Many investors find out about the advantages of investing in real estate through a self-directed IRA and are immediately interested in flipping properties. Flipping houses can be a great way to make money and grow your retirement savings.

However, flipping in a self-directed IRA is complex. You shouldn’t go to the next foreclosure auction with your Checkbook IRA until you have evaluated the concept thoroughly.

It is not as easy to flip properties in an IRA as one might think. You cannot simply find a distressed property, fix it up, and sell it at a profit. A self-directed IRA or Solo 401(k) is taxed differently than other types of IRAs or 401(k)s because of special IRS rules. It can be difficult to make a profit when flipping houses if there are many restrictions in place.

If you understand how an IRA or 401(k) operates, you can approach the opportunity to flip it strategically and choose an approach that meets your goals while following IRS guidelines.

Rule #1 – Hands Off

With a self-directed IRA, you are able to invest in a wide variety of opportunities. You can closely control what your IRA invests in and how the account is managed.

You need to remember that all IRA activities must be for the IRA’s benefit only. The IRA cannot be used for personal benefit or to provide benefit to the IRA through goods or services.

If you’re looking to invest in real estate flipping, you need to take a more hands-off approach and act more like a fund manager.

Your services have value. If you give those services to the IRA, it is like making undocumented contributions to your IRA. The IRS has rules that prohibit certain actions, and if you violate those rules, it could have a detrimental effect on your IRA.

You can act in an oversight and administrative role. Some people might think that it is acceptable to identify opportunities and negotiate purchases, come up with a rehab plan, hire vendors to do the work, and deal with the expense and income transactions along the way.

It would be a violation of IRS rules for you to perform work on the property yourself. You should also avoid making frequent runs to the hardware store to act as a delivery person for your contractors. You should not acquire any permits. Your hired contractors should acquire them instead.

For many investors who are experienced in the contracting trades, these restrictions can make the deal unworkable. Not everyone can make the transition from contractor to “investment manager” when their IRA is the investor, but it is a required change.

Rule #2 – Unrelated Business Taxable Income

This means that you won’t have to pay any taxes on the profits from the sale. So the same concept applies when your IRA makes a profit from selling a property, right? Not exactly.

An IRS or other tax-exempt entity is able to get money from passive sources without having to pay taxes. A tax-exempt entity will have to pay taxes on Unrelated Business Taxable Income if it frequently engage in a trade or business.

The purpose of this tax is to create a level playing field for businesses by preventing tax-free companies from having an advantage. When a tax-exempt entity generates Unrelated Business Taxable Income, the resulting tax paid is referred to as Unrelated Business Income Tax.

Passive investment that is fully tax sheltered refers to holding a stock and selling it at some point in the future. However, fixing houses up to sell them is not seen as passive- this is an activity in real estate development.

If your IRA buys and sells houses regularly or on a repeated basis, it will generate UBTI. The tax rates for income that a trust earns from an investment can be as high as 37%, which can reduce the profit from a flip transaction.

So what is “regular or repeated”? What the IRS says about this is that it all comes down to the specific circumstances of the case.

There is no specific frequency or time-period that is outlined by the IRS for how often property can be flipped before it crosses a threshold. The IRS does not have a specific definition of what constitutes a hobby, but it does have the flexibility to determine if an activity is substantially similar to a commercial enterprise in the same field. If your IRA is engaging in flipping transactions, it may be subject to Unrelated Business Income Tax.

This means that an occasional flip transaction is not likely to be considered a trade or business regularly engaged in. If you only invest in property flips through your IRA and are also doing this outside of your IRA, you may have a lower chance of being exposed to UBTI.

The concept of UBTI is challenging because the taxpayer is responsible for determining whether their IRA has tax liability and filing accordingly. If you do not file or pay the taxes that you owe for your IRA, and you are audited, you will be subject to additional penalties. You should not flip your IRA too often because it is not good for it.

Weighing the Options

Keep the IRS rules in mind when deciding if your flipping strategy is realistic. This can be a significant adjustment for many investors who are just starting to evaluate a self-directed IRA in terms of expectations.

There are a few ways to “flip” that work under the guidelines for retirement plans. The best option for you depends on your expertise, how much money you have, and how much you want to be involved.

How to Invest in Real Estate With a Self-Directed IRA: Is It The Best Option?

Do you want to invest in something other than stocks, bonds, mutual funds, and ETFs? AC: Or, are you a beginner investor looking to use money in your retirement account because a real estate expert mentioned the term “self-directed IRA real estate?”

Real estate can be an excellent way to accumulate wealth and achieve financial independence. It is important to understand the rules before you start looking to purchase a real estate property. There are strict regulations to follow when investing in real estate with a self-directed IRA.

Some people believe that investing in real estate with a self-directed IRA is a bad idea, while others believe it can be a good strategy. After reading this article you may find that investing is or is not a viable option for you. A decision that makes sense now may not make sense later on.

What is a Self-Directed IRA?

Two common types of Individual Retirement Accounts are the Traditional IRA and the Roth IRA. There are two options available that offer tax benefits that can be accessed after 59 ½ without penalty.

