Buy Real Estate in Your IRA

This is an article by Kelli Click at Sterling Trust that I've found very informative.

Retirement Planning
Buy Real Estate in Your IRA

A little-known IRS provision lets you extend your real estate purchasing with tax-deferred dollars.

BY KELLI L. CLICK

Are stock market woes preventing you from building wealth in your retirement account? If so, you might be interested in a small, but growing, trend among individual retirement account owners—investing their retirement funds in real estate.

How It Works
If the option of using tax-deferred funds to purchase property sounds appealing, you’ll need to locate an independent IRA custodian that allows real estate investments and work with that company to set up an IRA account. Most banks and brokerage companies—the most common IRA account options—limit your choices to certificates of deposit, stocks, mutual funds, annuities, and similar financial instruments. But Section 408 of the Internal Revenue Code permits individuals to purchase land, commercial property, condominiums, residential property, trust deeds, or real estate contracts with funds held in many common forms of IRAs, including atraditional IRA, a Roth IRA , and a Simplified Employee Pension plan, or SEP-IRA.

To find a custodian that specializes in real estate, search under terms such as “real estate IRA” or “self-directed IRA.” This latter term was coined by the financial industry in the 1980s to distinguish the self-directed IRA from other IRAs that focus on stocks and bonds. The IRA account holder can’t serve as the custodian of his or her own account. However, it’s important to select a custodian knowledgeable about the types of investment you’re interested in, because the custodian holds title to the real estate. Do your homework, and understand what you’re getting into.

Fees can vary widely among custodians, as can the flexibility of the services provided for account holders. If the custodian holds real estate on your behalf, but does not service it (collect the rent, etc.), you may have to contract with other providers. However, be sure that all rents are paid into the IRA and that all taxes are paid by the IRA.

Purchasing the Property
Most IRA custodians that hold real estate will usually allow you to purchase raw or vacant land, residential properties, or commercial buildings for your portfolio. In addition, some custodians may permit foreign property or leveraged property.

Since buying a property may require more funds than you currently have available in your IRA, you also can have your IRA purchase an interest in the property in conjunction with other individuals, such as a spouse, business associate, or friend. Also keep in mind that if the property is leveraged, the debt must be a non-recourse promissory note.

Unfortunately, Internal Revenue Service regulations will not let you use the real estate owned by your IRA as your residence or vacation home. Nor can your business lease space in your IRA-held property. The underlying premise for any real estate investment purchased with IRA funds is that you can’t have any personal use or benefit of the property. To do so may cost you plenty in taxes and penalties.

There are a few other IRS limitations as well. You cannot place a real estate property that you already own into your IRA. Your spouse, your parents, or your children also couldn’t have owned the property before it was purchased by your IRA. Property owned by siblings may be allowed, since the Internal Revenue Code (section 4975) specifies that only “lineal descendents” be disqualified.

Once you’ve chosen a property, your IRA custodian—not you personally—must actually purchase it. The title will reflect the name of your IRA custodian for your benefit (such as Silver Trust Co., Custodian FBO John Doe IRA). In addition, if you put up earnest money with your personal funds, you’ll need to make sure you include that amount in the total due so that the title company can reimburse you upon closing.

Operating an IRA-held Property
Because all property expenses, including taxes, insurance, and repairs, must be paid from funds in your IRA, you’ll need liquid funds available in your account. Of course, all income generated from the property will be deposited in your IRA account so you can use that money to cover your costs. You also can make annual contributions within federal guidelines.
Currently, you can contribute $3,000 annually to a traditional or Roth IRA ($3,500 if you’re age 50 or older) and as much as 15 percent of your annual compensation, up to $40,000, if you’re a self-employed individual with a SEP-IRA. If your account doesn’t have funds to cover property expenses, you will have to withdraw the property from your IRA and pay taxes on the value of the property, as well as possible penalties for early withdrawal.

It’s also possible to sell properties while they are held by your IRA, so long as the purchaser is not a family member. Once a deal closes, your IRA account now holds the cash proceeds—ready for you to make your next investment. An alternative is to sell an IRA-held property with seller financing so that all payments made by the buyers are paid to the IRA.

Distributing Your Property
You can withdraw real estate from your IRA and use it as a residence or second home when you reach retirement age (age 59½ or older for a penalty-free withdrawal). At that time, you can elect either to have the IRA sell the property or take an in-kind distribution of the property. Under that arrangement, your IRA custodian assigns the title to the property to you. You will then have to pay income taxes on the current value of the property if it’s been held in a traditional IRA. If the property was held in a Roth IRA, you won’t owe taxes at distribution. This makes a Roth IRA extremely attractive if you anticipate that your real estate investments will appreciate over time.

