Property flipping is one of the more popular investment interests for those considering a self-directed IRA or Solo 401(k) retirement plan. Over the last several years, the opportunity to flip houses at a considerable profit has remained strong in many local markets.
With the key benefit of a self-directed retirement plan being the ability to have more direct control over investment activities, its no wonder that flipping is so popular.
There are several complexities to flipping houses in a tax-sheltered IRA or 401(k) plan, including needing to remain at arm’s length and potential exposure to UBIT taxation if flipping is conducted on a repeated basis.
We’ve covered those topics in prior articles and would emphasize the importance of fully understanding the potential pitfalls of flipping in an IRA before embarking on this strategy.
For many investors, there is a good opportunity to successfully perform the occasional flip and generate a solid, tax-sheltered profit for their retirement plan.
In light of this popular opportunity, we wanted to take a bit of a nuts-and-bolts view of what a flip transaction looks like in a self-directed IRA LLC. The concepts are similar in a Solo 401(k) trust, but for simplicity, we’ll discuss the IRA LLC structure in our example below.
Understand the Strategy
As is the case with most any investment, a thorough evaluation of the flipping strategy is probably the most critical step in the whole process. You need to be sure you understand the arm’s length restrictions that apply in an IRA, and know what you can and can’t do.
You’ll also want to determine how much flipping you intend to do in your IRA and whether that will create exposure to UBIT. If so, you may want to scale back on frequency, or look into alternative approaches such as private lending to flippers.
Understand your Market
Is flipping the right strategy where you live? It may or may not be, depending on many factors like the age and condition of homes, pricing trends, who is buying currently and more.
Before even considering individual properties as potential flips, you’ll want to be sure that the likelihood of success is there at the big-picture level.
Setup your Checkbook IRA or Solo 401(k) Plan
Your self-directed retirement plan needs to be in place before you start pursuing deals in earnest.
You need to write offers in the name of your plan, and any pre-purchase expenses like earnest money or inspections need to be paid with plan funds.
If you’re planning on purchasing at auction or from a wholesaler, you need to be able to act immediately. Setting up and funding a plan can take 3-4 weeks, so being ready to go in advance is a must. If you find a great opportunity before your plan is in place, it’ll likely become a missed opportunity.
Trying to execute such projects with an account held by a self-directed custodian that will serve as your transaction processor is just not practical. Flips involve a lot of transactions, some of which can be very time-sensitive.
You won’t be able to wait 3-5 days for a custodian to review paperwork and fund expenses. Paying all those per-transaction fees will increase your administrative expenses. You need the checkbook in your hand — plain and simple.
Purchasing the Property
Properties to flip can be acquired in many ways; through a standard realtor transaction, from a property wholesaler, or at auction. In all cases, the LLC is the purchaser of property and will be on title.
As the manager of the LLC, you can negotiate the terms of purchase and execute contracts for purchase.
You can also issue funds by wire, ACH or cashier’s check from your LLC-held bank account to fund the acquisition of the property. You have full executive authority for the LLC, and don’t need to obtain 3rd party approval for the transaction.
Insure the Project
Proper insurance is important to protect your IRA investment from hazard losses or potential liability.
Flip transactions produce a lot of potential exposure to risk in both of these areas, and require specialized insurance to guarantee coverage.
Because flip properties are typically vacant and it’s generally obvious when they’re being worked on, they can be prime targets for thieves and vandals. If remodeling supplies or your contractor’s tools are stolen from a job-site, your IRA LLC will need to be covered.
Any policy needs to be in the name of the LLC, and specifically designed for vacant flips. Not all insurers provide such policies. Some that do are listed on our Vendor Resources page.
In addition to property hazard insurance, you’ll likely want to have an appropriate liability and/or umbrella policy for the LLC.
Create your Project Plan
This step may start prior to or after purchase, depending on how the property is acquired. You’ll need to evaluate the necessary repairs and upgrades, obtain quotes from your contractors, and develop a solid project plan for the rehab.
Establishing a scope of work and getting the right team members in place with a workable schedule is critical to a successful flip. If you have the expertise, this is a part of the project you can perform personally in your role as the LLC manager.
You can also choose to hire or partner with a contractor and let them manage the rehab process.
Step Back and be the Fund Manager
As a disqualified party to your IRA, your role in executing the project plan is limited.
You can certainly administer the process and oversee the project. Selecting vendors or materials, checking in on progress, and dealing with the financial transactions of paying for expenses are all within the realm of reason, and wouldn’t be considered providing a benefit to the IRA. Of course, these administrative tasks are performed in your role as the manager of the LLC.
Use the LLC bank account to pay for all expenses, and never mix in personal funds – even if you plan to reimburse yourself.
You shouldn’t become actively involved and add value to the IRA via the provision of goods or services. This means you should not be the person applying for permits or utilizing any personal licensing you may have in relation to the project. You also don’t want to become the delivery person for your contractor and make daily trips to the hardware store.
Performing work on the project is also a major no-no. Your time and energy has value. If you gift these items to the IRA, you are essentially making non-documented contributions to your IRA. IRS rules strictly prohibit this.
The best approach is to think of yourself as a fund manager. Your role is to put the IRA capital to work in a fashion that will produce results.
If you keep to this line of thinking and stay in the background, you’ll be on the right side of the IRS rules. Sure, this can be limiting, but think about it this way: you don’t get to invest your IRA in a publicly traded company and then provide services to that company in return for additional dividends to your IRA. Real estate is no different.
No Credit Accounts
A common question we often hear is whether the IRA LLC can obtain a credit card or commercial account for flip projects.
Using borrowed money, potential access to commercial discounts, and rewards points are all appealing. Unfortunately, this isn’t possible in a self-directed IRA.
You may not pledge a personal guarantee on behalf of any debt instrument utilized by the IRA. As a disqualified party, to do so would violate IRS rules. We’ve yet to find a bank that will issue a credit card to your IRA-owned LLC without such a personal guarantee.
Market the Property
Properly marketing your flip property to potential buyers is an important step to on the path to profit.
Some investors like to get a sign on the property on the day construction starts to create buzz. Alternately, it may make more sense to wait until the project is fully completed and the house is sparkling inside and out to attract the highest quality buyers.
The type of neighborhood, expected time on market, and price point will all be determining factors to help you decide when best to start marketing.
However you choose to approach the timing of your marketing efforts, be sure to do a quality job.
Focus on curb appeal. Have professional photographs taken. It may make sense to lightly stage the property to make it more appealing than an empty space.
Work with your realtor to market your property in its best light, and across as many channels as possible. This will increase interest and may result in a quicker sale or a higher sales price.
If you are a licensed realtor, you should hire someone else to sell your IRA-owned property. Acting as realtor to your IRA is problematic. You can’t receive a commission personally, and to provide your licensed services to the LLC for free would also be a violation of self-dealing rules.
Additionally, any expenses for marketing must be paid via the LLC.
As the manager of the LLC, you can negotiate and complete the sales transaction on behalf of the entity.
Be sure that the LLC is listed as the seller of the property and the LLC tax ID is utilized. The title company or attorney will need to issue form 1099-S to report the income to the LLC, which is fine.
The IRS will know that the LLC is wholly owned by a tax-exempt IRA, and not expect this income to show up on a tax return.
When the deal is done, funds are issued to the LLC bank account and the IRA receives its pay day. Your next job is to find a suitable new opportunity in which to put the IRA capital back to work.