Last Updated on February 7, 2020
Real Estate IRA Rules You Should Know
A Self-Directed Roth IRA LLC offers you the ability to use your retirement funds to make almost any type of investment. With a Self-Directed IRA LLC, you no longer require custodian consent to make an investment. Because it’s a Roth retirement account, all your gains are tax-free, even when take a distribution.
There are many advantages that come along with self-directing your IRA. One of the primary benefits is the freedom to invest in what you know and understand, like real estate. However, there are real estate IRA rules to keep in mind before using your Self-Directed Roth IRA to make any real estate investment.
Before we continue, it’s important to note that the IRS and Department of Labor only describe the types of investments that are prohibited. That’s why it’s wise to know the IRS prohibited transaction rules.
Prohibited Transaction Rules
The basis of the prohibited transaction rules stem from the premise that investments involving Roth IRA and related parties are handled in a way that benefits the retirement account and not the IRA owner. The rules prohibit transactions between the Roth IRA and certain individuals known as “disqualified persons”. These rules can be found in Internal Revenue Code Section 4975. In general, 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 Roth IRA holder, any ancestors or lineal descendants of the Roth IRA holder, and entities in which the Roth IRA holder holds a controlling equity or management interest.
The IRS permits using a Self-Directed Roth IRA LLC to purchase real estate or raw land. Since you are the manager of the Self-Directed Roth IRA LLC, making a real estate investment is as simple as writing a check from your Self-Directed Roth IRA bank account. The advantage of purchasing real estate with your Self-Directed Roth IRA LLC is that all income and gains are tax-free, assuming the Roth IRA has been opened for 5 years and the Roth IRA holder is over the age of 591/2 when the distribution is taken.
For example, if you purchased a piece of property with your Self-Directed Roth IRA LLC for $100,000 and you later sold the property for $300,000, the $200,000 of gain appreciation would generally be tax-free. Whereas, if you purchased the property using personal funds (non-retirement funds), the gain would be subject to federal income tax and in most cases state income tax.
When it comes to using a self-directed Roth IRA to purchase real estate, there are a number of rules that should be followed in order to make sure the real estate Roth IRA investment does not violate any of the IRS prohibited transaction rules.
- The deposit and purchase price for the real estate property should be paid using Self-Directed Roth IRA LLC funds or funds from a non-disqualified third-party
- No personal funds or funds from a “disqualified person” should be used
- All expenses, repairs, taxes incurred in connection with the Self-Directed Roth IRA real estate investment should be paid using retirement funds – no personal funds should be used
- If additional funds are required for improvements or other matters involving the real estate investments, all funds should come from the Self-Directed Roth IRA or from a non “disqualified person”
- If financing is needed for a real estate transaction, only non-recourse financing should be used. A non-recourse loan is a loan that is not personally guaranteed and whereby the lender’s only recourse is against the property and not against the borrower.
- The Roth IRA holder or “disqualified person” in connection with the real estate investment should perform no services in connection with the use of self-directed IRA LLC. In general, other than standard management type of services (necessary and required tasks in connection with the maintenance of the LLC), no active services should be performed by the LLC manager or a “disqualified person” with respect to the real estate transaction.
- Title of the real estate purchased should be in the name of the Self-Directed Roth IRA LLC. For example, if Joe Smith established a Self-Directed Roth IRA LLC and named the LLC XYZ, LLC, title to real estate purchased by Joe’s Self-Directed Roth IRA LLC would be as follows: XYZ LLC
- Although the use of a non-recourse loan is permitted with a self-directed Roth IRA when buying real estate, the use of a non-recourse loan would impose a tax pursuant to IRC 514 on a percentage of the income generated by the Roth IRA investment based off a percentage of the debt used in proportion to the amount of cash invested. This tax is especially difficult in the case of a Roth IRA, which generally offers tax-free income and gains.
- Keep good records of income and expenses generated by the real estate investment
- All income, gains or losses from the Self-Directed Roth IRA LLC real estate investment should be allocated to the IRA and be returned to the Roth IRA LLC bank account
- Make sure you perform adequate diligence on the property you will be purchasing especially if it is in a state you do not live in
- Make sure you will not be engaging in any self-dealing real estate transaction which would involve buying or selling real estate that will personally benefit you or a “disqualified person”
- If you need to make additional Roth IRA contributions to your Self-Directed IRA, the contribution should be made to the Roth IRA custodian/administrator and then the funds will be transferred to the Roth IRA LLC.
Using a Self-Directed Roth IRA LLC to buy real estate is quick and easy, however, there are a number of IRS rules and potential tax issues that must be addressed before making the Self-Directed IRA real estate investment.