Whether your retirement strategy is to hold properties or buy and sell for gain, real estate investing through your IRA can yield extraordinary returns toward your future retirement.

IRA Options
While any form of IRA allows for real estate investment, there are other pluses and minuses to consider when choosing the account type that’s best for you:

• A traditional IRA lets you deduct annual contributions (currently set at $3,000, or $3,500 if you’re age 50 or older) from your income. However, once you begin withdrawing money, those funds will be taxed as regular income.
  
• A Roth IRA gives you no deduction on your current contributions (again $3,000), but does allow you to withdraw funds tax-free. If you expect to buy a real estate investment in an IRA and hold it for a long period, this is probably your best option, particularly if the property increases in value over that period.
  
• A SEP-IRA is designed for self-employed individuals and small companies. You can contribute up to 25 percent of your compensation, or $40,000, whichever is less. However, keep in mind that if you have employees, you must make contributions for them as well. This option is a great alternative for real estate practitioners who can make the higher contributions because they can build up funds more rapidly to purchase properties. Withdrawals from a SEP-IRA are treated like those of a traditional IRA for tax purposes.
  
  Kelli L. Click is vice president of sales and marketing at Sterling Trust Co., a self-directed IRA and 401(k) custodian, in Waco, Texas.

FAQa About Owning Real Estate In Your IRA Or 401k

I recently put together the following list of FAQa on using your IRA or 401k to purchase real estate.

Real Estate IRA FAQ’s

Question: I’ve never heard of this before. Is it new?

No investments in real estate, non-traditional investments and LLCs have been allowed since the creation of the IRA. However, only about 2% of all IRA funds are invested outside of stocks, bonds and mutual funds. Why? Because most investors don’t know they have other options available. Stockbrokers and bankers have no incentive to explain all the options to you.

Question: Why does my current IRA brokerage firm say I can’t buy real estate in my IRA?

Custodians determine the type of assets they will hold and may not choose to hold all assets the Internal Revenue Service (IRS) allows. Life insurance contracts and collectibles are the only investment types prohibited by the IRS as an IRA investment. IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option. So, just because your broker doesn’t offer real estate as an investment, doesn’t mean that you can’t do it; it just means that you can’t do it through that brokerage firm.

Question: Are there restrictions on the type of property that my IRA can purchase?

No. As long as it is an investment, your IRA can purchase any type of real estate (raw land, pre-development, commercial, residential, etc.).

Question: I’d like to buy a vacation home now and rent it out until I retire, then use it as my residence during retirement. Is this allowed?

No. This is a common prohibited transaction. You can never occupy a property purchased with IRA or 401k funds.

Question: Can my IRA invest in an LLC with other members?

Yes. You, any family members, their IRAs, eligible 401(k)s (or other qualified plans), and unrelated third parties may all be initial members of an LLC created to purchase real property. Each member’s interest is held separately within the LLC. Once the initial funding of the LLC is complete, however, future transactions may be limited due to the prohibited transaction and self-dealing rules.

Question: Are there going to be taxes and penalties when I move my IRA into the Self-Directed IRA?

Absolutely not! You are not taking money out of your IRA; you are transferring the assets into another type of IRA that allows you to self-direct the investment choices.

Question: At what again can I begin to withdraw money from my IRA?

You can begin at the age of 59½.

Question: I have an old 401k from a former employer. Can I roll it over to a self-directed IRA for real estate investment?

Though almost all 401k or corporate pension plans will not allow rollovers for current employees, once an employee leaves, he or she can rollover their pension plan into an IRA. The full amount does not have to be rolled over. Only move it to a self-directed account when you are ready to begin using the IRA for real estate investment.

Question: Can I buy a fixer-upper with my IRA, use the IRA money to fix it up and then be the property manager?

Yes. With the Self-Directed IRA you can do all of these things, check with your custodian to confirm they will hold the property in your IRA before you make a purchase offer.

Question: Can I contribute real estate or real estate paper to my IRA?

No. Contributions must be in cash. However, you can convert a traditional IRA that holds assets other than cash, to a Roth IRA. Some determination of value will need to be filed with the custodian to set the value of the conversion for tax purposes.

Question: Why wouldn’t I not go ahead and transfer to a true self-directed custodian?

There is no reason to move the IRA to a self-directed custodian until you are ready to start using the funds to invest in real estate investments.

Question: Can I make a loan to myself from my self-directed IRA to invest in real estate or must I use other people's IRA funds?

