Rental property is the most popular asset choice for investors with a self-directed IRA or Solo 401(k) plan.
Whether you’re looking to invest in a local property and self-manage the project, or to put your IRA capital to work in another state through the services of a turnkey provider, there are many benefits associated with real estate investing.
Income-producing real estate has always been a key pillar in creating wealth. And putting your tax-sheltered IRA or 401(k) savings to work can be a strong step forward in securing your retirement future.
The Benefits of a Rental Property in Your IRA
There are many reasons a rental property is a popular investment choice for your self-directed IRA. Real estate provides:
- A solid asset that provides security for your investment principal
- A less volatile asset than many conventional choices
- Income through positive cash flow
- Potential for asset appreciation over time
- The option to use leverage and increase ROI on a dollar-for-dollar basis
- An excellent portfolio diversification choice
Most investors have a good understanding of real estate, since they’ve been renters and homeowners throughout their life.
This experience allows you to “invest in what you know”, which is a key benefit of investing with a self-directed retirement plan.
Investing in rental property with a self-directed IRA or Solo 401(k) plan comes with some special considerations.
Here’s what you need to know about buying a rental property in your self-directed retirement plan.
Start with a Plan
When making any investment, you need to start with a business plan.
When it comes to investing in a rental property, you’ll want to have a framework to guide you along the way.
Understanding property values, vacancy rates and market rents when comparing properties is an important starting point.
There are many tools you can use to research and evaluate markets and properties. The advice of a local expert like a realtor, fellow investor, or attorney can be helpful.
Other important considerations include:
- Knowing your purchase budget
- Anticipating rehab and operational costs
- Lining up necessary vendors like contractors, insurance providers and property management
- Thinking about one or more exit strategies
Next, your self-directed retirement plan needs to be setup and funded before you start making offers on properties. This is important for compliance reasons as discussed below.
With an established and funded plan, you’ll be positioned to write stronger offers — potentially with all cash, and with shorter closing periods. This can lead to successful offers with aggressive pricing.
Offers and Contracts
When buying a property for your self-directed IRA, all contracts and expenses must be handled through the plan itself.
It’s prohibited to personally place a property under contract and provide earnest money, and then assign or transfer the contract to the IRA. This is considered self-dealing by the IRS.
There are ways to utilize 3rd parties to lock up a deal before your plan is in place and funded. But this approach can be stressful, and could weaken your ability to make a strong offer.
In a Checkbook IRA, the LLC is the purchaser of the property and will be on the title. You can execute the contracts in your role as manager of the LLC.
With a Solo 401(K), the 401(K) Trust is the purchaser of the property and will be on title. You may sign contracts as the plan trustee.
Any sales-related expenses, like earnest money deposits or inspections, must be paid from the retirement plan bank account. You can write a check, get a cashier’s check, or wire funds as necessary. However, you can’t use personal funds or funds belonging to a disqualified party to your IRA.
Be sure your real estate agent is familiar with these requirements before they start writing offers. You never want to write an offer in your own personal name or use personal funds if you intend to have the plan held by your retirement plan.
Closing on the Property
As the signatory for your Checkbook IRA or Solo 401(k), you can directly handle the real estate closing process, and are not required to submit documents to a 3rd party custodian for review and execution.
This makes the closing process very simple:
- The IRA owned LLC or Solo 401(k) trust will be on title
- You can execute the paperwork
- You can fund the transaction directly from your plan account
- Be sure the plan tax ID is associated with the transaction
You’ll then retain any transaction associated records like closing statements or the deed. There’s no need to forward those records to a 3rd party.
Expenses & Income
All expenses associated with your plan-held property must be paid directly from the plan account. This includes regular and predictable items like insurance, HOA fees, management, and property taxes, as well as any costs for maintenance, repairs, and landscaping.
You may use most any method of funding such as checks, wires, debit cards, etc., so long as all transactions flow directly through the plan held bank account.
Never use personal funds or funds belonging to a disqualified party, even if you plan to reimburse yourself. This could be viewed as co-mingling of funds, which is a prohibited transaction.
All income from the rental of a property must be deposited to the plan account. Your tenants can make payments to the LLC or 401(k) trust account using checks or direct deposit.
Whether the funds are delivered to you or directly to the bank doesn’t matter, as long as the funds are issued to the plan and not to you personally.
Rent can be paid to your property manager if you’re using one. The property manager can forward the net amount after expenses are paid to the plan.
