Many retirement plans allow investing in real estate, which can be a great way to diversify your portfolio. Since its founding in 2005, Safeguard Advisors has established thousands of self-directed plans for investors wanting to invest in rental properties, flipping houses, leasing out farmland, or participating in a syndicated commercial real estate deal. There are many reasons that self-directed investors are attracted to real property investments, and there are many ways an IRA or 401(k) can invest in real estate. What are the main things to think about when doing this type of investing? Before we continue, let’s take a moment to understand what a Self-Directed IRA is.
What is a Self-Directed IRA
” A self-directed Individual Retirement Arrangement (IRA) is an individual retirement account that allows the account owner to direct the account trustee to make a broader range of investments. This includes investments such as real estate, franchises, precious metals, and private equity. The IRS requires that a qualified trustee or custodian hold the IRA assets on behalf of the IRA owner.
A self-directed IRA functions similarly to a traditional IRA in that taxes on returns are deferred until retirement, regardless of how much money is made. To receive the potential benefits of investing in real estate or owning an account, there are many rules and regulations that must be followed.
Why Real Estate?
Many people believe that investing in real estate is one of the best ways to create wealth. The saying goes that they’re not making land anymore. although we continue to produce more people, demand is still present Real estate is a real asset, meaning it is not exposed to the risk of total value loss that one can experience with paper assets. Real estate values are less likely to change rapidly than other assets in the market, so they tend to be more stable over time. Real estate can be a good investment because it can appreciate in value and produce income through renting. Real estate is an asset class that is very prevalent and is something that most people understand well. A lot of people are attracted to investing in something they can see in their own community.
What Kind of Real Estate Can be Held in an IRA?
Different types of retirement plans can invest in real estate in various ways. The IRS does not limit what types of real estate can be owned. Following are some of the common types of real estate investments:
- Residential rental properties
- Commercial properties & apartments
- Industrial or storage properties
- Raw land, farm land, ranches & timber land
- Real estate development projects
- Property flipping
- Real estate partnerships, joint ventures, or syndicated investments
- Real estate crowd funds
Rental Property
We will now take a closer look at how transactions for rental property work in an IRA.
The Internal Revenue Service does not allow any type of retirement plan to have any benefits for anyone who is not allowed to have them. The most important thing to remember when doing a real estate deal with an IRA or 401(k) is that it must be done for the sole benefit of the IRA or 401(k).
- The plan will purchase the property and be on title
- All expenses for the acquisition and maintenance of the property must be paid for with plan funds
- Any contracts such as leases, insurance, or construction services should be executed via the plan and not in your own name
- All income produced by the rental or future sale of the property must go to the plan, and will be tax-sheltered to the plan.
You are not allowed to use the plan to benefit yourself in any way, such as by being paid for managing the plan, using property that is part of the plan, or renting property to a family member or family-owned business. You or a disqualified party may not add value to the plan by providing goods, services, or facilities.
You have the authority as the IRA LLC manager or Solo 401(k) trustee to administer plan investments. Rental real estate includes opportunities like identifying deal negotiations, signing contracts, paying bills, and receiving income into the plan account.
But imagine scaling that same operation up to a portfolio of hundreds of properties. Managing a few single-family homes on your own may not be a problem, but try doing that same thing with hundreds of properties. Although owning a 30-unit apartment complex requires more paperwork, the IRS may view this as providing a service.
Using Mortgages
You can use a self-directed IRA or Solo 401(k) to buy property with debt financing, such as a mortgage. You’re not limited to all-cash purchases. This means that you or anyone else related to the IRA is not allowed to pledge a personal guarantee for the mortgage. You cannot put your assets up as collateral for the IRA’s debt.
If you use debt to finance your IRA, you may be subject to taxes. There is a tax on income that an IRA (Individual Retirement Account) earns that is based on borrowed money that is not from the IRA.
The impact of UDFI taxation is generally not significant. A $100K property with a $60K mortgage that produces 10% return would pay an annual tax bill of $100-$200, depending on the available write-offs for expenses. The small amount you will have to pay in tax will be far outweighed by the overall benefit of using leverage. The IRA should receive a higher rate of return on each dollar invested in a property with a mortgage.
If you have a Solo 401(k) plan, you don’t have to pay taxes on debt that you use to buy real estate. If you qualify for a Solo 401(k) plan and want to use leverage in your real estate investing, it’s much simpler and less expensive in terms of taxes.
Active Deals and UBTI
One key consideration to keep in mind when choosing a deal type is the possibility of being liable for Unrelated Business Taxable Income (UBTI). This means that an IRA does not have to pay taxes on income that it receives from passive sources. If a tax-exempt entity engaging in business activities on a regular or repeated basis, which compete with businesses that pay taxes, then the entity is subject to Unrelated Business Income Tax. The purpose of this tax is to level the playing field for businesses that pay taxes, by making it more difficult for businesses that don’t pay taxes to compete.
Activities that are not subject to the Unrelated Business Income Tax would include interest, dividends, royalties, and rent from real property. These activities would produce passive income.
