At 6:45 am on a cold morning in January I found myself sipping coffee with several individuals at a local coffee shop. Despite the early morning, the energy level was high. This was partly attributed to the caffeine running through our veins, but mostly due to the topic of discussion. It was our first time gathering to discuss the formation of a real estate investing advisory group – exciting stuff! We were a blended group of individuals. The age and experience of those at the table varied from 17 years in age to about 50 years in age. Some had never owned real estate and others owned multiple residential and commercial buildings.
During our time together, someone suggested a book about the tax advantages of owing real estate. Fast forward three weeks and my reading lead me to the concept of owning real estate within a self-directed IRA. The best book on this topic is ‘The Self Directed IRA Handbook’ by Mat Sorenson. Studying this concept lead me to six key aspects you must understand about this arrangement.
Disqualified Individuals: are not permitted to use or service the property in any way. Simply put, a disqualified person is the IRA owner, their spouse, and children. You cannot personally maintain, repair, or pay for anything related to the property. The leaky sink, dented sheet rock, chipped paint, etc. needs to be repaired by a qualified person whom is paid directly from the IRA. Likewise, you cannot personally live on the property, nor can your spouse or children. This is nothing to push your luck with. It is also an area of significant focus in Mat’s book. If it’s determined a disqualified person benefited from real estate owned by your IRA the custodian will issue a 1099-R and the full market value will become taxable and potentially penalized for early withdrawal. If you consider these manageable restrictions, you’ve passed the first test. Many people, myself included, would be challenged by this limitation.
Bank Leverage: can be used to purchase real estate but this must be a non-recourse loan, meaning no personal guarantees to disqualified individuals are permitted. You essentially need to locate a lender who’s willing to provide a collateral based loan. Because of this, lenders require a larger down payment, often as much as 40%. This is also nothing to push your luck on. Be sure to scour the mortgage documents for carve-out guarantees. These essentially permit the lender to go after the carve-out guarantors, which could be the IRA owner.
As it pertains to bank leverage, you also must be aware of unrelated debt financed income (UDFI). This is a tax applying to gains within an IRA which are attributed to debt. This tax applies to income and capital gains derived from debt-financed property, including debt used to purchase or improve a property. In essence, the proportion of income and gains resulting from debt is subject to capital gains rates of 15-20%, paid by IRA funds.
Ordinary Income: received by an IRA could become subject to unrelated business income tax (UBIT). This would apply to non-passive real estate activity, such as property that was purchased with the intent to immediately sell, such as house flipping. Income subject to this would be taxed at trust tax rates. This is a progressive tax but is 37% for income above $12,950. UBIT is a complex area of law because the wording leaves room for interpretation. To be clear, long term gains from property held for over one year are exempt from UBIT. Gains from property held for less than one year are not always subject to UBIT but would be if the IRS determines these gains a result of ordinary course of business. To quote Mat, “…self directed IRA investors should avoid engaging in an activity whereby the real estate owned by the IRA is primarily for sale in the ordinary course of the trade or business of the IRA.” Due to this complexity and potential high tax liability, it’s best to avoid flipping houses within an IRA. If your IRA becomes subject to UBIT it must file IRS form 990-T. The payment of this tax would be paid by the IRA’s funds and not with personal funds.
Hire Professionals: You need to rely on professionals to help maintain compliance with your self-directed IRA. In his book, Mat provided an example of a court ruling where a prohibited transaction occurred in the past and the IRS assessed a 20% penalty for substantial under reporting of taxes. The individual in this case pleaded ignorant to the transaction being prohibited but the IRS assessed this penalty because “…the IRA owners did not rely on professional advice or a reasonable legal position as to whether the transaction in question was a prohibited transaction.”
Solo 401(k)s: remove a few of the concerns mentioned above. As the name implies, a solo 401(k) is for those who are self employed and don’t have employees. These accounts are best for someone who’s wanting to save aggressively. Between the employee and the employer, contribution limits are $57,000 with a $6,500 catch-up allowance. Additionally, this type of account is not subject to UDFI tax on leveraged real estate. Lastly, the consequence of a prohibited transaction is less severe. Such transactions within a solo 401(k) are subject to a 15% excise tax on the amount involved. One of the largest disadvantages to a solo 401(k) is that required minimum distributions are not waived if you’re still working and contributing to them.
IRA/LLC: is a highly advisable approach, where you establish a new LLC and list the IRA as the owner. Mat says this is a common approach because it provides asset protection and administrative benefits. As the manager of the LLC you’re able to execute investment transactions without getting the IRA custodian involved, although the LLC is still restricted from the same prohibited transactions as the IRA. Also, an injured person would only be able to sue the LLC and would not be able to sue the IRA, IRA owner, or custodian. For these reasons the IRA/LLC seems logical.
Just because you’re allowed to own real estate in an IRA doesn’t mean you should. Because of red tape and the tax drag from leverage, I tend to believe there are few instances this makes sense. It seems the most likely situation to consider this arrangement is if a screaming deal presents itself and your only available funds are in a self-directed IRA.
Reflecting on Mark Kohler’s comments in his book ‘What Your CPA Isn’t Telling You’, there are several tax and relational benefits of individually owning real estate. On paper, many rental properties operate at a net loss, therefore allowing owners to build equity in an asset that improves their current tax situation and later sold at favorable long-term capital gains rates. Also, being able to hire your kids to help manage rental properties allows parents to deduct these wages and instill work ethic. Each of these benefits are lost when owned within an IRA.
Most of my focus in writing this article has been on tax and logistical implications. With these in mind, i’m partial to this concept. There seem to be few situations when IRA ownership of real estate is more beneficial. First off, real estate held outside of an IRA provides opportunities for tax deductions while being held, can give parents and children joint projects to work on together, allows for favorable bank leverage, and future gains can be taxed at favorable capital gains rates. When held within an IRA you are not allowed to repair or maintain the property in any way, the ability to leverage money is more limited and often penalized, future gains are taxed at less favorable income rates, and would be subject to RMDs which create logistical challenges. You could of course choose to own real estate within a Roth IRA but this still has many of the same disadvantages as a traditional IRA. This being said, the best retirement account to own real estate seems a solo 401(k) due to the treatment of disqualified transactions and not being subject to UDFI tax.
If you’re interested in learning more about self-directed IRAs or purchasing physical real estate within an IRA I highly suggest reading Mat Sorenson’s book and consulting an attorney, accountant, and financial advisor familiar with self-directed IRAs.