Real Estate and the Self-Directed IRA
July 13, 2021
By Dan Gibson
Of all the investments made by investors holding self-directed individual retirement accounts (“SDIRAs”), real estate is the most common. When it comes to real estate, the SDIRA can invest in residential and commercial properties, apartment complexes, syndications, land and mineral rights. However, the investor using an SDIRA should keep in mind that real estate must be held as an investment. The investor and disqualified persons (spouse, ancestors, lineal descendants and spouses) cannot reside, work or receive a salary in connection with the real estate. Income should not be paid to and expenses should not be paid by the IRA owner. The IRA or the single-member limited liability company (“IRA/LLC”) owned by the IRA is the owner of the property and should receive the income and pay any expenses in connection with that property. In addition, all contracts, deeds and legal documents must be in the name of the IRA or IRA/LLC.
One of the benefits of investing in real estate is the ability to leverage the purchase with debt. An IRA or IRA/LLC can use debt to finance a real estate purchase. However, the debt can only be non-recourse. This means that the only recourse for the lender in the event of a default is to take back the property. The debt will be considered a prohibited transaction if the IRA owner’s credit is used to obtain the loan or the IRA owner personally guarantees the loan. There is one caveat when financing a real estate deal with an IRA or IRA/LLC. Some income may be subject to Unrelated Business Income Tax (“UBIT”). Debt-financed property owned by an IRA or IRA/LLC can result in a percentage of the income from the property, including a gain on its sale, being subject to UBIT. The theory behind UBIT is that since the IRA, directly or through its LLC, has income from borrowed money that is not its own, then that money is “unrelated” to the IRA. This income is known as Unrelated Debt Financing Income (“UDFI”). Since an IRA is a tax-exempt entity, rules require the IRA to pay UBIT on UDFI generated from loans used to purchase the real estate. For example, if an IRA’s LLC purchases a property and funds the purchase 60% with its own money and 40% from borrowed money, then, in general, 40% of the IRA’s share of net profits will be considered UDFI because that portion of the profits was created from money that was not owned by the IRA’s LLC. UDFI would then be subject to UBIT.
When managing the property, the IRA owner must limit their activities to administrative and investment oversight tasks only. The IRA owner (or a disqualified person) cannot physically work (demolition, repairs, construction, and so forth) on the property since this will constitute a prohibited activity.
The IRA owner needs to ensure that they do not overextend the IRA or IRA/LLC to the extent that it is unable to cover unexpected property expenditures. Income from the property and cash reserves within the IRA or IRA/LLC need to keep the IRA or IRA/LLC self-contained. The IRA owner or a disqualified person cannot just pay the expenses to cover the shortfall. As a last resort, in the event that the IRA or IRA/LLC becomes overextended, the owner can utilize Department of Labor Prohibited Transaction Exemption 80-26 (PTE 80-26). This allows the IRA owner to loan money to the IRA. The loan is allowable as long as (1) funds are only used for ordinary and necessary expenditures; (2) the loan must be interest-free and unsecured; and (3) any loan longer than 60 days must be documented in writing.
With a self-directed IRA, you can buy an investment property and distribute it later for personal use. You can even use your account to acquire the perfect home for your retirement years. You’ll need to purchase the property through your IRA, which will own it as an investment until you retire. You can also rent the property until you are ready to retire and move in. But you and any disqualified persons cannot use the property because that would be a prohibited transaction. When comes time to retire, you will distribute the property as an “in-kind” distribution, which means taxes are due if distributed from a traditional IRAs. If your future retirement home was appraised at $250,000 at the time of the distribution, you will receive a 1099-R for $250,000 from your custodian upon distribution. This distribution will be taxed at ordinary income tax rates. For Roth IRAs, the distribution of the property will not be taxable as qualified Roth IRA distributions are not subject to tax.