Shifting savings from stocks to property
An Individual Retirement Account (IRA) is a savings program designed to defer income taxes on deposits and all gains until withdrawals are made. An IRA is an investment account, a conduit for the investment of savings, but not an investment itself. [Internal Revenue Code §4975(e)(1)]
Funds held in an IRA may be used to acquire and own multiple types of investments, such as stocks, bonds, mutual funds, precious metals, real estate and other investments. Low real estate prices coupled with favorable rental conditions have drawn the attention of individuals with IRAs who are interested in shifting from securities to real estate. They are looking to purchase income-producing real estate with their IRA funds. Income-producing properties offer higher annual yields and better price returns in the long-term than stocks and bonds. Additionally, real estate functions as a store of wealth with an inflation hedge for properties bought at mean-price levels as we now have for the first time in 15 years.
One way of investing in real estate with your IRA is to buy shares in a real estate investment trust (REIT). However, a REIT investment is similar to stock ownership since the investor has no control over the management or operations of the investment.
The self-directed IRA
Another method of investing IRA funds in real estate is to directly purchase and own real estate through a self-directed IRA (SDIRA). Like a traditional IRA, the SDIRA is used for wealth accumulation through tax planning. The SDIRA provides the flexibility ofasset diversification outside of the traditional Wall Street selection of stocks and mutual funds, as real estate, property tax liens and trust deed notes can also be purchased with SDIRA funds.
Owning real estate within an SDIRA bypasses the individual income tax reporting typical for the ownership, operation and disposition of real estate. The owner of the IRA funds (the investor) does not own the property purchased through the SDIRA. Rather, the IRA is the vested owner of the property. Taxwise, the investor does not and cannot report or claim:
- rent collected;
- property operating expenses;
- mortgage interest deductions; or
- depreciation deductions.
The long-term benefit of an SDIRA investment in real estate is the deferral of income taxes on all annual income and sales profits earned from the properties purchased. Instead of paying income tax on otherwise reportable operating income and sales profits, income taxes are paid only on cash distributions when the owner withdraws monies from the IRA account for their personal use.
As in any IRA situation, all monies withdrawn from the IRA are taxed as personal income at individual income rates, not capital gains or dividend rates. To avoid penalties for early IRA withdrawals, the investor must also adhere to specific time frames for withdrawals and distributions.
In an SDIRA, the investor makes and controls the investment decisions for placement of funds accumulated in the IRA account, instead of trusting the account to an uncontrolled investment banker or employer. However, ownership of the property acquired using SDIRA funds is vested in the name of the investor’s IRA account, not in the name of the investor. For example, John Smith uses IRA funds to purchase real estate. Title is not held in the name of “John Smith” as an individual, rather, it is held in trust by the custodian as “ABC Trust Company, custodian FBO (“for benefit of”) John Smith IRA.”
A custodian’s administration, not property management
To begin the process, a custodian is appointed for all retirement plans, including SDIRAs. In an SDIRA, a custodian’s primary duty is to administer and manage the IRA account on the IRA owner’s behalf. Management is controlled by the Internal Revenue Service (IRS) under its regulations.
The SDIRA custodian is responsible for all transactions made with SDIRA funds. They file all IRS paperwork, and keep and report tax information. Additionally, SDIRA custodians counsel IRA owners of controlling IRS codes and regulations, such as those relating to prohibited transactions.
When purchasing an investment property with SDIRA funds, the custodian directs the investor on how to structure the transaction. However, it is the investor who is responsible for locating the income property to be purchased and negotiating the terms for acquisition by the SDIRA. All documents for the purchase of the property must be in the name of the IRA, including the initial purchase offer. The custodian’s directions need to be strictly followed to avoid any missteps that might interfere with the funding of the purchase by the custodian.
Once the investor identifies the property to be purchased, the process of funding the closing through an SDIRA is similar to that of a standard real estate transaction, with one exception: the involvement of the third-party SDIRA custodian. However, while the investor retains all the duties of a typical buyer, it is the custodian who funds the purchase of the property and ensures that it’s vested in the name of the IRA account.
