With United States real estate prices near historical highs even as home sales continue to fall modestly, many investors looking to use their retirement funds to invest have had to look for alternative capital options. Since the use of leverage comes with certain restrictions and tax implications for retirement account owners, doing a joint venture between multiple retirement accounts has become a popular option over the last few years. This article will explore the IRS rules surrounding the use of multiple retirement accounts to fund a Self-Directed IRA investment as well as some tips to be aware of.
- The most tax-advantaged way to invest in real estate with an IRA is to avoid using leverage
- Using multiple retirement plans for a joint venture is not prohibited by the IRS
- Follow the tips listed below to make the most out of your investment
The IRS Prohibited Transaction Rules
The Internal Revenue Code (IRC) does not describe what an IRA can invest in, only what it cannot invest in. IRC Sections 408 and 4975 prohibits a “disqualified person” from engaging in certain types of transactions.
Under IRC 4975, a prohibited transaction is defined as:
(A) sale or exchange, or leasing, of any property between a plan and a disqualified person;
(B) lending of money or other extension of credit between a plan and a disqualified person;
(C) furnishing of goods, services, or facilities between a plan and a disqualified person;
(D) transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan;
(E) act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account; or
(F) 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.
The questions then becomes, what is a “disqualified person?”
The IRS has restricted certain transactions between the IRA and a disqualified person. The rationale behind these rules was a congressional assumption that certain transactions between certain parties are inherently suspicious and should be disallowed.
The definition (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. More specifically, a disqualified person is:
- A fiduciary (e.g., the IRA holder, participant, or person having authority over making IRA investments),
- A person providing services to the plan (e.g., the trustee or custodian),
- An employer, any of whose employees are covered by the plan,
- An employee organization any of whose members are covered by the Plan,
- A 50 percent owner of C or D above,
- A family member of A, B, C, or D above (family members include the fiduciary’s spouse, parents, grandparents, children, grandchildren, spouses of the fiduciary’s children and grandchildren (but not parents-in-law),
- An entity (corporation, partnership, trust or estate) owned or controlled more than 50 percent by A, B, C, D, or E. Whether an entity is a disqualified person is determined by considering the indirect stockholdings/interest which would be considered under Code Sec. 267(c), except that members of a fiduciary’s family are the family members under Code Sec. 4975(e)(6) (lineal descendants) for purposes of determining disqualified persons. D person
- A 10 percent owner, officer, director, or highly compensated employee of C, D, E, or G,
- A 10 percent or more partner or joint venturer of a person described in C, D, E, or G.
IRC Section 4975(e)(2) does not list a retirement account as a “disqualified person” in connection with the application of the prohibited transaction rules. In September 2021, a version of the Build Back Better bill was released that contained a provision that would treat retirement accounts as a “disqualified person” in relation to the retirement account owner, but the bill was not passed. Hence, one can use multiple IRAs or 401(k) plans in a joint venture directly or via an LLC without triggering the IRS prohibited transaction rules. In addition, since a retirement account is not deemed a disqualified person, the joint venture can between the IRAs of disqualified persons, such as a spouse, child, or parent.
Structuring a Joint Venture Transaction using a Self-Directed IRA
The most common way one can use multiple retirement accounts to make an investment is via a Self-Directed IRA. There are two options for the plan.
Full Service Self-Directed IRA
With a full-service Self-Directed IRA, a special IRA custodian, such as IRA Financial, will serve as the custodian of the IRA. The IRA funds are generally held with the custodian and at the IRA holder’s sole direction, they will then invest the IRA funds into your investment choice. You can establish multiple IRAs and have the IRA custodian facilitate an investment using funds from the various plans. Title to the investment would be made in the name of the IRAs and all income and gains would flow back to them pro rata without tax.
For example: Nancy needs $250,000 to purchase a rental property with her IRA. She has a traditional IRA worth $185,000 and a Roth IRA valued at around $90,000. She needs to use funds from both accounts to fund her investment. Since an IRA is not deemed a “disqualified person,” Nancy will be able to have the property owned by her two IRAs. She directs her custodian to invest $180,000 from her IRA and $70,000 from her Roth. Title to the property will show both accounts as owner, such as IRA Company Custodian FBO of the Nancy Smith IRA 72% and IRA Company Custodian FBO of the Nancy Smith Roth IRA 28%. Profits and losses would go 72%-28% to the respective IRAs.
Checkbook Control Self-Directed IRA LLC
The Self-Directed IRA LLC with “Checkbook Control” has been growing in popularity with investors looking to make alternative investments that require a high frequency of transactions, such as rental real estate. Under the Checkbook IRA format, a limited liability company (“LLC”) is created which is funded and owned by the IRA and managed by the IRA owner. This allows one to eliminate certain costs and delays often associated with using a full-service IRA custodian. The structure allows the investor to act quickly when the right investment opportunity presents itself cost effectively and without delay.
The LLC can be set-up in any state and a bank account is opened in the name of the LLC allowing the IRA owner to have control over the funds. In the case of the use of multiple IRAs, ownership in the LLC will be pro rata based on the amount contributed by the respective IRAs. Profits and loses would flow to the IRA owners pro rata. All investments are made in the name of the LLC with full limited liability protection.
Using the information as the example above, only this time Nancy would need to form an LLC for her Self-Directed IRA. Since the property will be in Texas, Nancy elects to form the LLC in Texas. The LLC is formed, a Tax ID number is acquired so the LLC can open a bank account and an LLC operating agreement is drafted showing the LLC managed by Nancy and the Traditional IRA as 78% owner and the Roth IRA as 28% owner. The LLC is funded with cash from her IRAs. Once the LLC receives the cash, Nancy wires the funds to her closing attorney to purchase the property. Title to the real estate would be in the name of the LLC and not the IRAs. Again, all profits and losses flow back to the LLC, and are divvied up between the two plans.
Note, for simplicity’s sake, the examples used one person with multiple IRAs. However, that doesn’t have to be the case. You can have multiple people each using his or her own retirement account for the joint venture.
Tips for Structuring a Joint Venture with Multiple IRAs
Below are several important tips to keep in mind when structuring a joint venture transaction using multiple IRAs:
- Make sure you keep a safety net of funds available in the IRAs or LLC for unforeseen property expenses or less revenue than projected.
- Consider using a property management company if you are not using an LLC.
- One or more IRA owners can serve as the LLC manager.
- No compensation should be taken by a disqualified person for serving as manager of the LLC.
- No disqualified person should provide any active services to the real estate other than what is reasonable and necessary, such as selecting a property management company, an accounting firm, or making overall property related decisions for a third-party to implement.
- If you are going to buy real estate in various states and will be using an LLC, you should consider registering the LLC as a foreign LLC to do business in all states where the real estate is located.
- If you will be using an LLC that will be owned by multiple retirement accounts, remember that the LLC will need to file a federal and state partnership return.
- Be mindful of the required minimum distribution (RMD) rules; anyone that turns 73 in 2023 is required to withdrawing from a traditional IRA.
The ability to combine your retirement accounts or those of other to make self-directed investments is a great way to tap into needed capital to get a deal done. You can choose to use multiple accounts that you own, or partner with a family member, friend or colleague. Buying a real estate property outright is preferable to avoid unnecessary tax that arises when using leverage. Best of all, the income generated will flow back into the retirement plans without tax. Be mindful of the prohibited transaction rules and heed the tips we’ve outlined for the best possible outcome.