA

In general, the intent of the IRS prohibited transaction rules is that an IRA owner should make investments to exclusively benefit the IRA. To this end, IRC Section 4975(c)(1)(D) is clear that a prohibited transaction occurs when the income or assets of a plan are transferred to a disqualified person. Hence, if an IRA owned 100% of a real estate asset and the IRA owner used the real estate for any personal purpose, the IRS would have a strong argument that the personal use of the real estate violated the rules.  The same goes if the real estate is owned 100% by an LLC.

Therefore, if the IRA owns at least 50% of an asset, a disqualified person should not have any direct or indirect benefit from said asset. This can include staying at an IRA-owned property, or utilizing raw land held in the plan.

On the other hand, an argument can be made that if your IRA owns less than 50% of a real estate investment, the underlying investment or LLC would not be treated as a disqualified person. This is somewhat of an aggressive position since the IRS would argue that, as the IRA owner, you are receiving a direct benefit from your IRA asset in violation of IRC 4975. However, if the real estate is owned by an LLC, which is not controlled by a disqualified person, the IRS may have more difficulty making the argument.

The Plan Asset Rules

Taking this argument, a step further, under the “plan asset rules,” if an LLC is owned less than 25% by IRAs, the owners of the LLC (the IRAs) are not deemed to have a direct ownership in the LLC’s assets – i.e. the real estate.  An argument can be made that if the real estate is owned in an LLC that is less than 25% owned by retirement accounts, the plan asset rules would not treat the IRA as a direct owner. Therefore, the owner could gain some personal benefit from the asset, so long as he or she can show the investment was not made for any personal benefit.

In such a case, where the IRA owner paid for value for the use of the property, i.e. renting a cabin, and the IRA owned less than 25% of the asset, an argument can be made that because the plan asset rules do not treat the IRA owner of the LLC as a direct owner of the LLC’s real estate, use of the real estate would not trigger a prohibited transaction.

Please note – anytime an IRA owner gains any personal benefit from the use of an asset owned by an IRA, there is a string risk that the IRS could argue that a prohibited transaction occurred. Clearly, the lower percentage of IRA ownership coupled with the level of use will be an important determination of the IRS’s inclination to fight the transaction. For example, if your IRA owns 1% of a real estate fund that owns a hotel and you go on vacation and pay fair value for a hotel room, I believe the IRS would be hard pressed to argue a prohibited transaction occurred. Whereas if your IRA owns 75% of a real estate asset and you use the property for three months, the IRS would be far more motivated to argue that a prohibited transaction occurred.

Conclusion

When it comes to gaining some personal use of a real estate asset owned by your Self-Directed IRA, the safest approach is to not derive any personal benefit from the asset. This is especially true when the IRA will own more than 50% of the LLC and/or the asset itself. However, in the situation where a real estate asset is owned in an LLC where the total IRA ownership is less than 25%, the plan asset rules may provide some cover for an IRA owner to gain some personal use of the real estate asset on the same economic terms as a third-party. While you may be able to benefit from an IRA-owned asset, it’s generally not worth the risk of losing the tax benefits of the plan. Tread carefully, and always speak to a professional before making any investment.