IRA Investments in Real Estate Partnerships
Many of the most stable and best performing types of real estate investment opportunities pose a problem. They are expensive. While apartments, medical office complexes, and industrial facilities can all produce consistent and above average returns, most investors do not have enough money in their self-directed IRA or Solo 401(k) to fund a deal on their own.
Utilizing partnership vehicles can be a great way to diversify some of your tax-sheltered retirement savings into larger real estate deals. By pooling your plan funds with capital belonging to other investors, you can achieve greater scale than you can on your own.
Following are some key things to keep in mind when considering real estate partnerships.
Investing in real estate partnerships can have several advantages.
Commercial real estate has always been a stable and high-performing asset class. Most investors cannot purchase such larger deals on their own. Participating in a partnership opens the door to these types of opportunities.
Most partnerships acquire multi-tenant properties, which reduces vacancy risk. When your IRA owns 100% of a single rental unit, a vacancy means a 100% loss of income. When your plan owns a fraction of a multi-tenant property, a single vacancy will not impact income as severely.
Many real estate partnerships are led by someone with extensive experience in the type of property and market where the investment is taking place. Being able to leverage that expertise and have your IRA take a more passive role is a great way to invest.
Types of Partnerships
There are a few different types of partnership structures available, depending on the scale of the project and the amount of capital required.
Joint ventures typically involve a small number of investors and can be suitable for smaller deals.
Rather than create a formal partnership entity with its own layer of administrative and tax requirements, investors simply take title to a property jointly as tenants-in-common. Each partner is responsible for their own share of income and expenses and will manage their own filing obligations.
A formal joint venture operating agreement between the parties is recommended, but there is no need to create or maintain state business entity filings or file a partnership tax return in most cases.
Small Partnerships of Equals
Sometimes there are benefits to creating an entity such as an LLC for several investors to partner into.
The entity layer can simplify administration of the investment, as it will have its own bank account, insurance policy, etc.
Usage of an LLC can also provide a unified layer of liability protection for all involved partners.
It is possible to have a small number of partners each of whom have administrative authority. Alternately, one or a small number of partners can take an active role in the management of the project and other partners can simply provide capital.
A partnership of this type will need to file applicable tax returns at the state and federal level, and will pass income to the individual partners on a schedule K-1. Each partner is then responsible for their own income reporting based on that K-1.
Some larger deals will utilize a partnership structure often referred to as a real estate syndication. In this case, there is a general partner that puts together the deal and operates the investment. Limited partners simply provide a share of capital and rely on the general partner to run the show.
Being a limited partner is a more passive role, and is therefore a very popular route for IRA and 401(k) investors looking to diversify into real estate without needing to be hands on.
As with a smaller partnership, the entity will issue K-1’s to limited partners, who will then be responsible for reporting their share of income as appropriate to their tax status as an individual, IRA, etc.
Who Can Your Plan Partner With?
When participating in any kind of partnership, it is important to keep IRS rules surrounding prohibited transactions and disqualified persons in mind.
Any direct or indirect transaction or provision of benefit between an IRA and a disqualified person such as you, your spouse, lineal family, or a business entity controlled by you or close family members can put your plan at risk of severe tax consequences.
The best practice is to avoid partnerships that combine IRA or 401(k) funds and a disqualified person. This strategy eliminates a key factor of compliance risk.
There are several plan providers and attorneys who speak about the ability to partner IRA money with funds belonging to disqualified persons, and it is “technically” possible to do so in a way that has perceived minimal risk.
The key argument made is that if the partnership is formed with all involved parties starting on day one, and each party retaining their own share of expenses and income over the life of the project, then there is no transaction being created between any of the parties.
The challenge is that situations can change in ways that might not keep that rigid simplicity in place. A partner could die, divorce, or otherwise want out of a project. A deal can run into a cash flow issue where not all parties are able to bring new cash in the same percentages as the original capitalization. It is difficult to entirely future-proof any real estate transaction, and that equates to compliance risk.
There are some cases where the flow of capital may be clean, but other forms of benefit are being provided between the IRA and a disqualified person, potentially including even the possibility of participating in a deal they could not without access to the other party’s funds.
At the end of the day, the IRS has the leeway to determine whether a violation has occurred based on their interpretation of the facts and circumstances. Do you really want to introduce that risk factor?
Management of Partnerships
In a small partnership, it is OK for each member to vote their own interests, and you can do that on behalf of your plan.
If you or a disqualified person are providing a layer of services to a partnership that goes beyond administering your plan’s interest in the deal, that can create problems. You cannot benefit from the plan, such as receiving compensation for services performed to the partnership.
The reverse is also true. You cannot provide benefit to the plan through the provision of goods or services. Your time and personal resources or capital have value, and if you are in effect gifting that value to your IRA or 401(k), you are basically making a non-documented contribution to the plan. The IRS can view that as a prohibited transaction.
Partners Can Fund as They Choose
Many new IRA investors believe their IRA can only partner with other IRA money. This is simply not true or necessary. What matters to the IRA is operating in accordance with IRS rules. Whether another partner in a deal is using IRA money or their own cash is of no relevance.
Adding Leverage to the Mix
In addition to pooling investor cash from multiple partners, may ventures will also employ debt-financing such as a mortgage. This is especially common in larger deals and real estate syndications.
A retirement plan can participate in a debt-financed deal. The same concerns about the use of leverage apply as if the IRA or 401(k) were investing on its own.
Any debt instrument must be non-recourse with respect to the IRA, meaning that the IRA account holder or any disqualified person to the IRA is not pledging a personal guarantee. It is possible that some partners not using IRA money might place a guarantee on debt, while an IRA partner does not, but those can be difficult loans to negotiate with a bank.
With an IRA, the portion of income attributed to borrowed capital is considered Unrelated Debt-Financed Income (UDFI) and subject to taxation.
A Solo 401(k) is not taxed on UDFI when the debt in question is used for the acquisition of real property.
A Popular Option
Real estate partnerships are an increasingly popular way for investors to deploy their self-directed IRA or Solo 401(k). When you add up the benefits of investing passively into larger deals that are professionally run, it makes sense that more and more people are considering this type of opportunity.
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