Jim Hitt, CEO of American IRA, explains, “Many people are surprised to learn that you can own real estate – not just REIT shares or other stocks, but actual rocks, soil, brick and timber real estate – within your Individual Retirement Arrangement. The IRA vehicle allows you to realize all the advantages of the IRA – tax deductions, no capital gains taxes, deferral of income tax, asset protection, and in some cases, tax-free income – while allowing you to invest in all types of real estate.”
The key to using their IRA to invest in real estate is a special vehicle called the ‘self-directed IRA ,’ sometimes called a “real estate IRA.” With these plans, they take over the role normally played by investment companies, such as brokerage companies, mutual fund houses and insurance companies. Instead, they, or their designated representative, take close control of their IRA.
IRS rules don’t allow them to have possession of the assets directly, however. They can’t have a suitcase of stock certificates next to the pile of oily rags by the furnace in their garage and call that their IRA. Instead, they have to have a third party administrator hold the assets on their behalf. When they select our firm as the administrator of their IRA account, however, they have much more flexibility to invest in what they know than they would with a traditional brokerage or insurance company. If they are a mediocre stock picker but a real estate ace, it makes sense for them to stick to their circle of competence. Our firm lays the administrative foundation, and lets them do what they do best – pick real estate – within their IRA.
Prohibited Transaction Rules
The IRS does place some limits on what they are allowed to do with assets in their IRA:
- They cannot use the property for their own benefit. This means they cannot stay in a rental property, even for a night. Many people make the mistake of thinking they can use the property for up to two weeks for their own benefit without losing the tax advantages of the IRA. It is true that tax rules for rental properties do allow them to stay in their own property for up to two weeks. However, this is not true for real estate within an IRA.
- They cannot buy property directly from their IRA, nor sell directly to it. Nor can their designated beneficiary, nor any of ancestors or descendants or any spouse of an ancestor or descendant. For example, their IRA cannot buy or sell directly to their parents, grandparents or children, nor to their spouses. Furthermore, their IRA cannot buy or sell directly to companies or entities they own or control.
- They cannot have the IRA pay them or their company to manage it, nor provide any product or service to it. They also cannot have their IRA do business directly with companies controlled by them or their family members.
- Their IRA cannot do business directly with any of the professionals who service the account. For example, their CPA or financial planner cannot also be the person repairing the roof on a property owned by their IRA.
- They cannot lend money directly to their IRA, nor borrow from it.
- They cannot borrow money directly from their IRA, nor can they use their IRA to lend to their family members , defined as their children, grandchildren, parents or grandparents and any of their spouses or entities they control. However, siblings, aunts, uncles and cousins may be acceptable.
- They cannot pledge their IRA as collateral for a loan – all debt in the IRA must be non-recourse debt. They cannot sign a personal guarantee on a loan within the IRA.
- They cannot commingle personal funds with funds within IRA accounts . They may, however, partner with themselves and others at the time of acquisition of the asset.
But enough of what they can’t do. Here is what they can do, investing in real estate in a self-directed IRA :
- Contrary to popular belief, they can, in fact, borrow money within their IRA to purchase real estate. It has to be non-recourse financing (terms may vary by lender); however, non-recourse financing and unrelated debt income tax (UDIT) will apply. UDIT is only assessed on the percentage of the profit that relates to borrowed funds. For more information on this topic, see our article on leveraged real estate.
- They can collect rental income, tax-deferred and all the income goes into their retirement account.
- They can own real estate within a Roth IRA and collect rental income, tax free.
- They can sell property within the IRA without having to worry about capital gains taxes.
- They can buy raw land.
- They can buy residential or commercial real estate.
- They can diversify by buying real estate in other countries.
- They can use a tax-deferred exchange inside their IRA to defer UDIT tax.
Mr. Hitt concludes, “If you enjoy real estate, you want the chance to use leverage within your IRA account to fund your retirement, and you are up for acting as a landlord, you should consider using a self-directed IRA to own real estate. This is a great opportunity afforded to us by our government; however, you need to be watchful of a few pitfalls. If you are mindful of those pitfalls, this is a phenomenal tool.”