When most people think of retirement accounts, they think of a corporate 401k or an Individual Retirement Account. But many don’t know that the simple IRA, which has been around since 1974, can hold real estate investments that are not limited to REITs (Real Estate Investment Trusts). These are called “self-directed IRAs” and they are super powerful for building your retirement portfolio holdings quite quickly.
What is a Self-Directed IRA?
Self-directed IRAs (Individual Retirement Accounts) give you the ability to choose from a variety of investments such as private placements, real estate, businesses, and more. Educating yourself and your clients on the benefits of self-directed retirement plans can help you grow your business.
The term “self-directed” means that you, as an individual, have complete control over selecting and directing your own IRA or 401(k) investments. With a self-directed IRA account, you can buy real estate, precious metals, notes, limited partnerships, commercial paper, foreign exchange, gold, commodities, and many other types of assets. With these accounts, you make all of the decisions regarding your investments. The self-directed IRA custodian or administrator completes the documents required to establish your account and purchase your investment.
The Benefits of Self-Direction
You can invest in what you know and understand. By combining your personal knowledge and network with the benefits of tax-free growth in a retirement account, you can potentially build wealth and secure your future much more effectively than through traditional retirement plans.
With a self-directed IRA, you are not limited to the investment offerings of your custodian/trustee. It’s a common misconception among Americans that the only investments allowed in a retirement account are stocks, CDs, and mutual funds. The truth is that broader investment options have been available to the public since 1975.
Example: A Real Estate Purchase Example Utilizing a Self-Directed IRA
- Jane opens her self-directed IRA account. Jane’s first real estate transaction involving her plan was the purchase of a duplex.
- She was familiar with a property and knew that the tenants had been there for over five years and were not likely to move in the near future. She decided to make an all cash offer of $400,000.
- The current owner needed cash, so the timing was ideal. She made an offer on the property in the name of the plan.
- The cash flow on the property was $9,600 per year gross and $6,000 net.
This cash flow satisfied her plan’s needs. The offer was accepted by the seller.
- Jane completed a Direction of Investment (a/k/a/ DOI) for the purchase of the property and sent it the custodian or administrator along with a copy of the contract which had been read and approved by her. The contract is signed on behalf of her IRA and a $20,000 good faith deposit is sent to the title company from her IRA in accordance with the instructions on the DOI.
- A preliminary title report showed no prior liens or other conditions that would preclude the purchase. All closing documents were read and approved by Jane.
- The title company / escrow agent sent the read and approved documents to custodian/administrator for review and execution.
- Rental or lease agreements were assigned to the name of the IRA.
Property management agreements were made between the IRA and the provider.
- The funds are sent from Jane’s IRA and the completed documents to the title company / escrow agent.
- The deal was closed. The deed was then recorded in the name of custodian/administrator for the benefit of Jane’s IRA and was sent back to custodian. The custodian/administrator maintained the deed in safekeeping.
- Jane’s IRA now owns the property.
- Tenants were instructed to make all payments to the custodian/administrator. All income was then deposited and credited to the IRA account.
- Service providers such as utilities and insurance companies were instructed to bill the name of the IRA.
- All expense bills, such as taxes, hazard insurance, maintenance, gas, electric and disposal services were sent directly to custodian/administrator to be paid from IRA funds at the custodial bank.
As you can see, the purchase of a property in an IRA is as straightforward as making that purchase personally.
What You Are Not Allowed To Do with a Self-Directed IRA
Self-directed individual retirement accounts provide a great deal of freedom, flexibility, and choice of potential self-directed investments. However, they are also governed by a set of rules that self-directed investors must be aware of and follow.
Some types of self-directed transactions violate the basic intent of your IRA and may subject your account to risks and penalties.
Your retirement plan is intended to benefit you when you retire and not before.
Transactions that can be interpreted as providing immediate financial gain to the account holder or other disqualified persons holders are not allowed.