The Traditional IRA allows you to postpone paying taxes on your contributions and earnings until you withdraw the money. Although money contributed to a traditional IRA has not been taxed, it will be taxed when it is withdrawn. In contrast, money contributed to a Roth IRA has already been taxed and thus can be withdrawn without owing any additional taxes.

Some prefer the Roth IRA option because it allows them to avoid paying taxes on their withdrawals from their retirement account. Although there are many types of IRAs, most brokerage firms only invest in the stock market. This includes mutual funds, bonds, ETFs, etc.

The main advantage of a self-directed IRA is that it allows the account holder to invest in a wider range of assets than a traditional IRA. These assets can include non-publicly traded start-up companies, precious metals, and real estate. A self-directed IRA can be used to purchase rental properties, land, flipping projects, and whole sale deals.

If you want to take advantage of the tax benefits from a self-directed IRA, you must use the money from the IRA to fund all real estate transactions. This is called an “arms-length transaction.” This means you cannot pay any expenses out-of-pocket or work on the property yourself. Instead of using the IRA to pay for all expenses, they have to hire a third-party to perform improvements.

Any income generated from an investment property or profit made from a sale must go back into the IRA. An investor who acquires retirement funds can reinvest them in another real estate deal. You can’t withdraw money from your account until you’re the appropriate age without being penalized.

Benefits of Using Self-Directed IRA to Invest in Real Estate

Tax Shelter

An IRA is beneficial because it provides tax shelter. Investors can avoid paying taxes on any money they make from renting out properties or selling houses they have renovated. The goal is similar to a self-directed Roth IRA. However, contributions are already taxed, but withdrawals are tax-free.

Potential for Higher Returns

The stock market can fluctuate from year to year. In contrast, real estate is an asset that can be seen and touched, which has shown to be more stable historically. Rental properties, especially those with multiple units, have the potential to bring in more money than the stock market.

However, not every real estate investment is equal. Although self-directed IRAs allow people to invest in real estate, it is still the investor’s responsibility make sure they understand what they’re getting into, such as estimating monthly expenses and calculating the cash on cash return.

Restrictions and Drawbacks of Using Self-Directed IRA

The IRS does not allow certain types of transactions when investing with a self-directed IRA. If an investment violates any rules, it may be taxed as income. Some things to keep in mind when investing in real estate are the following: location, type of property, and the condition of the property. Another thing to think about is your own financial situation- can you afford the property, and are you in a good enough financial position to take on the risks associated with investing in real estate.

Lack of Liquidity

An illiquid asset is one that cannot be quickly converted into cash, like real estate as opposed to stocks. Additionally, you are not able to sell real estate properties in separate parts.

If you need money right away, real estate is not going to be the best option. It can take a seller weeks or months to close on a property.

In addition to the normal federal and state taxes you will pay on your IRA withdrawal, if you withdraw from your IRA before 59 ½, you will also be subject to an early withdrawal penalty of 10% of the total withdrawal amount. At age 70 ½, you are required to start withdrawing the minimum distribution.

No Sweat Equity Allowed

Regular real estate investors have the option of making repairs themselves, rather than hiring someone to do it. This includes strategies like buy & hold and house flipping. This option allows investors to save money on labor costs by doing the work themselves instead of hiring someone to do it.

An account holder is not allowed to do any improvements or repairs on an investment property with a self-directed IRA. An investor is only allowed to hire a third-party to perform work if they are paid from the IRA.

Contribution Limits

The IRS requires that all real estate transactions be funded by the IRA. This issue can crop up if there aren’t enough funds in the IRA to support costs.

For the 2021 tax year, the maximum contribution a person can make is $6,000, according to the Internal Revenue Code. More expensive items, like a new roof or furnace, can cost more than that.

An investor must do proper analysis when selecting a property. They should plan for unexpected expenses and set that money aside in the IRA.

No Family Members Involved

The self-directed IRA cannot purchase a property for personal use, such as a primary residence or second home. You are not allowed to live in one of the duplex units even if you “house hack” because you are a disqualified person.

This means that certain family members are not allowed to participate in any activities related to buying, selling, or living in a property. Otherwise, the investment would become disqualified. The family members who are not allowed are spouses, parents, grandparents, children, grandchildren, and the spouses of those people.

Lack of Ownership

Although an investor may be the self-directed IRA holder, the investment property itself is owned by the IRA. Since the IRA owner does not technically own the property, they cannot claim common tax deductions such as property tax and depreciation.

Getting a Mortgage With a Self-Directed IRA

It is possible for an IRA to get a mortgage loan from some banks. Though it is a non-recourse loan, meaning the bank can foreclose and repossess the property if payments are not made, it is still a loan from the IRA.

The bank will also be taxed on the amount it is financing as unrelated business taxable income. This tax is called Unrelated Debt-Financed Income Tax (UDFI).

For example, an investor purchases a property for $200,000. The IRA pays $60,000 upfront, which is 30% of the total cost. The bank finances the remaining $140,000 while the other hand is not mentioned.

The IRS will tax the $140,000 as non-IRA funds. Bank financing is usually avoided by investors because they fully fund a real estate purchase with the IRA.