After the investor identifies the property, the investor requests the earnest money deposit from the custodian. Similarly, the investor also instructs the custodian where to wire funds for closing. All funds used to purchase the property, including earnest money deposits must come from the SDIRA, with the investor at no time using their personal funds.
In addition to disbursing funds for SDIRA real estate purchases (with the exception of purchases made through an SDIRA LLC), the custodian is also responsible for disbursing funds for ALL operating expenses incurred in the operation and ownership of the property. Disbursements are made upon the request of the investor.
Custodians impose custodial fees for their administration of an SDIRA. Custodial fees vary, depending on the service level required. Most custodians also charge a transaction fee every time the investor authorizes a check to pay any expenses such as a maintenance bill or property taxes.
The demand for real estate investments by IRA holders is infrequent. Most IRA custodians do not provide real estate investment services as most custodians do not have the understanding or inclination to manage them. An investor looking for an IRA custodian to purchase real estate will not likely find one in the big banks. They think Wall Street, not Main Street.
However, investors with IRAs looking to make real estate investments can find a selection of IRA custodians by searching the web under “real estate IRA” or “self-directed IRA.”
Restrictions and prohibited transactions
To begin purchasing real estate using funds held in an SDIRA, the property purchased must be an investment. An investor may not make personal use of a property held by an SDIRA. If occupied, it must be by a tenant, not by the investor or their family. Also, real estate purchases made with SDIRA funds must be arms’ length transactions. [IRC §4975(c)(1)]
Several restrictions are placed on who is allowed to be a party to the purchase transaction, as well as on the use of the property on acquisition.
Individuals and entities classified as disqualified persons are prohibited from having any interest in the property bought or sold by the SDIRA. Disqualified persons include:
- the IRA account owner and beneficiaries as well as most members of their family, including:
- their spouse;
- blood relatives (children, parents, grandparents, etc.);
- the spouses of blood relatives (son-in-law, daughter-in-law, etc.);
- fiduciaries of the SDIRA such as the custodian or trustee, or any other SDIRA advisors; and
- any entity (corporation, partnership, trust, etc.) in which any disqualified person or persons have a combined 50% or greater share. [IRC §4975(e)(2)]
Prohibited transactions include most transactions between the IRA and disqualified persons. The following SDIRA transactions and uses are prohibited:
- using the SDIRA-owned property as security for a personal loan;
- using the SDIRA funds to purchase property for the investor’s personal use (residence, vacation home, etc.);
- allowing a disqualified person to live in SDIRA-owned property; and
- personally receiving rental income from the SDIRA-owned property. [IRC §4975(c)(1)]
The purpose of these restrictions is to prevent self-dealing. Avoiding prohibited conduct minimizes conflicts of interest that jeopardize the IRA’s tax-deferred status.
The entire value of the IRA is considered fully distributed when a prohibited transaction occurs. This includes funds and investments held by the SDIRA not involved in the prohibited transaction. Once the IRA funds are distributed, the investor is subject to a substantial tax liability on the entire IRA if the transaction is not corrected within the taxable period. Further, a 15% penalty tax may be levied against the disqualified person on the full amount of the transaction. [IRC §4975(a-b)]
SDIRAs investments in investor-controlled LLCs
When purchasing income-producing real estate, many investors like to practice a bit of risk management by placing real estate ownership and title in the name of an LLC. An SDIRA LLC shields the investor’s other IRA funds and personal assets held outside of the LLC from a loss resulting from the ownership of the property vested in the LLC.
Another benefit of creating an SDIRA LLC is the investor gains “checkbook control”.Checkbook control gives the investor, as manager of the SDIRA LLC, direct access to the IRA funds allowing them to avoid:
- custodial delays in the disbursement of funds for acquisitions and property expenses; and
- custodial fees based on transactions and account value.
When the investor using an LLC vesting finds a property suitable for purchase using their IRA funds, they simply write a check from the SDIRA LLC bank account to escrow and close the transaction – in the name of the LLC.
Checkbook control also allows the investor to avoid timing issues when funding earnest money deposits and closings using SDIRA funds. This control eliminates the risk of a custodial delay which jeopardizes the investor’s purchase opportunity.
