Flipping Houses in an IRA
For the purposes of this article, flipping is defined as the purchase of property with the intent to sell at a profit shortly after making significant improvements. If you have particular expertise in buying and selling real estate, and you are looking for ways to expand your real estate investment practice in a tax-advantaged way, flipping real estate in an IRA is an excellent way to do so, and you’re in luck: IRS rules allow you to hold a wide variety of assets in an IRA – including real estate. This means that real estate investors can take advantage of all the tax benefits of using an IRA, SEP-IRA, SIMPLE IRA, or solo 401(k) plan. For now, we’ll talk primarily about IRAs.
Advantages of Real Estate Investing
The many advantages of real estate investing are well-known to market veterans. And the vast majority of these advantages apply to retirement accounts as well. Using a self-directed IRA to invest retirement assets in real estate, including property flipping, allows you to take advantage of these lucrative aspects of real estate investing.
Leverage. Real estate has intrinsic value that is well understood by lenders. It is therefore relatively easy to borrow money to leverage your real estate portfolio. While historic unleveraged capital growth in the real estate market are modest and in line with many other asset classes, the judicious use of leverage has historically put real estate in a class of its own, when looked at on a return on invested capital basis. The IRS allows you to borrow money within your IRA to leverage real estate purchases, as well as handle immediate cash flow needs. Any loans taken out by your IRA need to be non-recourse loans only. The lender can have no claim to any collateral outside the IRA, and you cannot sign a personal guarantee.
Diversification. Real estate has historically provided an important diversification benefit against more traditional retirement investing asset classes such as stocks, bonds and funds.
Inflation Protection. As the purchasing power of the dollar declines, real estate potentially provides an important hedge against the ravages of inflation. A given plot of land, for example, will still yield the same number of bushels of wheat or corn, regardless of whether the dollar collapses or not. And no matter what happens to inflation, people still need to live somewhere. Demand for housing transcends inflation and everything else in the market.
Potential for Growth. Unlike bond income, the income from real estate investments tends to grow over time. This, in turn, supports gradual appreciation in property prices, and leads to eventual capital appreciation. In some cases, economic development or expansion in an area can cause a rapid and substantial increase in property prices – leading to ‘flipping’ opportunities.
Control. When you invest your IRA assets in a mutual fund, for example, you give up control. You have no input as to what happens with your money, and no control over how the fund manager invests it. You won’t even know what they’re doing with it for weeks or months, when the fund publishes its portfolio. By electing to self-direct your retirement investments, and by investing in real estate, you maintain full control over the investment. You can take positive steps to help the property appreciate in value, such as making renovations and improvements that improve the expected selling price of the property.
Advantages of Using an IRA or Other Retirement Account
Your IRA generally allows you to defer taxes on ordinary income or on long or short-term capital gains – though there are certain exceptions, in some cases, for profits attributable to leverage. This means that you can collect an unlimited amount of rental income, tax-deferred, or tax-free, if you use a Roth IRA. Your IRA generally allows you to defer taxes on profits generated by the IRA–unless, of course, it’s a Roth, which is tax free—until you reach age 59½. If you use a Roth IRA, you never pay income or capital gains taxes. However, if you have profits attributed to leverage, that percentage of your profits will be subject to unrelated debt income tax (UDIT) because it is not IRA money.
Likewise, you can buy or sell an unlimited number of investment properties within your IRA, tax deferred. However, you should be aware of unrelated business income tax. If you are determined to be engaged in the business of “flipping properties” – that is, if the IRS determines you to be a dealer in real estate, you will be judged to be operating a business within your IRA, which may generate a UBIT liability. This is a question you should raise with your tax advisor. Qualified tax advice is a must. American IRA does not provide individual tax advice.
If you use a Roth account, rather than a traditional IRA, your income and capital gains can grow within the account tax free. True, you can also get a deferral on capital gains taxes using a 1031 exchange. But you can only do so as long as you are exchanging one real estate investment property for another, and only during a specific time period. By using an IRA, you can move in and out of real estate as often as you like, provided you keep the sales proceeds in the IRA itself. If a transfer is delayed for whatever reason, you don’t have to worry about incurring a current capital gains tax liability within an IRA like you do if you don’t execute a 1031 exchange by the deadline. This may help you be much more selective about the real estate trades you make.
There are some things to be aware of when using your IRA for any kind of real estate investing:
- You cannot use the property for your own personal benefit.
- You cannot lend to or borrow from your IRA, nor can your ascendants, descendants, their spouses or any entities they control.
- You cannot do business directly with your IRA. For example, you cannot set up a construction company and have your IRA hire your company to work on the house. The same restriction applies to your ascendants, descendants, their spouses and any entities they control.
- You cannot stay in properties your IRA owns, even overnight.
- If you use leverage, the IRS may impose a tax, called “unrelated debt income tax,” on a portion of the IRA’s profits. In some cases, however, this tax does not apply to assets held in self-directed Solo 401(k) plans. Consult your tax advisor for more information on how this tax may affect you.
- Any money your IRA borrows must be in the form of non-recourse debt. This means that the lender can hold no claim on any assets outside of the IRA whatsoever. The entirety of the loan must be either unsecured or secured by assets within the IRA. You cannot sign a personal guarantee in this debt.
- Because there is no tax on current income to deduct against, you cannot take deductions for depreciation of rental properties held in a retirement account.
- Be aware of the restrictions on contributing new money to retirement accounts. Any expenses your IRA incurs over and above the $5,000 annual contribution limit for IRAs ($6,000 if you are over age 50), for example, must be paid for with money in the IRA already, money rolled over from other retirement accounts, or borrowed. You cannot make a massive cash infusion from outside the IRA using a traditional or Roth IRA account. However, you can take advantage of the higher contribution limits of SEP IRAs or Solo 401(k)s to intervene during a cash crunch, if you hold your property within one of these plans. SEP IRA contribution limits can be as high as $49,000 per year – many times that of an IRA.
Where We Come In
American IRA is a third-party administrator with particular expertise in self-directed retirement accounts, including real estate IRAs, 401(k)s, SEP IRAS and SIMPLE IRAs. Although not IRA products, you can also self-direct Coverdells and health savings accounts (HSAs) as well. This is a very specialized area of investment, and not every broker or other advisor has the skills to navigate the various rules and regulations that apply to self-directed retirement accounts. It’s important to partner with a firm that has skills and experience specific to self-direction and real estate within an IRA or other retirement account.
For more information, or to simply explore your options, call American IRA today at 1-866-7500-IRA (472). We look forward to working with you.