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Some Helpful Tips For Investing In Real Estate Using Retirement Funds

Most people mistakenly believe that their retirement accounts must be invested in traditional financial related investments such as stocks, mutual funds, exchange traded funds, etc. Few Investors realize that the Internal Revenue Service (“IRS”) permits retirement accounts, such as an IRA or 401(k) plan, to invest in real estate and other alternative types of investments.  In fact, IRS rules permit one to invest retirement funds in almost any type of investment, aside generally from any investment involving a disqualified person, collectibles and life insurance.

One of the primary advantages of purchasing real estate with retirement funds is that all gains are tax-deferred until a distribution is made or tax-free in the case of a Roth account (after-tax). For example, if one purchased a piece of property with retirement funds for $100,000 and later sold the property for $300,000, the $200,000 of gain appreciation would generally be tax-deferred. Whereas, if you purchased the property using personal funds (non-retirement funds), the gain would be subject to federal income tax and in most cases state income tax.

The two most common vehicles for purchasing real estate with retirement funds is the self-directed IRA or an employer sponsored 401(k) plan.  However, most employer 401(k) plans do not offer real estate as a plan investment option and, thus, the self-directed IRA has become the most popular way to buy real estate with retirement funds.  Establishing a self-directed IRA is quick and relatively inexpensive and can be done in just a few days.  The most challenging aspect of investing in real estate using retirement funds is navigating the IRS prohibited transaction rules.  In general, pursuant to Internal Revenue Code (“IRC”) Section 4975, the retirement account holder cannot make a retirement account investment that will directly or indirectly benefit ones self or any disqualified person (lineal descendant of the retirement account holder and related entities), perform any service in connection with the retirement account investment, guarantee any retirement account loan, extend any credit to or from the retirement account, or enter into any transaction with the retirement account that would present a conflict of interest.  The purpose of these rules is to encourage the use of retirement account for accumulation of retirement savings and to prohibit those in control of the retirement account from taking advantage of the tax benefits for their personal account.

Aside from navigating the IRS prohibited transaction rules, the following are a handful of helpful tips for making real estate investment using retirement funds:

  • The deposit and purchase price for the real estate property should be paid using retirement account funds and not from any disqualified person(s)
  • All expenses, repairs and taxes incurred in connection with the retirement account real estate investment should be paid using retirement funds – no personal funds from any disqualified person should be used
  • If additional funds are required for improvements or other matters involving the retirement account-owned real estate investment, all funds should come from the retirement account or from a non-“disqualified person”
  • Partnering with yourself or another disqualified person in connection with a retirement account investment could trigger the IRS prohibited transaction rules.
  • If financing is needed for a real estate transaction, only nonrecourse financing should be used. A nonrecourse loan is a loan that is not personally guaranteed by the retirement account holder or any disqualified person and whereby the lender’s only recourse is against the property and not against the borrower.
  • If using a nonrecourse loan to purchase real estate with a self-directed IRA, the unrelated business taxable income (“UBTI”) rules could be triggered and a tax rate reaching as high as 40 percent could apply.  Note – an exemption from this tax is available for 401(k) plans pursuant to IRC 514(c)(9). If the UBTI tax is triggered and tax is due, IRS Form 990-T must be timely filed.
  • No services should be performed by the retirement account holder or any “disqualified person” in connection with the real estate investment.  Please see: Finally Some Clarity On What You Can And Cannot Do In Your Self-Directed IRA for additional information
  • Title of the real estate purchased should be in the name of the retirement account. For example, if Joe Smith established a Self-Directed IRA LLC and named the LLC “XYZ, LLC”, title to the real estate purchased by Joe’s Self-Directed IRA LLC would be as follows: XYZ LLC.  Whereas, if Joe Smith established a self-directed IRA with ABC IRA Trust Company (custodian), and the custodian purchased the real estate directly on behalf of Joe without the use of an LLC, then title would read:  ABC IRA Trust Company FBO John Doe IRA.
  • Keep good records of income and expenses generated by the retirement account owned real estate investment
  • All income, gains or losses from the retirement account real estate investment should be allocated to the retirement account owner of the investment
  • Make sure you perform adequate diligence on the property you will be purchasing especially if it is in a state you do not live in.
  • Beware of fraud if purchasing real estate from a promoter.
  • If using a self-directed IRA LLC to buy real estate, it is good practice to form the LLC in the state where the real estate will be located to avoid any additional filing fees.  Also, be mindful of any annual state LLC filing or franchise fees.

Using retirement funds to buy real estate can offer retirement account holders a number of positive financial and tax benefits, such as a way to invest in what one knows and understands, investment diversification, inflation protection, and the ability to generate tax-deferred or tax-free (in the case of a Roth) income or gains. The list of helpful tips outlined above should provide retirement account investors looking to buy real estate with a guideline of how to keep their retirement account from running afoul of any of the IRS rules.  However, retirement account holders using retirement funds to invest in real estate must be mindful of the broad application of the IRS prohibited transaction and UBTI rules and should consult with a tax professional for further guidance.

Post courtesy of Forbes.