For real estate investors, the fact that conventional IRAs typically only allow investments in stocks, bonds, CDs and mutual funds can seem a bit limiting. Drawn to the historically safe investment of tangible real estate, savvy real estate investors may not want to settle for a real estate mutual fund or a real estate investment trust (REIT), and would prefer to execute more control and add physical property to their individual retirement account.
As it turns out, the IRS (under ERISA) does allow investments in real estate in both traditional and Roth IRAs if the investor employs a self-directed IRA (SDIRA). SDIRAs are increasing in popularity, though still fairly uncommon, making up less than 5% of all IRAs. SDIRAs open the door for alternative investment options to be held in retirement-advantaged accounts.
Real Estate Acumen
Before embarking on the necessary steps to hold tangible real estate in an IRA, it is advisable for the investor to not only be a savvy, knowledgeable investor but also have a strong understanding of real estate and understand the long-term growth potential of prospective investments. Otherwise, real estate mutual funds or public REIT funds might be a better choice in terms of adding diversification, liquidity, and ease of investment. Of course, unlike with a REIT or real estate mutual fund, the investor of a self-directed IRA with real estate has total control and the IRA directly owns the real estate project, instead of slivers of real estate managed by others.
Forming a Self-Directed IRA
Legally, conventional and self-directed IRAs are fairly similar in terms of taxation and maximum contributions ($5,500 for 2018; $6,500 if over age 50; and income limitations for Roth models). The key differences are the formation and working with IRA administrators that specialize in alternative assets. To open a SDIRA, regulations first require that a custodian/trustee hold the IRA assets on behalf of the owner. Since they make up a tiny sliver of the IRA market, investors will need to branch outside of standard banks and brokerage firms and find a custodian or trustee that specializes in these less typical investments.
With the emphasis on “self-directed,” the custodian or trustee should only be a passive party that executes directions from the IRA owner and maintain the administrative duties to maintain the tax status of the IRA. Self-directed custodians/trustees provide no guidance, recommendations or advice to the IRA owner. Their job is to provide an annual valuation to the IRS each year and ensure the asset(s) are properly insured. As with the conventional IRAs, the custodian/trustee will charge fees for their services. Overall, the setup and maintenance process has the potential be more complicated and more costly than conventional options. The trade-off, of course, is the additional investment options and additional control the account owner has. That said, care should be taken when choosing the administrator. Feel free to reach out to Withum’s Real Estate Team for recommendations of custodians that we have dealt with.
In order to complete the transaction to own real estate, the property would be purchased/owned by an LLC that would in turn be owned by the SDIRA. This would incur additional setup fees and expense. It is notable, however, that a single member self-directed IRA LLC (owned 100% by the SDIRA) would be exempt from annual tax return filings. Additionally, this arrangement allows the investor to maintain “check book control” over properties, offering greater freedom and control to the owner.
Following the Rules [Avoiding Disqualification]
It is imperative that if choosing to hold real estate in an IRA, the specific rules for doing so must be followed unequivocally. Since that emphasis is heavy of the “self-directed,” the investor needs to be aware of (and avoid) prohibited transactions.
The parameters to qualify to have an SDIRA own realty include:
- Cannot have transactions between the IRA and “disqualified persons” because IRA owners cannot make investments or loans that benefit themselves or certain family members directly or indirectly
- Cannot purchase real estate from IRA owner, spouse, children, grandchildren, great-grandchildren, parents and grandparents
- Cannot have self, family members or businesses occupy any real estate owned by the IRA (purchasing a vacation home that the investor would use)
- Cannot mix non-retirement funds and IRA funds
- All expenses related to the property (property taxes, association fees, maintenance, improvements, etc.) must be paid from the IRA
- All rental income must be funneled into the IRA
- Cannot provide services to the plan (i.e. cannot provide any maintenance or repair to a property, such as delivering a new water heater); must hire and pay someone through the IRA for all steps
- Thus, the IRA needs to have a healthy cash cushion to pay for the annual valuations, fees, and any improvements/operating costs necessary for the property
If these criteria are not adhered to, the entire IRA could be disqualified, creating a taxable distribution for the entire account, as well as possible excise tax penalties.
