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The Basics
The rules governing allowable investments by IRAs preclude an IRA's
investment in life insurance, collectibles (e.g., artwork, antiques,
metals, gems, and most coins) and S corporations.
All other types of investments are permitted, and thus the range of possible
investment choices is nearly unlimited. Consequently, an IRA can purchase any form of
real estate.
Real estate IRA investing opens up a huge range of alternative
investments for individuals who are knowledgeable about real estate investing
or who work with knowledgeable advisors, sponsors, or brokers. Investing
in real estate for your retirement may serve as a means to diversify your
retirement portfolio to hedge against the cyclical changes in the stock
market, economy and bank and government-based investments.
For many who are experienced with real estate investing, real estate
investments hold the potential to protect against the loss of principal
while generating better than market rate returns through income
production and capital gains. When real estate investments are not
leveraged, both income and capital gains can flow back to IRAs tax-deferred
(or tax-free if the IRA is a Roth IRA).
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Easy
If you have your IRA purchase real estate from an unrelated party
and pay cash for it, and you do not use the real estate for personal
reasons while it is in your IRA (i.e., you treat it strictly as
an investment), there are no special issues.
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More difficult
If your IRA invests in real estate through a down payment and leveraging,
there are some significant issues:
- You cannot personally guarantee a loan for your IRA;
- It may be difficult to get a bank to allow an IRA to be the debtor
without a personal guarantee. However, there are now some banks that specialize
in loans to IRAs. Currently, the minimum IRA down payment for such loans is 30%,
although the exact amount is up to the lender;
- Your IRA will pay tax on UDFI (Unrelated Debt Financed Income),
which is the income and/or capital gains attributable to the leveraged
portion. (UDFI is taxed at the trust tax rate because an IRA is
treated as a trust for this purpose.)
As a consequence, although it is perfectly legal, it may not be
desirable to have an IRA carry debt in a real estate investment
transaction if there is any significant risk that the IRA will
be unable to pay the mortgage payments.
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What you can't do
in an IRA with real estate
- Your IRA cannot directly or indirectly buy real estate from
a "disqualified person". Who is a disqualified person?
- The IRA owner;
- the IRA owner's spouse, descendant (e.g., son), or ascendant
(e.g., mother);
- spouse of a descendant of the IRA holder;
- a fiduciary of the IRA or person providing services to the
IRA (e.g., the trustee or custodian);
- an entity at least 50% of which is owned (or at least 50%
of the beneficial interests are held) by a combination of
the above (e.g., if you and your spouse own 50% of an LLC,
that LLC is a disqualified person with respect to your IRA);
or
- a 10% owner, officer, or director or highly compensated
employee of such an entity.
- You cannot have your IRA enable an investment for yourself or
another disqualified person. In other words, if the IRA's investment
is deemed essential to accomplishing a transaction in which both
you and your IRA invest, then the transaction would be considered
a prohibited transaction.
- Your IRA cannot purchase a real estate asset and then have a
disqualified person use it while it is in the IRA. For example,
you cannot buy a vacation home and use it partly for personal
use, even though you might rent it to unrelated persons the rest
of the year.
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What you can do in an
IRA with real estate
Buying real estate from an unrelated party (i.e., one who is not a disqualified
person) with cash is the simplest way of investing in real estate with
your IRA. Your IRA can buy raw land, commercial property, residential
(e.g., rental) property, real estate options, as well as extend loans
(e.g., first and second mortgages), secured by real estate with your IRA,
to unrelated parties.
As discussed above, your IRA can also buy property through leveraging,
provided the loan is not guaranteed by the IRA owner (or any other disqualified
person) and that the IRA has enough liquidity to support the mortgage
and expenses. Generally, most custodians will have limits on the amount
of leverage they will permit. Also, as previously mentioned, leveraging
can result in income taxes on UDFI that must be paid by the IRA. Generally,
these taxes are higher than would be paid on income generated from a property
that you buy and finance personally. In addition, the UDFI taxes must
be paid from funds from the IRA and, therefore, there has to be enough
liquidity in the IRA to cover these taxes. See IRS Form 990T and its accompanying
instructions for details.
There are a variety of ways, however, that an IRA can participate in
a real estate investment without a full cash capital investment. For example,
your IRA can co-invest with other parties. You could also have your IRA,
and other parties participate in real estate investing by becoming members
of an LLC that buys and sells property.
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Examples of real estate investments that
can be made using IRA funds
Example I
John's IRA has purchased a single-family home from an unrelated seller.
John now wishes to have the IRA sell it to his sister with a first mortgage
that his IRA will hold.
The purchase of a single family home from an unrelated party is
not a problem. John pays $300,000 cash and his IRA holds the grant
deed from the sale to his IRA by the third party. John's IRA later
sells his sister the property and takes back a first mortgage and
a down payment in exchange. His IRA gives her a market rate loan
for 15 years and receives a 10% down payment. Since this is a $280,000
debt owed to the IRA and not by the IRA, there is no concern about
the potential liability of the IRA. John's IRA has a fixed income
investment and is protected because it holds the trust deed in the
event his sister defaults on the loan. The transaction may also
have the incidental benefit of allowing John's sister to purchase
the home more easily than she could have on the open market.
Example II
Allison wants to form an LLC that will buy property that will
be developed. She wants to make her IRA the primary investor. She
expects to have other investors in the LLC.
Allison's IRA can participate in the formation of the LLC provided
Allison and related persons and parties do not already own 50% or
more of the LLC in aggregate. If she is just starting the LLC, then
the IRA can own something less than 100% (e.g., 90%). The LLC is
considered a real estate operating company and, therefore, the assets
are not considered plan assets unless there is 100% ownership by
the IRA. If the company's assets are deemed plan assets, then a
transaction between the company and the IRA owner is considered
a transaction between the IRA and a disqualified person (such as
the IRA owner) and is therefore possibly a prohibited transaction.
Because of some recent legal rulings involving self-dealing, we
recommend that you consult with a competent attorney if you intend
to have a personal role in any entity in which your IRA is an investor.
If the LLC was not a real estate operating company or other type of operating
company (for example, if it was a hedge fund), then the aggregate ownership
of all IRAs and employee benefit plans would have to be less than 25%
in order for the LLC's assets not to be considered IRA assets. (The interest
owned by the IRA owner is disregarded for purposes of calculating the
relevant percentage.)
Example III
Howard wants to have his IRA purchase a $400,000 rental property with
a 50% down payment. Is this possible and are there any special considerations?
Yes, it is possible, but there are special considerations such as:
-Disqualified persons (such as the IRA owner and his or her spouse) cannot
personally guarantee the loan for the IRA. The loan must be supported
by the property itself or some other property that the IRA owner owns;
-The IRA will be subject to tax (UDFI
or UBIT) on any income and/or capital gains attributable to
the leveraged portion of the investment;
It should be noted, as an alternative to borrowing, that the IRA can purchase the
property with other parties, all of who pay cash. When this is done,
there is no UDFI and there are no issues associated with the financing.
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Conclusion
In summary, the tax laws (1) require that the investments in an
IRA not benefit the IRA owner or other "disqualified persons"
and (2) prevent "self-dealing" between the IRA and the
IRA owner or other disqualified persons. However, by properly structuring
an IRA investment in real estate, an IRA can obtain the benefits
of real estate investment in a manner that complies with applicable
tax laws.top
(The foregoing is a general discussion. It is not intended, and should
not be relied upon, as an opinion or advice on any legal, tax or investment
aspects of IRAs. An IRA owner considering an IRA investment in real property
should consult with his or her own advisor.)
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