Active business deals in the real estate sphere would include any kind of development or dealer activity, such as new home construction or flipping of houses. You should be careful and talk to a licensed tax professional if you’re trying to make money through investments. You may need to tweak your investment strategy to make it more passive in order to increase profits and reduce your tax liability.
Joint Ventures and Syndicates
This can work in two ways: one is to pool money with other retirement account investors in order to make a larger investment; the other is to work with an experienced outside investor who can help finance a slightly larger investment than your retirement account alone would permit You can use your IRA or 401(k) to invest in larger deals by teaming up with other investors. You can pool your money with other retirement account investors to make a larger investment, or you can work with an experienced outside investor who can help finance a slightly larger investment than your retirement account alone would permit. This can be done in many ways, including:
- Simple joint ventures between the IRA and one or more partners to purchase a property as tenants-in-common. An IRA may partner with anyone not viewed as a disqualified party, whether that party is also using IRA or non-IRA funds.
- Participating in a real estate syndicate or private placement such as a LLC or LLP formed to bring many investors into a large deal like an apartment, commercial project, golf course, etc.
- Investing in real estate crowd funds.
The same rules and considerations that apply to a deal an IRA may do on its own, also apply to any of these deal types. There are a few things to keep in mind when choosing a business partner to avoid any issues down the road. It’s best to steer clear of anyone who is not qualified and avoid any businesses that involve a lot of leverage or would be considered a trade or business as this could result in some tax exposure.
Self-Directed IRA Rules for Real Estate
Self-directed IRA’s have many benefits associated with them, one of which is the ability to buy real estate. To experience the benefits of something, the best way to go about it is to follow the rules. There are rules that must be followed when using a SDIRA to purchase real estate. These rules include: (1) not being able to purchase property that is owned by you or a “disqualified person;” (2) not being able to have indirect benefits; (3) IRA investments must be uniquely titled; (4) being able to buy real estate in combination with other funds; (5) If financing the IRA is required to pay Unrelated Business Income Tax (UBIT); (6) Any expenses that are related to IRA-owned properties must be paid from the IRA; (7) any income generated via self-directed IRA-owned real estate must be returned to your IRA. Continue reading below to learn more about these rules.
SDIRA Rule 1: Property cannot be owned by you
You are not allowed to use your IRA to purchase property that you already own, or that is owned by a “disqualified person.”
SDIRA Rule 2: You cannot have indirect benefits
You cannot exploits benefits from property that is owned by your self-directed IRA for your own personal gain. There are a number of potential benefits to owning a property through an IRA, including the ability to rent out space in the property.
SDIRA Rule 3: Property must be uniquely titled
IRA investments are legally considered to be separate from you as an individual. Therefore, investments should be titled in the name of your IRA.
SDIRA Rule 4: Property can be purchase with combination funds
You can purchase real estate with other funds in your SDIRA. Partnerships and undivided interest are two alternatives that exist.
SDIRA Rule 5: Must pay UBIT if financing.
If you finance any investments in your IRA, you have to pay the Unrelated Business Income Tax (UBIT).
SDIRA Rule 6: Expenses must be paid from IRA
All expenses associated with any property owned by an IRA must be paid out of the IRA. Some of the expenses associated with owning a property are: building association fees, utility bills, maintenance fees, renovations, and property taxes.
SDIRA Rule 7: Income generated must return to IRA.
The income generated by the self-directed IRA-owned real estate must be reinvested in the IRA. Income generated by property owned within an SDIRA must be paid directly into the IRA.
5 Steps to Get Started with an SDIRA
Starting down the road to a self-directed IRA real estate investment is made easier when you follow these five steps:
Step 1: Identify a potential investment and complete the necessary due diligence.
Before you make any investment decisions, you should speak to your accountant or financial advisor. These individuals will help make sure that you have done your research by thoroughly investigating all alternative assets, including investment real estate properties.
Step 2: Request the funds and direct your investment.
You will need to complete a Direction of Investment form before you can invest. This form is to be used when you are ready to invest, it has the instructions on how much to invest, where to send the funds and what documents need to be signed. The account owner of a SDIRA has the ability to direct the account trustee to make a more diverse range of investments.
Step 3: The investment is processed.
Your account trustee will make sure that your chosen investment is carried out according to the instructions in the DOI. After you finish the purchase and finalize the closing, your IRA will own the asset you acquired.
Step 4: Manage your new investment within the IRA.
You must pay all expenses for your IRA-owned investment from your IRA. Income or profits generated from the IRA must be returned to the IRA. The later sequence of events can allow you to put off paying taxes, which can be beneficial.
Step 5: Plan your next steps and have an exit strategy.
You have control over your SDIRA’s direction and how long it lasts. It is your responsibility to sell or lease an asset, but your account trustee will carry out the sale or lease based on your instructions. The proceeds from the sale will be placed in your SDIRA in lieu of the asset.
Before you take any of the above steps, you should talk to a financial professional, accountant, and/or tax attorney.
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