Funding the Investment
If the investor’s expertise in real estate leaves he or she confident that investing in real estate is the right option for his or her particular situation, he or she can purchase and own any type of real estate (commercial or residential property, vacant land, offshore real estate, etc.), keeping care that the qualifications are met.
With IRAs being limited in terms of contribution, another issue in purchasing real estate is simply having enough funds to do so. This can be worked around if the IRA is well-funded, including utilizing roll over options from 401(k)s which have higher contribution limits.
It is possible to leverage property, but that involves adhering to additional restrictions and complications. Using debt to purchase real estate is one of the advantages that investors use in general outside of retirement accounts. But debt inside the SDIRA diminishes tax benefits. IRAs are allowed to borrow money, but borrowings must be through a nonrecourse loan (fully secured by the property as collateral with no personal guarantee), which may be more difficult to obtain than a standard mortgage. This also triggers UBTI, which can defeat the advantages and intent of investing within an IRA to start with. This means that even within the account, if the IRA put 30% down and took out a mortgage loan in the IRA for 70% of the property, which was subsequently rented out, then 70% of the rental income would be subject to tax.
In the SDIRA, the rental income is treated as dividend income and is not taxable under the IRA umbrella. In a traditional IRA, this would defer taxes until normal retirement distributions occur. In a Roth IRA (with the taxes paid on the original investments), the dividends would never be subject to additional federal taxation. This makes an appealing case for real estate investments to be held in Roth IRAs over traditional IRAs, if funds are built up in the Roth over time, rolled over from a Roth 401k or converted from a traditional IRA. A conversion from a traditional IRA to a Roth IRA is also an option, but would render a federal and state taxable event on all funds. Depending on the taxable amount for a given year, this may not be worthwhile.
This brings up an important note about taxation when dealing with traditional IRA models. If a property held outside of a retirement account was held for longer than one year and sold, it would be treated as a long term capital gain and have favorable taxation rates (federal maximum rate of 20%, or 23.8% with Medicare surtax; or 25%/28.8% of any depreciated portion). For a traditional IRA, where the taxes are deferred, the distributions will be subject to ordinary income tax rates during retirement (for 2018 the top federal tax bracket is 37%). Of course, the investor’s retirement income could potentially be in a much lower tax bracket, and certain medical expenses could offset the taxable amount. Then again, the reverse could be true.
RMDs and Inheritance Planning
Care must also be taken to ensure that the real estate has enough positive cash flow to allow future required minimum distributions (RMDs) to occur. An RMD is equal to a percentage of one’s total traditional IRA balances, based on remaining life expectancy and is mandatory in the year the owner reaches age 70-1/2.
While Roth IRAs do not have RMDs, if the Roth IRA is inherited by a non-spouse, the RMD kicks into effect (non-spouse heirs must begin RMD withdrawals from any type of IRA by 12/31 of the year following the IRA owner’s death). Unless there is a cushion of other funding, the RMDS can pose an issue since it would be difficult to sell off the real estate holdings in small pieces (or as a whole) to pay out the RMDs, which have steep penalties (50%) for non-compliance (opting to not take an RMD).
Another inheritance planning caveat exists. Beneficiaries of an IRA do not get a step-up in basis. Typically, when property is inherited by an heir, the beneficiary would receive a step-up in basis (re-adjusting the asset to reflect the fair market value when inherited, as opposed to the assumable lower price when the property was initially acquired). When property in an IRA is inherited, there is no step-up in basis, leaving the presumably lower purchase price as the basis for if the property is eventually sold.
While using a SDIRA to obtain long-term wealth, there are enough barriers of entry and cautions that require the decision to do so to be weighed carefully. For perceptive, experienced real estate investors with substantial wealth in an IRA (or ability to convert funds into an IRA), owning real estate within the SDIRA can prove to be a valuable strategy to add diversification to holdings and grow and build wealth. However, without those compensations, the decision to both open a self-directed IRA and place real property among the holdings should be made with caution.
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