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Using a Self-Directed IRA LLC to Purchase Real Estate
Invest in Real Estate with your IRA (individual retirement account)
Most investors mistakenly believe that they must invest their IRA in bank CDs, the stock market or mutual funds. Very few investors realize that the IRS permits real estate to be held in retirement accounts. Investments in real estate with a Self-Directed IRA LLC are permissible under the Employee Retirement Income Security Act of 1974 (ERISA). IRS rules permit you to engage in virtually any type of real estate investment, excluding those that involve a disqualified person.
Advantages of Using a Self-Directed IRA LLC to Purchase Real Estate
Income or gains an individual retirement account generates are tax-deferred or tax-free in the case of a Roth self-directed IRA. Using a self-directed IRA LLC to purchase real estate allows the IRA to earn tax-free income/gains and pay taxes at a future date. In the case of a Roth IRA the income/gains are always tax-free.
There are several advantages of using a self-directed IRA to buy real estate. The first is tax deferral or tax-free growth. For example, if you purchase a piece of property with retirement funds for $80,000 and later sell the property for $300,000, then the $220,000 of gain appreciation will generally be tax-deferred.
Whereas, if you purchase the property using personal, non-retirement funds, the gain is subject to federal income tax. In most cases, it may also be subject to state income tax.
Second, a self-directed IRA can allow you to invest in real estate assets you know and understand, such as a rental property or a piece of land.
Finally, having the ability to invest in alternative assets is a good source of investment diversification.
- Gains are tax free
- Positive cash flow is tax free
- No time limit for holding property
- IRA can borrow money - Leverage your investment with non-recourse financing
- Potential to earn a larger rate of return on invested capital
Tax Advantages of Buying Real Estate with a Self-Directed IRA LLC
When purchasing real estate with a Self-Directed IRA LLC, in general, all income and gains your pre-tax retirement account generates will flow back into the retirement account tax-free. In other words, you don't have to immediately pay tax on the returns of a real estate investment. You can pay at a later date, leaving the real estate investment to grow unhindered.
Generally, IRA holders make self-directed IRA real estate investments when they're in a higher income. Thus, they're in a higher tax bracket. IRA holders can make a withdrawal from the investment account when they're earning little or no income. In other words, when they're in a lower tax bracket.
Joe establishes a Self-Directed IRA LLC with $100,000 to purchase real estate and make other investments. Assume Joe keeps his self-directed IRA LLC open for 20 years. Further assume that Joe was able to generate an average annual pre-tax rate return of 8% and the average tax rate is 25%.
By using a tax-deferred self-directed IRA LLC strategy, after 20 years, Joe’s $100,000 investment will be worth $466,098. That's a whopping $349,572 after taxes on the earnings. Whereas, if Joe made the investments with taxable funds (non-retirement funds) Joe would have only $320,714 after 20 years.
As you can see, a self-directed IRA for real estate investments lets you save more.
Real Estate IRA Investment Options
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 a self-directed IRA, or IRA LLC is quick and easy.
Purchasing real estate with a Self-Directed IRA or IRA LLC is essentially the same as purchasing real estate personally.
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 (i.e. 50% for $75,000) and your family member, friend, or colleague can purchase the remaining interest (i.e. 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
A Self-Directed IRA LLC subject to UBTI is taxed at the trust tax rate because an IRA is considered a trust. For 2019, 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. However, 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 Group
You can easily and quickly establish your Self-Directed IRA/IRA LLC to make real estate investments. In 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!
We wrote the book on Self-Directed IRAs
The second installment in a four-part series, The Checkbook IRA: Why You Want it, Why You Need it, explores important topics regarding the self-directed IRA and why it has become the leading retirement structure to purchase real estate using IRA funds.
Following the success of Adam Bergman’s previous self-directed IRA book comes Self-Directed IRA in a Nutshell, a straightforward explanation on what IRA investors need to know about self-directed IRA retirement structure.
Get in Touch
Do you have questions about using your Self-Directed IRA to purchase real estate? If we didn't cover it in the article, contact IRA Financial Group at 800-472-0646. Or fill out the form and speak with an IRA specialist. Let’s get started today! Continue reading our Learn More pages to discover important information regarding the Self-Directed IRA.