Can I Invest in Real Estate with my IRA?
You can make real estate investments with your IRA. In fact, the IRS has always allowed investors to hold real estate in their retirement account, yet many investors use their IRA to invest in bank CDs, the stock market or other traditional assets. This is because banks and traditional financial institutions limit their clients to the financial products they sell, which does not include alternative assets, like real estate. When you establish a Self-Directed IRA through an IRA custodian, you have the freedom to invest in real estate and other alternative investments along with traditional investments. The Self-Directed IRA structure is perfectly legal. It is similar to a Traditional IRA, but allows you to diversify your retirement investments so they do not move in the same direction. The IRS permits you to engage in virtually any type of real estate investment as long as it does not include a disqualified person, such as yourself and lineal descendants.
Advantages of Using a Self-Directed IRA LLC to Purchase Real Estate
Real estate is one of the most popular retirement investments among self-directed investors. One primary reason is that real estate is a tangible asset that produces steady income. For many investors, particularly those with real estate experience, it has been an integral investment in building retirement wealth. The investment may also appreciate in value, however this is dependent on the location of the land or property you purchased.
We cannot tell what the future will bring, and the threat of inflation looms over many investors – but the rise of inflation leads to the rise of rental income. As a result, your property will maintain, but most likely increase in value. This is why real estate investments act as a hedge against inflation.
The best way to purchase real estate is with a retirement account, however most banks and financial institutions will limit you to the products they sell, such as bank CDs, stocks, bonds, mutual funds, ETFs, etc. When using a Traditional IRA, it is unlikely to gain the freedom to invest in real estate even if you establish what financial institutions promote as a “self-directed” IRA. When you choose a Self-Directed IRA custodian (passive custodian) you will be able to invest in real estate assets you know and understand, such as rental property, multi-family property or a piece of land.
What is a Self-Directed IRA for Real Estate?
A Self-Directed IRA through a passive custodian is a traditional IRA that allows you to make IRS approved investments using your retirement funds. Investments you can purchase with a Self-Directed IRA include alternative assets, such as real estate, as well as traditional assets, like mutual funds.
As with a Traditional IRA, all investments are either tax-deferred or tax-exempt with a Self-Directed IRA. Tax-deferral essentially means you do not have to pay taxes immediately. You can pay at a later date, and allow the investment to grow unhindered until you take a qualified distribution.
Let us take a look at the power of tax-deferral when investing with a retirement plan. Assume you establish your retirement plan with $100,000 and you keep it open for 20 years. If you generate an average annual pre-tax rate return of 8% and the average tax rate is 25%, your investment will be worth $466,098 after 20 years. After taxes, you receive $349,572 on the earnings. Over the years, your investment compounds by re-investing your original investment.
Ideally, you should begin real estate investing when you are earning higher income and in a higher tax bracket. That way, when you reach retirement age and you can take a distribution, you most likely earn less income or no income, therefore in a lower tax bracket. In other words, you take more money home.
What Real Estate Investments Can I Make with a Self-Directed IRA?
Below is a partial list of domestic or foreign real estate-related investments you can make with a Self-Directed IRA:
- Raw land
- Residential homes
- Commercial property
- Mobile homes
- Real estate notes
- Real estate purchase options
- Tax liens certificates
- Tax deeds
Investing in Real Estate with an IRA LLC is quick and easy. When you see an investment you want, simply write a check, wire the funds or use a debit card. It is essentially the same as purchasing real estate personally, but with the added benefit of tax-deferral.
Savvy Strategies for Using Your Self-Directed IRA to Purchase Real Estate
When using a Self-Directed IRA LLC to make a real estate investment, there are a number of ways you can structure the transaction:
1. Use your Self-Directed IRA LLC funds to make 100% of the investment
If you have enough funds in your Self-Directed IRA LLC to cover the entire real estate purchase (including closing costs, taxes, fees, insurance, etc.) you may make the purchase outright using your Self-Directed IRA LLC. You pay all ongoing expenses relating to the real estate investment out of your Self-Directed IRA LLC bank account. All income or gains relating to your real estate investment must return to your Self-Directed IRA LLC bank account.
2. Partner with family, friends, colleagues
If you don’t have sufficient funds in your Self-Directed IRA LLC to make a real estate purchase outright, your Self-Directed IRA LLC can purchase an interest in the property along with a family member who is a non-disqualified person. You can also purchase with a friend, or colleague. The investment will not be made into an entity owned by the IRA owner. Instead, it’s invested directly into the property.
For example, your Self-Directed IRA LLC can partner with a non-disqualified family member, friend, or colleague to purchase a piece of property for $150,000. Your Self-Directed IRA LLC can purchase an interest in the property (for example, 50% for $75,000) and your family member, friend, or colleague can purchase the remaining interest (50% for $75,000).
