Investing in real estate using a Self-Directed IRA has become a very popular way to get exposure to the asset class in a passive form. This article will explore the keys to making a tax efficient investment into a real estate fund using your IRA.
- 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?
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), and real estate investment funds. Our 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 investment strategy, which allows 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 are investment trusts that operate income-producing real estate. Further, 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 in a Real Estate 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 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 (IRC) only describes what you are not allowed to invest in using retirement funds. IRC Sections 408 & 4975 prohibits your IRA from engaging in certain type of transactions involving a “disqualified person.”
The definition of a “disqualified person” (IRC 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. In sum, every Self-Directed IRA investment must be made to exclusively benefit the IRA and not any disqualified person.
Therefore, when one is seeking to use IRA funds to invest in a real estate fund, it is important to be cautious that any disqualified person (including the IRA owner) owns, in the aggregate, over 50% of the real estate fund. Additionally, no disqualified person should 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.
Using a Self-Directed IRA (or Roth IRA) into a real estate investment fund has become increasing 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.
As always, IRA Financial does not provide investment advice and is simply here to educate you on the types of investments you can make with your self-directed retirement plan. Always consult with a professional before deciding on investments to make.