Investing in real estate using a Self-Directed IRA or Roth IRA has become a very popular way to get exposure to the real estate asset class in a passive form. This article will explore the keys to making a tax efficient Self-Directed IRA investment into a real estate fund.
- A Self-Directed IRA allows you to invest in almost anything, including real estate
- Real Estate funds are generally limited to accredited investors
- Be careful of both the Prohibited Transaction and UBTI Tax rules before making an investment
What is a Real Estate Investment Fund?
A Self-Directed IRA refers to an IRA account which allows the IRA holder to invest in IRS-approved alternative asset investments, such as private placements, and much more.
There are a variety of ways a retirement account investor can gain exposure to real estate. Investment options include direct real estate investment, real estate partnerships, real estate investment trusts (REITs), or real estate investment funds. The focus here will be on non-publicly traded real estate investment funds.
In sum, a real estate investment fund combined sources of capital from multiple investors for the purpose of making real estate investments. Almost all real estate investment funds use debt or leverage as part of their real estate investment strategy allowing for greater purchasing power.
Private real estate investment funds share some similarities with REITs in that they both use combined sources of capital to invest in real estate. However, there are some key differences between them, including the fact that REITs and most real estate funds are structured as pass-through vehicles, such as limited liability companies (LLCs) or partnerships.
The greatest attraction to making an investment in a real estate investment fund is that you are gaining access to professional real estate managers/operators with the hopes of generating high investment returns. To this end, many real estate investment funds are actively managed and target high-net-worth clients. Because of that, most private real estate funds are only available to accredited investors, not the general investing public.
Tips for Investing a Self-Directed IRA or Roth IRA in a Real Estate Investment Fund
Are you an Accredited Investor?
Before a Self-Directed IRA investor can invest in most private real estate investment funds, the IRA investor must generally satisfy the SEC definition of an accredited investor. The SEC defines an individual accredited investor as either having a net worth of $1 million (excluding the value of one’s primary residence) or have earned at least $200,000 per year in each of the past two years and expect to do so again in the current year. Married couples are allowed to aggregate their assets for the $1 million test, but they must have a joint income of at least $300,000 annually to meet the income test instead.
Most non-publicly traded real estate investment funds are structured as Reg A- or Reg D-type private placements in order to limit the fund’s SEC reporting obligations. Therefore, if the IRA owner satisfies the SEC accredited investor definition, the Self-Directed IRA would then be permitted to make the investment.
Understanding the Prohibited Transaction Rules
The Internal Revenue Code does not describe what a Self-Directed IRA can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits disqualified persons from engaging in certain types of transactions.
The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest. Essentially, the IRA investment must be made to exclusively benefit the IRA and cannot, in any way, directly or indirectly, benefit the IRA owner or any “disqualified person.”
Therefore, when one is seeking to use a Self-Directed to invest in a real estate fund, it is important to be cautious that the IRA owner nor any “disqualified person” owns, in the aggregate, over 50% of the real estate fund or will, directly or indirectly, benefit from the IRA investment in any way.
Navigating the UBTI Rules
If a Self-Directed IRA invests in a real estate fund that uses a nonrecourse loan to purchase real estate, the UBTI tax could apply on a portion of the net income associated with the leverage. Be aware, that most private real estate investment funds will use leverage in their real estate fund.
Therefore, even though the Self-Directed IRA will not be the direct borrower with respect to the leverage, because a real estate fund is typically set-up as a pass-through vehicle, the leverage would be attributable to the investor and could trigger the application of the UBTI tax.
If one uses a Self-Directed IRA to invest in a real estate investment fund that uses leverage to make the investment, and annual net income allocated to the Self-Directed IRA reported on a K-1 is above $1,000, the income would be subject to the UBTI tax. That tax rate has can go as high as 37%.
Any pro rata allocation of real estate investment expenses, such as depreciation that is associated with the real estate investment, would reduce any taxable income.
Note: if one is self-employed, one can establish a Solo 401(k) plan, which is exempted from the UBTI tax on the use of nonrecourse leverage associated with a real estate transaction.
Do Your Diligence
Using a Self-Directed IRA to invest in a real estate investment fund will involve more research and diligence than buying stocks. Before investing in a non-publicly traded real estate investment fund, one should spend time reading the fund’s prospectus and all other relevant materials on the fund’s past performance, their management, and investment strategies, Moreover, investing in a non-publicly traded real estate fund typically involves a lock-up period as well other potential liquidation restrictions.
Investing a Self-Directed IRA into a real estate investment fund has become increasingly popular over the years. However, most IRA custodians will fail to inform you of the key guidelines to follow, specifically the IRS prohibited transaction rules and the UBTI tax rules. In addition, prior to investing, you will likely need to confirm that you are an accredited investor.
Still, performing diligence on the real estate investment fund and its partners is an important way to confirm your economic expectations about the fund and its investment objectives.