You cannot borrow from your own IRA personally or through entities you control. This is a prohibited transaction. Even if the money will be used to purchase an investment, neither can you personally loan money to the IRA to purchase property in the IRA.

However, you can borrow money from someone else’s IRA to fund the purchase of a property for yourself as long as that individual is not considered a disqualified person. Likewise, you could loan money from your IRA to someone who is not a disqualified person.

Question: When must I start distributions from my Roth IRA?

Unlike the traditional IRA where distributions must start at age 70½, there is no requirement to make distributions from a Roth IRA during the life of the owner. Only upon death must distributions begin to the beneficiaries.

Question: When can I begin an IRA for my child or grandchild? Are there age limitations?

Great idea! There are no age limitations, but the child must have earned income to qualify. The IRS sets some strict criteria to assure the child really did do work at a reasonable wage. Just two years of $3,000 contributions to an IRA starting when the child is 13 in an account that averages a 10% return will be over $1,000,000 when the child reaches 65!

Question: What am I not allowed to do with real estate in my IRA?

Your IRA cannot directly or indirectly buy real estate from a "disqualified person".

Who is a disqualified person?

The IRA owner;

The IRA owner's spouse, descendant (e.g., son), or ascendant (e.g., mother);

Spouse of a descendant of the IRA holder;

A fiduciary of the IRA or person providing services to the IRA (e.g., the trustee or custodian);

An entity at least 50% of which is owned (or at least 50% of the beneficial interests are held) by a combination of the above (e.g., if you and your spouse own 50% of an LLC, that LLC is a disqualified person with respect to your IRA); or a 10% owner, officer, or director or highly compensated employee of such an entity.

Question: Where can I get a non-recourse loan for my IRA to buy property?

There are at least four sources for financing which do not violate the non-recourse requirements for IRAs.

1. Seller financing. Most sellers understand that if the loan goes into default they get the property back anyway, so asking for the loan to be non-recourse should not be too difficult to negotiate.
2. Private financing from financial friends. If you cultivate a reputation as a professional real estate investor, there should be no reason that your financial friends would not loan your IRA money on a non-recourse basis, either from their own funds or from their own IRAs.
3. Banks and hard money lenders. Non-recourse loans are not the norm; so many banks will turn you down. However, there are a few banks that make these types of loans, and at least one bank, which lends in all 50 states.
4. Finally, as mentioned above, you could take over a property subject to an existing loan, provided the originator of the loan is not you or another disqualified person.

Question: Is a Roth IRA a smart estate-planning tool when I plan on leaving the assets to my children?

Yes. The Roth IRA continues tax-free compounding even after you pass away. The children can get distributions tax-free over their projected lifetimes. For example, just $30,000 left to a six-year old at a 10% annualized return will generate over $4.6 million in distributions over the child’s lifetime!

Question: What is a Simplified Employee Pension (SEP) plan?

A SEP, also known as a SEP-IRA, is a retirement plan established by an employer. A one-person business is considered an employer for these purposes and may establish a SEP. An employer can use this SEP plan to make contributions to the IRAs of eligible employees, including himself or herself.

Question: Who is eligible to establish a SEP?

Any employer, including a sole proprietor, partnership, or corporation, can establish a SEP. The corporation may either be a for-profit corporation or a nonprofit corporation. A governmental entity may also establish a SEP. When a self-employed individual sponsors a SEP, he or she is considered to be both the employer and an employee.

Question: What are Prohibited Transactions?

An understanding of prohibited transactions is very important. The IRS defines a prohibited transaction as follows: “Generally a prohibited transaction is any improper use of your IRA account or annuity by you, your beneficiary or any disqualified person. Disqualified persons include your fiduciary and members or your family (spouse, ancestor, linear descendant, and any spouse of linear descendant).” IRS Publication 590

IRC 4975 is the section that lays out the rules on prohibited transactions. Prohibited transactions generally involve one of the following: (1) doing business with a disqualified person; (2) benefiting someone other than the IRA; (3) loaning money to a disqualified person; or (4) investing in a prohibited investment. You need to make sure that it is your IRA that benefits from a transaction rather than you personally. Beware of any “self dealing” transactions.

Question: How do custodians make their money?

Each year you are charged a fee for simply having an account with a custodian. A custodian generates revenue in a variety of ways:

Asset based fees – a fee based off the value of your account holdings.

Transactional fees – a fee for processing a purchase or sale of account assets.

Holding fees – a fee on each asset held in your account.

Special fees – escrow fees, bank-wire fees, overnight mail fees.

For more info on using your IRA or 401k to hold real estate feel free to email me at don.mcgraw@tetonlanddevelopment.com or call 949-370-6737