Depending on the type of real estate investment you are considering making, engaging a property manager could be a viable option.  This is especially true if you are considering using a Self-Directed IRA or Solo 401(k) plan to invest in the real estate.  This article will explore how one can buy real estate with an IRA or 401(k) and then describe how using a property management company can help protect your retirement account investment from the IRS prohibited transaction rules.

Buying Real Estate with an IRA or 401(k)

The IRS and Internal Revenue Code do not describe what a retirement account can invest in, only what it cannot invest in. IRC Sections 408 & 4975 prohibits “disqualified persons” from engaging in certain type of transactions. Essentially other than collectibles, life insurance, or transactions involving related parties, a retirement account is permitted to make the investment.  Real estate is the most popular type of alternative asset investment for retirement accounts. 

Traditional financial institutions make a business decision to not allow retirement plans to invest in alternative assets.  However, since the creation of IRAs and 401(k) plans in 1974, the self-directed retirement industry was founded to serve the needs of investors seeking to diversify their retirement assets and gain exposure to alternative investments.

The most important reason why using retirement funds to make investments is so popular is that, in general, all income and gains generated by the investment will be tax-deferred, or tax-free in the case of a Roth account.

What is a Self-Directed IRA?

A Self-Directed IRA is not a legal term that you will locate in the IRC and is essentially an IRA that allows for alternative investments, such as real estate. Since the creation of IRAs in 1974, the IRC does not prohibit IRAs from investing in alternative assets. There are two types of Self-Directed IRAs: full-service and checkbook control.

Full Service Self-Directed IRA

A full-service Self-Directed IRA is the most popular type of “SDIRA.”  A special IRA custodian, such as IRA Financial, will serve as the custodian of the IRA. The IRA funds are generally held with the IRA custodian and at the IRA holder’s sole direction, the custodian will then make the investment on your behalf. Title to the investment would be made in the name of the IRA and all income and gains would flow back to the IRA without tax. 

With a full-service Self-Directed IRA, the use of a property manager to help manage a real estate investment is more common since the property will be owned directly by the IRA and the IRA owner will have little involvement or control over the IRA assets.

Checkbook Control Self-Directed IRA LLC

The Self-Directed IRA LLC with “checkbook control” has been growing in popularity with investors looking to make investments, such as rental real estate that require a high frequency of transactions. Under the Checkbook IRA format, a limited liability company (“LLC”) is created, funded and owned by the IRA and managed by the IRA holder. It allows one the ability to eliminate certain costs and delays often associated with using a full-service custodian.  The structure allows the investor to act quickly when the right investment opportunity presents itself cost effectively and without delay. Title to the property is in the name of the LLC, offering some privacy if that’s what you’re looking for.

The use of a property manager is generally less common than with a full-service IRA since the IRA owner can serve as manager of the LLC and be more involved in the affairs of such.

What is a Solo 401(k)?

If one is self-employed or has a small business with no full-time employees other than the owners or their spouses, another popular vehicle to invest in alternative assets with retirement funds is known as the Solo 401(k). Also known as an Individual 401(k) or Self-Employed 401(k), it is a retirement plan that must be adopted by a business that does not have any non-owner full-time employees.

The Solo 401(k) plan has a number of attractive advantages in addition to the ability to invest in alternative assets, such as high contributions, a $50,000 loan option, the Mega Backdoor Roth 401(k), easy administration, and the ability to serve as trustee and gain checkbook control.

The IRS Prohibited Transaction Rules

In general, under IRC Section 408, an IRA may not purchase life insurance contacts (an exemption exists for Solo 401(k) plans), collectibles, or transactions identified under IRC Section 4975. The IRS has restricted certain transactions between a retirement plan and a “disqualified person,” which is loosely defined as the retirement account owner, their lineal ascendants and descendants, or any entity controlled by such persons.

The prohibited transaction rules are important to understand when it comes to investing in real estate with an IRA or 401(k). Treasury Regulations allow a retirement account owner to perform necessary tasks associated with an investment, such as selecting the investment, negotiating price, and hiring professionals. In contrast, 4975 is clear that a disqualified person is not permitted to perform services that are not necessary for the retirement account investment, such as painting a fence or fixing a toilet.  Hence, the need, in some cases, to hire a third-party management company for a real estate investment involving a retirement plan.

What is a Property Manager?

A property manager or management company is generally hired to handle the day-to-day operations of a property, such as a rental. This includes duties like collecting rent from tenants, advising on rent prices to fit the market, seeking out and approving new tenants, coordinating leases and following up on maintenance requests.  Most property management companies charge a monthly fee of between 8% – 12% of the monthly rent collected.

Advantage of Using a Property Manager

The primary advantage of engaging a property manager is to have an expert handle the day-to-day management of a real estate investment property.  For passive real estate investors, having a property manager is key to allowing the property owner to invest in real estate without having to be involved on-a day-today basis. For retirement plan investors, this is very helpful when contemplating the risks involved in triggering a prohibited transaction, which would create an immediate tax and penalty.

By hiring a third-party manager to handle the day-to-day responsibilities, this will help ensure that the retirement account owner remains passive and is not providing services to the asset. However, not all real estate investments require hiring a third-party property manager. For example, investing in a real estate fund or owning a property where the tenant is responsible for all maintenance, or where one has good local real estate trade-related connections, may make having a property manager unnecessary.

Helpful Tips

Below are some tips to help determine whether you should consider hiring a third-party manager to manage your Self-Directed IRA or Solo 401(k) real estate investment:

1. Make sure the property manager is not a disqualified person; siblings, cousins, friends, neighbors are okay.  Also, make sure the property management company is not controlled by a disqualified person.
2. Consider the level of activity you expect at the property – the higher the level of service required, the greater the need for a property manager.
3. The type of IRA you have will have an impact on whether you use a property manager. It’s more common with a full-service IRA.
4. What is your experience in managing real estate? If you have done property management on your own and you have connections in your community that you can tap into if there is a service need, then you may be able to do so passively without triggering the prohibited transaction rules.
5. The less service the retirement account owner does, the better!
6. Consider property management fees; the fees you pay will impact the profitability of the investment.
7. Online payment services, such as Zelle, make handling many tenant tasks seamless.
8. If money is no object, then using a third-party property management company is generally the safest approach with respect to the IRS rules.

Conclusion

Real estate continues to be the most popular type of alternative investment for retirement account investors for many reasons. Whether one establishes a full-service Self-Directed IRA, a Checkbook IRA, or a Solo 401(k) plan, using a property manager to help manage the investment is a smart way to keep it passive and stay clear of the prohibited transaction rules.

However, many investors feel comfortable handling the management of a real estate asset owned by an LLC. Just remember you need to be hands-off and the person you hire should not be a disqualified person. Of course, it’s always good to ask an expert if there’s doubt as you don’t want to lose the tax advantages of the retirement plan that holds the real estate.