Taxwise, an LLC is treated as a pass-through entity for federal and California state income tax purposes. Further, the SDIRA LLC is generally a single-member LLC with its sole ownership member being the IRA. The investor is merely a managing member with no ownership interest in the LLC. Since an IRA is a tax-exempt arrangement, all income and profits of the LLC flow-through tax free to the IRA which itself is not taxed. [IRC §408]
Prohibited transaction rules also apply to purchases made through an LLC. An investor is prohibited from first taking title to a property, then transferring title to their SDIRA LLC. The LLC transactions must also be arms’ length in nature. [IRC §4975(c)(1)]
When forming the SDIRA LLC, the LLC operating agreement must contain stipulations conforming to IRA tax provisions and information regarding prohibited transactions, which standard operating agreements do not contain. In addition, special management provisions are needed since the LLC will be managed by the investor, not the IRA. [IRC §408 and 4975]
Required content for LLC operating agreements may vary from one custodian to another. Operating agreements must also be properly prepared to both fit the needs of the LLC and meet the requirements of the IRS.
When retaining the services of a third party, such as an attorney, to assist in the creation of the SDIRA LLC, the LLC’s formation expenses must be paid by SDIRA funds. The investor may not use personal funds to pay any amounts incurred to form an SDIRA LLC. Payment of any debt or obligation of the SDIRA LLC by the account owner is a prohibited transaction.
Property management for IRA-owned real estate
Investors may choose to “self-manage” their IRA-owned property or hire a property manager. Self-managing can be cost-effective, but caution is required. The investor must follow all IRS regulations regarding the management of a property purchased through an SDIRA.
When self-managing IRA-owned property, the investor can screen and select tenants, and collect rent checks which are payable to the IRA (i.e. “ABC Trust Company, custodian FBO John Smith IRA”) and deposited through the custodian. Rents payable to an SDIRA LLC can be directly deposited into the LLC’s bank account established by the investor as manager of the LLC.
The investor can also perform maintenance and minor repairs that do not contribute “sweat equity” to the property. Maintenance and repairs that increase the property’s value are considered capital improvements, and cannot be performed by any disqualified persons, including the investor. Thus, if the investor is a licensed contractor, neither they nor their company can make any capital improvements to the property owned, a prohibited transaction. The purpose is to bar the conversion of the investor’s time and energy into tax-deferred IRA value. [IRC §4975(c)(1)]
The IRC states that the furnishing of goods and services between a plan and a disqualified person is a prohibited transaction. However, it does not explicitly spell out which management activities are prohibited. To avoid these personal contribution issues, an investor can hire a broker specializing in property management to handle the day-to-day property management of the IRA-owned real estate investment. This keeps the investor 100% clear of any possibility of prohibited transactions. [IRC §4975(c)(1)(C)]
Hiring a property manager also keeps the investors inactive in the operations of the investment. Thus, the investor avoids the risk of committing any prohibited transactions. However, the investor must also keep in mind that when hiring a broker to manage the property, rules regarding disqualified persons also apply. Thus, the management company cannot be owned by the spouse of the investor, or any other disqualified person.
Co-ownership of the investment
An investor is prohibited from using both SDIRA and non-SDIRA funds to acquire investment property which will be vested solely in the name of the SDIRA. This is a prohibited comingling of personal and IRA funds. [IRC §4975(b)]
However, the property may be purchased using a combination of SDIRA and non-SDIRA funds if the person or entity providing the non-SDIRA funds is also a vested tenant-in-common co-owner of the property. The co-investor can be the IRA account owner, individuals including relatives of the investor, or an entity such as an LLC. Each investor contributing funds to the purchase will appear on title as a percentage owner, based on their contribution towards the total costs of acquisition.
For example, the investor wants to purchase a property for $100,000 including acquisition costs, but they can only contribute $60,000 from the SDIRA to acquire the property. The investor, or any other person or entity, can contribute the remaining $40,000 from funds outside of the IRA. The resulting ownership will be a tenant-in-common situation with the SDIRA vested as a 60% owner of the property, and the co-investor owning 40%.
Here, the co-owned portion of the investment property purchased with non-IRA funds does not qualify for tax deferment under the IRA terms, even if the co-investor is also the IRA account owner. Co-owning the investment property requires all income and expenses be divided between the SDIRA and the co-owner based on their percentage share of ownership.
