When it comes to real estate investing with an IRA, there are two types of IRA vehicles that can be used to invest in real estate directly or indirectly. Direct real estate investments involve purchasing a stake in individual properties to flip the property or rent it out. Indirect real estate investing involves buying shares in a real estate-related project. Whereas indirect real estate investing is far more passive and involves owning real estate via an investment fund
The Two Self-Directed IRA Real Estate Options
Full-Service Self-Directed IRA
With a full-service Self-Directed IRA, a special IRA custodian, IRA Financial, will serve as the custodian of the IRA. Unlike a typical financial institution which generates fees by selling products and providing investment services, a self-directed IRA custodian earns fees by simply opening and maintaining IRA accounts and does not offer any financial investment products or platforms. With a full-service self-directed IRA, the IRA funds are generally held with the IRA custodian. The IRA owner will then direct the IRA custodian to invest the IRA funds in IRS-approved alternative asset investments, such as real estate. The title to the self-directed IRA asset will be in the name of the self-directed IRA custodian care of the IRA owner. For example: IRA Financial Trust Company CFBO John Doe IRA.
A Self-Directed IRA that is full-service is popular with retirement investors looking to invest in alternative assets that do not involve a high frequency of transactions, such as the purchase of raw land or private fund investments.
Self-Directed IRA – “Checkbook Control”
With a Self-Directed IRA with checkbook control, an IRA is set up with a Self-Directed IRA custodian, such as IRA Financial. The IRA is then invested into a special purpose limited liability company (“LLC”), which IRA Financial can help you establish. The self-directed IRA LLC is then managed by the IRA owner providing the IRA owner with “checkbook control” over the IRA funds. With a “checkbook control” self-directed IRA LLC, the manager of the Self-Directed IRA LLC will have the authority to make investment decisions without the involvement of the custodian. Plus, a self-directed IRA LLC will offer the IRA owner limited liability protection over IRA investments. Moreover, all self-directed IRA investments will be titled in the name of the LLC offering the IRA owner more privacy. without needing the consent of an IRA custodian. With a Self-Directed IRA LLC with “Checkbook Control’ you will be able to buy real estate by simply writing a check
All types of IRAs can be transferred tax-free to a Self-Directed IRA LLC. A Self-Directed IRA with “checkbook control” is popular with IRA investors seeking to invest in alternative assets, specifically real estate that require a high frequency of transactions.
Read More: Self-Directed IRA FAQs
Direct vs Indirect Real Estate Investment Options
Direct Real Estate Investments
Using a Self-Directed IRA to make a direct real estate investment generally involves more ongoing work than engaging in a passive real estate investment. The most common type of direct real estate investment is owning the actual real estate asset directly in a Self-Directed IRA or a Self-Directed IRA LLC. The real estate can be a residential or commercial asset inside or outside the United States. The property can be used to hold and sell, to flip, or to generate rental income.
Retirement investors who want to invest directly in rental properties must know to form the following plans:
- Finding the property
- Verifying that it is a good deal.
- Acquiring the property
- Managing the property
Before purchasing real estate with a self-directed IRA there are several matters to consider:
- Do your Homework
Buying real estate with a Self-Directed IRA typically requires a sizable investment. Hence, it is crucial to understand the financial aspect of the investment. Spending time researching the property’s value is crucial. In addition, researching the location of the property and the trends within that neighborhood can also prove very useful. Of course, a Self-Directed IRA real estate investor should fully evaluate the financial terms of the transaction and research any potential financial responsibilities involving the investment. For example, a Self-Directed IRA investor thinking about buying a home for investment purposes should make sure they have enough funds in their IRA to cover the purchase price, as well as any potential improvements. Furthermore, it is wise to give yourself a financial cushion to cover taxes and other basic property expenses in case you have trouble finding a tenant.
- Consider the IRS Prohibited Transactions
Internal Revenue Code Sections 408 & 4975 prohibit the Self-Directed IRA owner and any of their lineal descendants (disqualified persons) from directly or indirectly personally benefiting from any Self-Directed IRA investor. For example, a self-directed IRA investor nor his or her lineal descendants is permitted to use or even improve the property under the prohibited transaction rules. The self-directed IRA should be the sole party that benefits from the investment.
- Be Careful of UBTI
In general, if a self-directed IRA invests in real estate that involves a nonrecourse loan (leverage) or is deemed a trade or business operated via an LLC or partnership, a percentage of the income associated with the business could be subject a tax known as the unrelated business taxable income (UBTI or UBIT) tax, which can go as high as 37%. Hence, any self-directed IRA investor who will be using leverage, investing in a fund using leverage, or investing in a real estate business (multi-family development project), should consider the tax implications of the UBTI tax.
Generally, Real estate will make an attractive addition to anyone’s investment portfolio. However, investors must be prepared to put in the work.
Learn More: How to Avoid UBIT
Indirect Real Estate Investing
Retirement investors who do not feel equipped for the rigors of direct real estate investing can invest indirectly through real estate investment funds, REITs (real estate investment trusts), crowdfunding websites, private notes, or a silent partnership.
