The IRS and the Internal Revenue Code do not express what a Self Directed IRA real estate can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits Disqualified Persons from engaging in certain type of transactions. The purpose of these rules is to encourage the use of IRAs for accumulation of retirement savings and to prohibit those in control of IRAs from taking advantage of the tax benefits for their personal account.
The IRS has always allowed the use of retirement funds to purchase real estate. While the majority of financial institutions will not allow retirement funds to be allocated for real estate investments, even though the IRS permits it, as it is not profitable, other IRA custodians do allow for the purchase of real estate using IRA or 401(k) funds.
The Self Directed IRA Real Estate structure involves the establishment of a limited liability company (“LLC”), which is owned by the IRA (care of the IRA custodian) and managed by the IRA holder (you) or any third-party. The IRA Custodian, as recipient of the transfer of IRA funds from the previous custodian, would then invest the IRA funds tax-free into the new IRA LLC. As manager of the LLC, the IRA holder would then be able to make an investment by simply writing a check (checkbook control). Title to the property would be held in the name of the LLC and all income and gains generated by the real estate investment would generally flow back to the Self Directed IRA Real Estate tax-free! In addition, the LLC manager would be able to make the investment decision on his or her own without custodian consent – true checkbook control!
When it comes to using a Self Directed IRA to purchase real estate, it is important that one works with a tax professional who specializes in the IRS prohibited transaction rules. The reason for this is that the penalties for engaging in a prohibited transaction are severe (entire IRA will be treated as a distribution subject to tax plus a penalty may be imposed).
When using a Self Directed IRA to purchase real estate, there are a number of important items that should be considered before making a real estate investment:
- Only retirement funds should be used for the real estate investment
- no co-mingling of personal funds
- The real estate transaction should not involve a “disqualified person”. 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.
- All income and gains generated by the real estate investment should flow back to the Self Directed IRA LLC.
- Only IRA funds should be used to pay expenses related to the Self Directed IRA real estate investment.
- The IRA holder as manager of the Self Directed IRA LLC, nor any disqualified person shall be compensated in any way in connection with a Self Directed IRA real estate investment.
- The IRA holder as manager of the Self Directed IRA LLC, nor any disqualified person shall perform any services with respect to the real estate investment (i.e. repairs or improvements).
- The IRA holder, as manager of the Self Directed IRA LLC nor any disqualified person shall personally benefit in any way, directly or indirectly, in connection with a Self Directed IRA investment.
The prohibited transaction rules are extremely broad and the penalties extremely harsh (immediate disqualification of entire IRA plus penalty). Thus, the IRA owner self directing his or her investments must be especially cautious in engaging in transactions that could compromise his or her best judgment or result in a direct or indirect personal benefit.