Last Updated on February 28, 2020
You can Use Your Individual Retirement Funds to Buy a Home
Did you know that you are within your rights to purchase a home with your IRA? Along with using your IRA to buy a home, the Internal Revenue Service (IRS) permits you to use retirement funds for almost any type of investment. This excludes any investment that involves a disqualified person, collectibles, and life insurance in the case of an IRA.
A primary advantage of purchasing real estate with retirement funds is that all gains are tax-deferred until a distribution. If you use a Roth account (after-tax), all gains are tax-free. Let’s assume you purchase a piece of property with retirement funds for $100,000 and then sell the property for $300,000. The $200,000 of gain appreciation will generally be tax-deferred with your IRA.
Whereas, if you purchase the same property with non-retirement funds, the gain is subject to federal income tax, and in some cases, state income tax.
Retirement Vehicles for Purchasing Real Estate
The two most common vehicles for purchasing real estate with retirement funds is the self-directed IRA or an employer sponsored 401(k) plan. However, most employer 401(k) plans do not offer real estate as a plan investment option and. Therefore, the self-directed IRA is the most popular way to buy real estate with your retirement funds.
You can establish a self-directed IRA quickly, as it can be done in a matter of days. It’s also relatively inexpensive.
The most challenging aspect of buying a house using retirement funds is navigating the IRS prohibited transaction rules.
According to Internal Revenue Code section 4975, you generally cannot make a retirement account investment that directly or indirectly benefits you or any other disqualified person. A few examples of a disqualified person is the IRA holder (you), your lineal descendants and related entities.
Additionally, you cannot perform services in connection with the retirement investment or guarantee any retirement account loan. You cannot extend any credit to or from the retirement account, or enter into a transaction with the retirement account that may present a conflict of interest.
Types of IRAs You can Use to Buy a Home
A self-directed IRA is a type of vehicle that allows you to use your IRA funds to invest in real estate, such as the purchase of a house. A self-directed IRA can be used with a pre-tax IRA, Roth IRA, SEP IRA, or SIMPLE IRA. There are two types of self-directed IRA structures that can be used to purchase a house:
1. Custodian Controlled Self-Directed IRA
A self-directed controlled by a custodian allows you to make alternative asset investments, like real estate. You will need to work with a special IRA custodian, such as IRA Financial Trust. Traditional banks and financial institutions do not permit their IRA clients to make alternative asset investments with IRA funds because that isn’t their business model.
Generally, the IRA custodian holds the IRA funds and then invests the funds into a home, at your sole direction. The home will be owned by the IRA, care of the IRA custodian. A custodian controlled self-directed IRA is a popular option if you want to invest in alternative assets that do not involve a high frequency of transactions.
2. “Checkbook Control” Self-Directed IRA
A self-directed IRA with checkbook control requires that a special purpose limited liability company (LLC) be established. The individual retirement account owns the LLC, but you will manage it. As a result, you can make IRS approved alternative asset investment decisions on behalf of your IRA without seeking custodian consent.
With checkbook control, buying a home with your IRA is as easy as writing a check. Your IRA funds will be held at a local bank
Because your IRA funds are held at a local bank in the name of the IRA LLC, you simply need to make the real estate transaction by writing a check directly from the IRA LLC bank account. You can also wire the funds from the IRA LLC bank account.
How to Use an IRA to Buy a House
Setting-up a Self-Directed IRA to purchase real estate is quick and easy.
1. Establish a Self-Directed IRA
The first step to buying a house with an IRA is establishing a self-directed IRA. An account can generally be set-up in a day or so and can be done online or through an app.
2. Transfer of Funds
Once the self-directed IRA account is open, the next step is transferring in IRA funds or rolling in 401(k) plan funds that you will use to purchase the home. The rollover or transfer process is tax and penalty-free and typically takes a few days.
3. Use an LLC or not?
The next step is to decide whether you want to use an LLC that the IRA owns. The LLC will offer limited liability protection and may also speed up the process, but there is an establishment fee. Many real estate investors prefer using an LLC for the limited liability protection feature.
4. Make Your Real Estate Investment
The final step is working with the IRA custodian to make the investment on behalf of the IRA. Whether you use an LLC or not, the IRA custodian will facilitate the investment at your direction.
If using an LLC, the funds will be wired by the IRA custodian to the LLC bank account. Whereas, if you don’t use an LLC, the IRA custodian will send the funds directly to the seller of the house.
Title to the real estate will be either in the name of the LLC or the IRA care of the custodian. All income and gains generated by the real estate will generally be tax deferred or tax-free, in the case of a Roth IRA.
Using Leverage to Purchase Real Estate with an IRA
Pursuant to Internal Revenue Code Section 514, if an IRA uses debt to acquire a home, the debt-financed portion of the property is treated as unrelated business taxable income (UBTI or UBIT). The UBTI tax rates mirror the Trust tax rates, which is approximately 37%.
If an IRA owns “debt-financed property,” some portion of each item of gross income from the property, and a like portion of all related deductions, are included in unrelated business taxable income, whether the income is in the form of rent, interest, gain on disposition of the property, or some other character.
Property is debt-financed if:
- It’s held for the production of income
- The use of the property is not substantially related to the organization’s exempt purpose
- There is acquisition indebtedness with respect to the property.
The term “acquisition indebtedness” generally includes any liability incurred before, contemporaneously with, or after the acquisition or improvement of the property if it arose because of the acquisition or improvement. Additionally, if the need for the indebtedness was foreseeable at the time of the acquisition or improvement.
The application of Internal Revenue Code Section § 514 has a wide application. For example, using an IRA in conjunction with a non-recourse loan can turn a tax-deferred investment into a highly unfavorable taxable transaction.
Using an IRA to buy a house has become a popular investment option for many retirement account holders. It is essential to make sure that you will not be transacting with a “disqualified” person when using IRA funds to buy a house.
In addition, it is important to consider whether the use of an LLC is necessary or not. Furthermore, if debt will be used, the loan must be non-recourse and it’s wise to understand the unrelated business taxable income tax rules.