For example, an IRA holder may not:
- Borrow money from the IRA
- Sell, exchange or lease property to their IRA
- Receive unreasonable compensation for managing property held by the IRA
- Use their IRA as security for a loan
- Transfer plan income or assets to disqualified persons
- Lend IRA money to disqualified persons
- Extend credit on their IRA to disqualified persons
- Furnish goods, services or facilities to disqualified person
- Allow fiduciaries to obtain or use the plan’s income or assets for their own interest
For IRAs or 401 (k)s, a disqualified person is:
- The IRA holder and his or her spouse
- The IRA holder’s lineal descendants, ascendants and their spouses
- Investment advisers and managers
- Any corporation, partnership, trust or estate in which the IRA holder has a 50 percent or greater interest
- Anyone providing services to the IRA, such as the trustee or custodian
- (See IRS Section 4975 for a complete list of prohibited parties credentials)
In addition, direct investment of your self-directed IRA funds in life insurance, collectibles, which include works of art, rugs, antiques, metals other than gold and palladium bullion, gems, stamps, coins (except certain U.S.-minted coins), alcoholic beverages, and other tangible personal property as may be defined by the Secretary of the Treasury, is prohibited.
Having Your IRA Borrow Money
IRAs (and Qualified Plans) may borrow funds but may not be used as collateral for loans for personal use. Debt financing a property in an IRA is for the benefit of the IRA and is therefore not prohibited. The most difficult issue is finding a lender as loans to purchase property must be non-recourse. Most institutional lenders do not lend to IRA plans because such loans are not sellable in the secondary market. Community banks and other portfolio lenders, such as hard money or private lenders are much more likely to lend to IRAs (or Qualified Plans).
Here is what you need to know about obtaining a loan for your plan:
- The loan to value ratio is important for any lender.
- The loan to your plan must not permit recourse to you as an individual.
- You may not guarantee a loan, but a third party who is not related to you may.
Banks generally lend 60%-80% of the appraised property value (loan to value or LTV) or less on single-family dwellings. The lower the LTV, the more appealing the transaction may be to a lender. Private lenders or motivated sellers may lend more to your plan than banks. Also, your IRA may purchase a property subject to an existing debt.
Non-recourse loan FYI
- Lender will lend to the retirement plan.
- This lender may not have recourse to you. It may only have recourse to the asset.
- financed. This means the debt is secured by the subject property financed in the retirement plan and not by you personally.
- Your personal credit may not be used to facilitate the loan.
- A seller may carry-back financing.
- If you are using your IRA, debt financing will be subject to Unrelated Debt Financed Income Tax (UDFI). Refer to the next section for a brief discussion on this subject.
- UDFI does not apply if the debt had been paid off for 12 months or more.
- UDFI must be paid by the IRA or plan. The IRA or plan files IRS form 990T. You will need to contact a tax advisor to assist with this form.
- Debt may be paid by funds from other IRAs or plans provided that those funds are transferred or rolled over to the IRA plan with the debt.
- Debt paid from funds not in an IRA or plan will be considered an excess contribution and may be a prohibited transaction and subject to penalty.
EXAMPLE – IRA LLC (a/k/a Checkbook Control)
Many times, account owners want to invest in multiple properties and/or actively manage the properties that they purchase. Owning active properties can become transaction intensive when those properties are held directly in the IRA account.
This can lead to transactional fees, and more effort on the part of the account holder.
A solution is to setup a LLC that the IRA purchases or owns. The account holder becomes the manager of the LLC. As the manager, the account holder is able to purchase and manage the properties without direct involvement of the custodian.
The basic steps for accomplishing this are as follows:
- The custodian or administrator forms an LLC in the state of the account holder’s choosing.
- The account holder receives a package with an operating agreement, membership ledger, and banking authorization for opening a checking account.
- The account holder goes to their local bank and opens a checking account in the name of the LLC.
- The account holder submits a direction of investment (DOI) form to the administrator. The DOI instructs the custodian to fund the LLC by transferring the cash to the LLC’s checking account.
- The IRA funds are sent to the checking account.
- The account holder purchases property in the name of the LLC and signs as the manager of the LLC.
At this point all transactions are executed by the account holder as the manager of the LLC. It should be noted that running an LLC can and does put some new requirements on the account holder in the form of accounting and state filings as well as providing annual valuations to the custodian.
Checkbook control is not for everyone, but it can be a practical solution for some self-directed IRA investors.