All income or gain from the property will allocate to the parties in relation to their percentage of ownership in the property. Likewise, all property expenses must be paid in relation to the parties’ percentage of ownership in the property.
Based on the above example, for a $2,000 property tax bill, the Self-Directed IRA LLC will be responsible for 50% of the bill ($1,000). The family member, friend, or colleague is then responsible for the remaining $1,000 (50%).
We’ll discuss more on partnering with family, friends and colleagues later in this article.
3. Borrow money for your Self-Directed IRA LLC
You may obtain financing through a loan or mortgage to finance a real estate purchase using a Self-Directed IRA LLC. However, you must consider two important points when selecting this option:
1. If the IRA purchases real estate and secures a mortgage for the purchase, the loan must be non-recourse. Otherwise there will be a prohibited transaction. A non-recourse loan only uses the property for collateral. In the event of default, the lender can collect only the property and cannot go after the IRA itself.
2. Tax is due on profits from leveraged real estate. If your Self-Directed IRA LLC uses non-recourse debt financing (i.e., a loan) on a real estate investment, some portion of each item of gross income from the property are subject to Unrelated Business Income Tax (UBTI). This is pursuant to Code Section 514. “Debt-financed property” refers to borrowing money to purchase the real estate. For example, a leveraged asset that is held to produce income.
In such cases, only the income attributable to the financed portion of the property is taxed. Gain on the profit from the sale of the leveraged assets is also UDFI. However, it is not Unrelated Debt Financing tax (UDFI) if the debt is paid off more than 12 months before the property is sold.
There are some important exceptions from UBTI. Those exceptions relate to the central importance of investment in real estate from the sale of real estate. This includes:
- Most rentals from real estate
However, rental income the real estate generates that is “debt financed” loses the exclusion. That portion of the income becomes subject to UBTI. Thus, if the IRA borrows money to finance the purchase of real estate, the portion of the rental income attributable to that debt will be taxable as UBTI.
Let’s assume the average acquisition indebtedness is $50: the average adjusted basis is $100. 50 percent of each item of gross income from the property is included in UBTI.
UBTI Tax Rates
In most cases, when you use a retirement plan to make investments, you do not generate tax in the case of a Roth IRA, or the taxes will be deferred until a distribution, such as a Traditional or Self-Directed IRA. However, there are certain instances where you will trigger a tax known as the Unrelated Business Taxable Income (UBTI) tax. If you use retirement funds in a real estate transaction that involves a non-recourse loan, you will trigger the UBTI tax. In that case, it’s important to note that a Self-Directed IRA LLC subject to UBTI is taxed at the trust tax rate. This is because an IRA is considered a trust. For 2021, a Self-Directed IRA LLC subject to UBTI is taxed at the following rates:
- $0 – $2,550 = 10% of taxable income
- $2,551 – $9,150 = $255 + 24% of the amount over $2,550
- $9,151 – $12,500 = $1,839 + 35% of the amount over $9,150
- $12,501 + = $3,011.50 + 37% of the amount over $12,500
Partnering with a Family Member in a Real Estate Transaction – Prohibited Transaction?
Partnering with a family member is likely not prohibited if the transaction is structured correctly. Investing in an investment entity with a family member and investing in an investment property directly are two different transaction structures that impact whether the transaction will be prohibited under Code Section 4975.
The different tax treatment is based on who currently owns the investment. Using a Self-Directed IRA LLC to invest in an entity that a family member owns (and is a disqualified person) will likely be treated as a prohibited transaction.
However, partnering with a family member that is a non-disqualified person directly into an investment property is likely not a prohibited transaction. It’s important note that if you, a family member, or other disqualified person already owns a property, then investing in that property with your Self-Directed IRA LLC would be prohibited.
Set Up a Self-Directed IRA LLC with IRA Financial
You can easily and quickly establish your Self-Directed IRA/IRA LLC to make real estate investments. It only takes five steps.
- Identify the investment property.
- Purchase the investment property with the Self-Directed IRA LLC – no need to seek the consent of the custodian with a Self-Directed IRA LLC with “Checkbook Control”.
- Title to the investment property and all transaction documents must be in the name of the Self-Directed IRA LLC. The LLC manager must sign pertaining to the property investment.
- All expenses paid from the investment property go through the Self-Directed IRA LLC. Likewise, all rental income checks must be deposited directly in to the Self-Directed IRA LLC bank account. Do not depot IRA related investment checks into your personal accounts.
- All income or gains from the investment flow to the IRA tax-free!
Did You Know?
IRA Financial can help you with your retirement planning by answering any questions you may have about the many areas of Self-Directed Retirement, including Solo 401(k) and Self-Directed IRA accounts, and the UBTI Tax Rate, which is applicable to trusts or corporations, depending on the organization’s legal characteristics. Reach out now to our specialists and get more information.