Indirect real estate is a far more passive form of real estate investing than owning real estate directly in a Self-Directed IRA. With an indirect real estate investment, the Self-Directed IRA is a passive investor or limited partner in the real estate investment fund. The IRA will typically not manage the real estate investment and will essentially be a passive investor. In terms of the IRS prohibited transaction rules, engaging in an indirect passive real estate investment is a far safer investment since the IRA owner or any disqualified person will not be actively involved,
Below are some of the key factors to consider before using a Self-Directed IRA to make an indirect passive investment.
Due Diligence: Like a direct real estate investment, the IRA owner must perform the necessary due diligence to determine that the investment meets the IRA owner’s financial and retirement goals. It is also good practice to review the real estate fund documentation, including the private placement memorandum and all related subscription documents. Moreover, examining the promoters of real estate to better understand their track record and past performance is also helpful.
Accredited Investor Rules: 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 having earned at least $200,000 per year in each of the past two years and expecting 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. It is up to the individual investor to certify that they satisfy the SEC definition of an accredited investor.
Since an IRA is a retirement account and not a natural person, how does the SEC-accredited investor definition apply to a Self-Directed IRA. A Self-directed IRA is a type of IRA account that permits the IRA holder to invest in alternative asset investments, such as private placements, and much more.
The belief is that one would use the individual IRA owner’s financial status to determine if the IRA will satisfy the accredited investor rules. In other words, to determine if an IRA is deemed an accredited investor, you would look to the IRA owner to make that determination. If the IRA owner has income above $200,000 ($300,000 if married and filing jointly) for two consecutive years or has a net worth above $1 million, not excusing a primary residence, then the IRA will be deemed an accredited investor. From a legal standpoint, the idea is that since an IRA is treated as a trust under IRC 408, under the accredited investor trust rules, if each of the people creating the trust is an accredited investor individually, then the trust will also carry accredited investor status.
Most non-publicly traded or investment funds, such as private equity, hedge funds, and most private business investments, are structured as Reg A or Reg D-type private placements. The advantage of an investment complying with the Reg A or Reg D rules is that it limits the fund or business seeking financing SEC reporting obligations. Hence, if the individual self-directed IRA owner satisfies the SEC accredited investor definition, the self-directed IRA would then be permitted to make the Reg A or Reg D investment.
IRS Prohibited Transaction Rules: like a direct real estate investment, any self-directed IRA investor must consider the IRS prohibited transaction rules before engaging in an indirect real estate transaction. However, because an indirect real estate investment is so passive, so long as the IRA owner or any “disqualified person” controls the real estate investment and will directly or indirectly benefit from the IRA investment, the IRS-prohibited transaction rules are less likely to be an issue in an indirect IRA real estate investment.
UBIT: In the case of a self-directed IRA investment into a passive real estate fund, the UBIT or UBIT rules will only likely be triggered by the use of debt or leverage.
Almost all retirement account investments generating passive income will not be subject to UBIT) or Unrelated Debt Finance Income (UDFI) Tax. The UDFI is part of the UBTI family and triggers the same UBTI tax. However, since a retirement account is treated as tax-exempt, such as a charity under Internal Revenue Code Section 501, the UBIT tax rules will apply to retirement accounts in certain instances.
In summary, UBTI is triggered if:
- Retirement account uses a nonrecourse loan to buy an asset, such as stocks
- Retirement account invests in an active business through a passthrough entity, such as an LLC
Whereas, UDFI is triggered if:
- A self-directed IRA uses a nonrecourse loan (real estate acquisition financing) to purchase real estate). A specific exemption exists for 401(k) plans or pension plans that use a nonrecourse loan to acquire real estate under Internal Revenue Code (“Code”) Section 514(c)(9)
For 2024, the UBIT maximum tax rate is 37%., however, the UBIT tax rate does not apply if a retirement account generates less than $1000 of net UBIT income during the year. The UBIT tax rate is subject to the trust and estate income tax rates:
In 2024 the trust income tax rates are as follows:
- 10%: $0 – $2,900
- 24%: $2,901 – $10,550
- 35%: $10,551 – $14,450
- 37%: $14,451 and higher
Hence, the 37% maximum UBIT tax rate makes the UBIT tax a major issue for certain self-directed IRA investors.
Generally, whether an investor uses a Self-Directed IRA or personal funds to buy real estate, the ability to gain exposure to the real estate asset class has proven to be a wise investment over the years. As outlined above, whether one invests in real estate with a Self-Directed IRA directly or indirectly several factors must be examined before investing. The ability to generate tax-deferred or tax-free real estate income is the primary reason why millions of real estate investors have been looking to the self-directed IRA. The full-service self-directed IRA or a Self-Directed IRA LLC will allow a retirement investor to invest in real estate directly or indirectly in a tax-efficient manner and still gain investment diversification, hedge against inflation, as well as invest in a hard asset they know and trust.