A Self-Directed IRA LLC offers one the ability to use his or her retirement funds to make almost any type of investment on their own without requiring the consent of any custodian or person. The IRS and Department of Labor only describe the types of investments that are prohibited, which are very few.
The IRS permits using a Self-Directed IRA LLC to purchase real estate or raw land. Since you are the manager of the Self-Directed IRA LLC, making a real estate investment is as simple as writing a check from your Self-Directed IRA bank account. The advantage of purchasing real estate with your Self-Directed IRA LLC is that all gains are tax-deferred until a distribution is taken (pre-tax 401(k) distributions are not required until the IRA holder turns 70 1/2). In the case of a Roth Self-Directed IRA, all gains are tax-free.
For example, if you purchased a piece of property with your Self-Directed IRA LLC for $100,000 and you later sold the property for $300,000, the $200,000 of gain appreciation would generally be tax-deferred. 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.
- Be cognizant of the IRS prohibited transaction rules. The foundation of the prohibited transaction rules is based on the premise that investments involving 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 IRA and certain individuals known as “disqualified persons”. The outline for 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 IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest. When it comes to real estate, an IRA holder or any disqualified person may not be directly or indirectly personally involved or personally benefit directly or indirectly from the real estate transaction. For example, an IRA holder cannot purchase a home and personally live in it or have any disqualified person (i.e. parent, child, spouse, daughter/son-in-law, etc.) personally use it.
- The deposit and purchase price for the real estate property should be paid using Self-Directed IRA LLC funds or funds from a non-disqualified third-party.
- No personal funds or funds from any “disqualified person” should be used.
- All expenses, repairs, taxes incurred in connection with the Self-Directed 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 IRA or from a non “disqualified person.”
- If financing is needed for a real estate transaction, only nonrecourse financing should be used. A nonrecourse 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.
- With a Self-Directed IRA the use of a nonrecourse loan would be subject to tax pursuant to Internal Revenue Code Section 514. The tax rate could reach 39%.
- No services should be performed by the IRA holder or “disqualified person” in connection with the real estate investment. In general, other than typical trustee type of services (necessary and required tasks in connection with the maintenance of the plan), no active services should be performed by the plan participant 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 IRA LLC. For example, if Joe Smith established a Self-Directed IRA LLC and named the LLC XYZ, LLC, title to real estate purchased by Joe’s Self-Directed IRA LLC would be as follows: XYZ LLC.
- Keep good records of income and expenses generated by the real estate investment
- All income, gains or losses from the Self-Directed IRA LLC real estate investment should be allocated to the IRA.
- 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 transactions, which would involve buying or selling real estate that will personally benefit you or a “disqualified person.”
A Blueprint for What a Self-Directed IRA Real Estate Investor Can and Cannot Do
The Cherwenka case (In Re Cherwenka (113 AFTR 2d 2014-2333) (508 B.R. 228), (Bktcy Ct GA), 03/06/2014) involved a Georgia statutory bankruptcy estate exemption for IRAs, which covered a Self-Directed IRA held by Michael Cherwenka, who was in business of “flipping” houses. Michael Cherwenka established a Self-Directed IRA to buy real estate. The Cherwenka case is really the first case that offers a detailed framework about the type of activities or tasks a Self-Directed IRA real estate investor can perform without triggering the IRC 4975 prohibited transaction rules. In the case, Cherwenka was not compensated for any real property research he performed, nor was he compensated for any recommendations, management or consulting services he provided relating to how the IRA properties were improved before resale. Cherwenka explained his role in buying and selling off these properties as being limited to identifying the asset for purchase and later selling the asset. Cherwenka engaged contractors to decide or oversee the scope of work which improved properties. Cherwenka testified that he “read and approved” the expense forms prior to the IRA custodian paying funds to reimburse the submitted expenses. Contractors were paid by the job, which accounted for labor costs, but no management fee or additional cost was included in the expenses submitted to the IRA custodian. Cherwenka stated he would inspect or confirm that work was completed through site visits or communication with his “team” before he would approve expenses to be paid by the IRA custodian.
Because most Self-Directed IRA real estate investors tend to perform the same sort of tasks that Cherwenka performed, such as locating the property, reviewing transaction documents, engaging contractors to perform property improvements, inspection of improvements, approval of expenses, and coordinating with the IRA custodian regarding the real estate, the case offers a clear blueprint for the type of activities or tasks that a Self-Directed IRA real estate investor can do without violating the IRC Section 4975 prohibited transaction rules.