In this scenario, the co-investor is required to report the income and expenses generated from their 40% share of the investment. Also, co-ownership does not change or eliminate rules regarding prohibited transactions that affect or benefit the SDIRA-owned property.
Cash flow and expenses
Ongoing expenses associated with owning and managing the investment property vested in the name of the SDIRA must be paid by the SDIRA. Likewise, all operating income generated by the investment property so vested must also flow into the SDIRA.
Thus, the investor may not take cash flow directly from the investment and bypass the IRA. The improper withdrawal of rental income destroys the SDIRA tax status, prematurely bringing on income taxes and penalties.
At all times, the SDIRA needs to have sufficient cash reserves to pay all property-related carrying costs in the event of a negative cash flow situation. Investors must be careful not to deplete all of the SDIRA funds during the purchase. At the onset, the investor needs to prepare a budget setting forth minimum reserves for negative cash flow and unexpected expenses. Real estate operations are subject to a cyclical market for tenants. Also, additional one-off expenditures for emergency maintenance or replacements are going to be incurred.
The investor’s deposit of funds into an IRA is restricted to the maximum annual contributions allowed for traditional IRA tax accounting. Any payment of the SDIRA’s debts or expenses by the investor is deemed a disguised contribution of money to the IRA.
Financing the purchase
Leveraging a purchase with financing may also be helpful in attaining additional or larger properties. However, financing real estate funded by an IRA is more complicated than financing a purchase to be vested in the name of the investor.
First of all, the loan must be nonrecourse, meaning that the IRA, the investor and the LLC do not have personal liability for the loan in the event of a default. The only security the loan can have is the investment property itself. If the IRA fails to make payments, the only recourse the lender has is to seize the property.
Secondly, banks generally do not provide mortgage financing for acquisitions in the name of an IRA since it is not an entity or individual. However, banks that will finance the purchase of a property through an IRA generally limit their funding to a loan-to-value (LTV) of no greater than 60%.
The leveraged purchase of property through an SDIRA generates income reportable by the SDIRA on annual operations and any sale of the property. Part of the income is attributed to the borrowed money on a pro rata basis, known as unrelated debt financed income (UDFI). Thus, UDFI on “debt-financed” property leads to double taxation. The SDIRA pays a UDFI tax during the year the income is received, and the investor pays income taxes when withdrawing funds from the IRA. [IRC §514]
For example, an investor purchases a rental property through their SDIRA using a 40% down payment and 60% financing.
The rental income would be exempt from taxation if the SDIRA owned the property clear of debt. However, in our scenario, the property is 60% encumbered. Thus, assuming the average debt level for the year was 60% of the purchase price, 60% of all net rental income and 60% of any profits on the sale of the property are subject to the UDFI tax. The other 40% is tax-deferred as the investment made by the IRA. The capital obtained by borrowings to purchase the property did not become a contribution to the SDIRA, but did contribute to the purchase and thus a percentage of the incomes (and expenses). A co-owner’s investment not structured as a loan avoids this UDFI tax. [IRC §512(b)(4)]
The percentage of net income and profits treated as reportable income for UDFI purposes decreases as the principal amount of the debt on the property decreases.
The SDIRA (or SDIRA LLC) files Form 990-T and pays a tax if the property generates more than $1,000 in gross income subject to UDFI during the year. Although the instructions for Form 990-T make the “fiduciary” responsible for filing the tax return, many SDIRA custodians declare in their custodial agreements that the IRA account owner is responsible for filing tax returns. When the debt-financed investment is owned by an SDIRA LLC, the investment paperwork is sent directly to the IRA account owner for tax reporting.
After the first 990-T is filed, an SDIRA subject to UDFI must file on-going quarterly estimated tax payments.
Before transferring IRA funds to a SDIRA, an investor might ask themselves: in the next ten years, will my money generate the most earnings in traditional IRA stock market investments or in a rental property the operations of which I will oversee?
There are many things to consider when deciding where to invest retirement funds. Knowing how to structure LLCs, calculate UDFI and avoid prohibited transactions are just some of the challenges one may encounter with an SDIRA.