The Basics
The rules governing allowable investments in IRAs
preclude an IRA's investment in life insurance, collectibles (e.g.,
artwork, antiques, metals, gems, and most coins) and S corporations.
All other types of investments are permitted, and
thus the range of possible investment choices is nearly unlimited.
Consequently, any form of real estate can be purchased by an IRA.
Real estate investing through an IRA opens up a
huge range of alternative investments for individuals who are
knowledgeable about real estate investing or who work with
knowledgeable advisors, sponsors, or brokers. Investing in real
estate for your retirement may serve as a means to diversify your
retirement portfolio to hedge against the cyclical changes in the
stock market, economy and bank and government-based investments.
For many who are experienced with real estate
investing, real estate investments hold the potential to protect
against the loss of principal while generating better than market
rate returns through income production and capital gains. When real
estate investments are not leveraged, both income and capital gains
can flow back to IRAs tax-deferred (or tax-free if the IRA is a Roth
IRA).
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The Easy Way:
If you have your IRA purchase real estate from an
unrelated party and pay cash for it, and you do not use the real
estate for personal reasons while it is in your IRA (i.e., you treat
it strictly as an investment), there are no special issues.
Financing:
If your IRA invests in real estate through a down
payment and leveraging, there are some significant issues:
You cannot personally guarantee a loan for your
IRA.
Some custodians will limit the amount of debt the
IRA can carry. It may be difficult to get a bank to allow an IRA to
be the debtor without a personal guarantee; Your IRA will pay tax on
UDFI (unrelated debt financed income), which is the income and/or
capital gains attributable to the leveraged portion. (UDFI is taxed
at the trust tax rate because an IRA is a trust.) As a consequence,
although it is PERFECTLY LEGAL, it may not be desirable to have an
IRA carry debt in a real estate investment transaction.
What you can't do in an IRA with real estate
You 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.
You cannot have your IRA enable an investment for
yourself or another disqualified person. In other words, if the
IRA's investment is deemed essential to accomplishing a transaction
in which both you and your IRA invest, then the transaction would be
considered a prohibited transaction. Your IRA cannot purchase a
real estate asset and then have a disqualified person use it while
it is in the IRA. For example, you cannot buy a vacation home and
use it partly for personal use, even though you might rent it to
unrelated persons the rest of the year.
What you can do in an IRA with real estate:
Buying real estate from an unrelated party (i.e.,
one who is not a disqualified person) with cash is the simplest way
of investing in real estate with your IRA. Your IRA can buy raw
land, commercial property, residential (e.g., rental) property, real
estate options, as well as extend loans (e.g., first and second
mortgages), secured by real estate with your IRA, to unrelated
parties.
As discussed above, your IRA can also buy
property through leveraging, provided the loan is not guaranteed by
the IRA owner (or any other disqualified person) and that the IRA
has enough liquidity to support the mortgage and expenses.
Generally, most custodians will have limits on the amount of
leverage they will permit. Also, as previously mentioned, leveraging
can result in income taxes on UDFI that must be paid by the IRA.
Generally, these taxes are higher than would be paid on income
generated from a property that you buy and finance personally. In
addition, the UDFI taxes must be paid from funds from the IRA and,
therefore, there has to be enough liquidity in the IRA to cover
these taxes. See IRS Form 990T and its accompanying instructions for
details.
There are a variety of ways, however, that an IRA
can participate in a real estate investment without a full cash
capital investment. For example, your IRA can co-invest with other
parties. You could also have your IRA, and other parties participate
in real estate investing by becoming members of an LLC that buys and
sells property.
Examples of real estate investments that can be
made using IRA funds
Example I
John's IRA has purchased a single family home
from an unrelated seller. John now wishes to have the IRA sell it to
his sister with a first mortgage that his IRA will hold.
The purchase of a single family home from an
unrelated party is not a problem. John pays $300,000 cash and his
IRA holds the grant deed from the sale to his IRA by the third
party. John's IRA later sells his sister the property and takes back
a first mortgage and a down payment in exchange. His IRA gives her a
market rate loan for 15 years and receives a 10% down payment. Since
this is a $280,000 debt owed to the IRA and not by the IRA, the
custodian is not concerned about the potential liability to the
IRA. John's IRA has a fixed income investment and is protected
because it holds the trust deed in the event his sister defaults on
the loan. The transaction may also have the incidental benefit of
allowing John's sister to purchase the home more easily that she
could have on the open market.
Example II
Allison is a real estate developer who wants to
form a real estate development company in the form of a limited
liability company and then manage the company. She wants to make her
IRA the primary investor and she intends to be compensated by the
LLC to manage it. She expects to have other investors in the LLC.
Allison's IRA can participate in the formation of
the LLC provided Allison and related persons and parties do not
already own 50% or more of the LLC in aggregate. If she is just
starting the LLC, then the IRA can own something less than 100%
(e.g., 95%) and she can still be compensated for managing it,
provided that an independent person must approve the compensation.
The LLC is considered a real estate operating company and,
therefore, the assets are not considered plan assets unless there is
100% ownership by the IRA. If the company's assets are deemed plan
assets, or if approval of compensation is not made by an independent
person, then a transaction (e.g., being paid for service) between
the company and the IRA owner is considered a transaction between
the IRA and a disqualified person (the IRA owner) and is therefore a
prohibited transaction.
If the LLC was not a real estate operating
company or other type of operating company (for example, if it was a
hedge fund), then the aggregate ownership of all IRAs and employee
benefit plans would have to be less than 25% in order for the LLC's
assets not to be considered IRA assets. (The interest owned by the
IRA owner is disregarded for purposes of calculating the relevant
percentage.)
Example III
Howard wants to have his IRA purchase a $400,000
rental property with a 50% down payment. Is this possible and are
there any special considerations?
Yes, it is possible, but there are special
considerations such as:
-Disqualified persons (such as the IRA owner and
his or her spouse) cannot personally guarantee the loan for the IRA.
The loan must be supported by the property itself or some other
property that the IRA owns;
-The IRA will be subject to tax (UDFI) on any
income attributable to the leveraged portion (around 50%) on the
investment;
-Most custodians and banks will not finance a
property purchase with less than 50% down when an IRA is the
borrower.
It should be noted, as an alternative, that the
IRA can purchase the property with other parties, all of whom pay
cash. When this is done, there is no UDFI and there are no issues
associated with the financing. top
Conclusion
In summary, the tax laws (1) require that the
investments in an IRA not benefit the IRA owner and (2) prevent
"self-dealing" between the IRA and the IRA owner or other
disqualified persons. However, by properly structuring an IRA
investment in real estate, an IRA can obtain the benefits of real
estate investment in a manner that complies with applicable tax
laws.top
(The foregoing is a general discussion. It is not intended, and
should not be relied upon, as an opinion or advice on any legal, tax
or investment aspects of IRAs. An IRA owner considering an IRA
investment in real property should consult with his or her own
advisor.)
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