Not many American retirement account holders realize that the Internal Revenue Code (IRC) allows for real estate (as well as many other alternative assets) to be held inside retirement accounts, such as an IRA or 401(k) plan. IRS rules permit individuals to engage in almost any type of real estate investment, aside generally from any investment involving a “disqualified person”.
So why do millions of Americans still not know that they can buy real estate with their retirement funds? The answer comes down to money. It is estimated that there is close to $28 trillion dollars in retirement funds, with the significant majority invested in traditional assets, such as stocks and mutual funds held at traditional banks and financial institutions.
Today, out of the roughly 52 million IRAs in the United States, estimates suggest that only 2 to 4 percent of them are self-directed. Basically, this means that almost 95 percent of Americans with Individual Retirement Accounts invest their retirement funds only in traditional, equity-type investments.
These banks and financial institutions make money when retirement account funds are invested in their financial products and keep your money there for a long time, whether through highly profitable trading commissions or by leveraging the power of your savings. They make no money when you use your money to invest in alternative or nontraditional investments such as a plot of land or a private business. They get no commissions as a result. They lose access to your money, too. Why would they inform you, then, that such a strategy was permissible and possibly even preferable depending on the circumstances? Yet, social media has helped educate the millions of retirement account holders of the opportunity to use retirement funds to buy real estate or other alternative assets through a Self-Directed IRA.
A Self-Directed IRA signifies a type of IRA account that is able to hold traditional assets, such as stocks, as well as alternative assets, such as real estate. A Self-Directed IRA can hold pre-tax traditional IRA assets, as well as Roth, and can also be used for a SEP or SIMPLE IRA. There are a large number of Self-Directed IRA custodians, or trust companies, that allow retirement account holders the ability to hold alternative asset investments. Alternative asset investments, such as real estate, can either be held directly by the IRA custodian or via a limited liability company (“LLC”), which is known as “checkbook control”.
There are many potential advantages of using retirement funds to make alternative asset investments. The primary advantage being the ability to generate tax-deferred or tax-free (when using a Roth IRA) income. The power to better diversify your retirement portfolio by investing in assets that you understand is another huge plus.
Buying real estate in your IRA may not be for every retirement account holder. One needs to have sufficient funds in his or her IRA to be in a position to buy a piece of real estate. In addition, there are a number of other important items to consider before deciding:
- Be Comfortable with the Investment: Real estate is generally a relatively large investment vis a vis the value of most Americans IRAs, thus, it is important to make sure you have done your research and diligence on the real estate investment you are considering. It is good practice to look at multiple properties, research the market you are considering, speak to realtors or other real estate investors, and most importantly, be comfortable with allocating a sizable chunk of your retirement assets to a real estate investment property. As you will soon learn, you are not permitted to reside in the property, so don’t make your investment decision based on your personal preferences.
- Understand the Economics of the Investment: It is important to have a good handle on the costs involved in owning the property. It is vital that you are realistic and objective when trying to learn the real numbers before closing. Look at previous years’ tax returns, property-tax bills, maintenance records, etc. to get a good idea of the real income and expenses. Also, it is important that you make sure to leave some extra funds in your IRA to cover any potential unforeseen property related expenses, since all expenses must be paid using IRA funds.
- Understand the Prohibited Transaction Rules: IRC only states what one cannot invest in. IRC Sections 408 & 4975 prohibits “disqualified persons” from engaging in certain type of transactions. 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 IRA owner, any lineal descendants, such as parents, children, spouse, daughter/son-in law of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest.
- Be Mindful of Using a Loan: If you will need to use a loan to close on your Self-Directed IRA real estate investment, only non-recourse financing may be used. A non-recourse loan is a loan that is not personally guaranteed by the IRA owner (the borrower) and whereby the lender’s only recourse is against the property and not against the borrower. However, when a Self-Directed IRA is investing in a real estate transaction involving the use of a non-recourse loan would be subject to tax pursuant to Internal Revenue Code Section 514, known as the Unrelated Business Taxable Income (UBTI). The tax rate could reach 37%.
Using a Self-Directed IRA to buy real estate has several advantages, although, it may not be for everyone. However, Self-Directed IRA investors wishing to use retirement funds to invest in real estate must be mindful of the four items outlined above and should consult with a tax professional for further guidance.