All income produced by the investment is tax-sheltered to the retirement plan. Because none of the income is taxed as it’s earned, there are no deductions against taxation in the form of depreciation or other write-offs.
Investing in real estate with an IRA or 401(k) is as simple as income – expenses = return on investment. From an income and tax perspective, real estate in your IRA is no different than owning a dividend producing stock in your IRA.
You can self-manage your IRA’s rental properties, or choose to hire a professional property manager.
Using a 3rd party manager is typically a best practice, as that person or team will have the necessary expertise to ensure compliance with state and local regulations. They’ll also have experience with finding, screening and managing tenants over time.
With a property manager, you can also reduce your risk of being seen as self-dealing or providing services to your plan.
A hired property manager is simply a vendor providing services to the plan. Those services should be paid by the plan account, or deducted from rental income.
If you choose to self-manage your account, you’ll need to be sure to act in accordance with IRS guidelines. IRS rules prohibit any direct or indirect benefit between a plan and a disqualified party, in either direction.
As the signatory for the plan, you’re allowed to administer investments. This includes executing contracts, selecting vendors, paying expenses and receiving income on behalf of the plan. But you can’t compensate yourself for these administrative activities.
Maintenance & Repairs
Any time your plan-held property needs maintenance, you’ll need to hire an outside vendor who isn’t a disqualified party.
IRS rules prohibit you from providing benefit to the plan by providing services or furnishing goods or materials. This means you shouldn’t perform work on a property, including repairs, maintenance or landscaping.
Your time has value. If you gift that value to the IRA, that’s seen as making undocumented contributions to the plan, and artificially inflating the tax-sheltering as a result.
It’s important to have the right kind of insurance in place for your IRA or 401(k) held property.
You’ll want a commercial landlord & liability policy where the IRA-owned LLC or Solo 401(k) trust is the named insured.
You shouldn’t obtain a policy in your own name and list the plan as an “additional insured”, as this could be seen as self-dealing. Plus, this type of policy may not provide adequate coverage.
Not all insurance companies can offer such programs. Most retail homeowner-focused insurance agents will likely try to push you towards the additional insured model, which could be problematic. Seek out a commercial provider of landlord insurance. See our vendor resources page for knowledgeable providers for these policies.
In your role as the manager of the IRA-owned LLC or trustee of the Solo 401(k), you retain all records associated with plan transactions.
This involves tasks like keeping an appropriate paper trail of purchases, sales, expenses and income. The details associated with an investment aren’t typically necessary for a tax return. But record keeping helps create an audit trail.
As the person responsible for managing and growing your retirement savings, you might want to produce performance reporting for your own benefit.
The plan will need to perform year-end reporting, and you’ll want to be sure you’re prepared to facilitate that.
In a checkbook IRA, you’ll need to provide to the IRA custodian a statement of fair market value for the LLC. This statement is a summary number listing the total value of all LLC held assets. The custodian will then report on the IRA using form 5498.
With the Solo 401(k), you’ll also be summing up the plan value at the end of the year. For Solo 401(k) plans under $250K in value, all recordkeeping and end-of-year valuation is purely internal and for your benefit.
If the total plan value exceeds $250K during the tax year, then a 5500-EZ informational return must be filed with the IRS.
In the case of a property holding, a 3rd party broker price opinion is suitable for most investors. Tax records and internet sources such as Zillow aren’t considered accurate.
A formal property appraisal is only required for investors with an IRA that is subject to Required Minimum Distributions, such as a non-spousal inherited IRA or a tax-deferred IRA for an account holder over age 70 ½.
If you engage a 3rd party vendor to provide services in excess of $600 to the plan, such as a contractor to perform work on a property, the plan will need to issue a 1099-MISC to report that income.
Anyone producing income to the IRA or 401(k) (like a property manager) may issue a 1099-MISC to the plan to report that income. The income needs to be properly reported to the plan tax ID, and not to you personally.
Due to the configuration of the plan tax ID, the IRS will know this income is going to a tax-exempt retirement plan, and won’t expect to see that income on a tax return.
Selling the Property
When a rental property is eventually sold, it’s a non-event for tax purposes. The IRA is simply liquidating the investment and returning to a cash position.
There’s no federal or state income tax associated with the transaction. In some states, there may be a transfer tax that applies to the sale of real estate. Your IRA or 401(k) won’t be exempted from such transfer taxes.
The closing process will result in a 1099-S being issued to your plan. As with all plan transactions, the plan tax ID should be used to ensure that the IRS sees the non-taxable status. Keep this document with your plan records.
Put Your Expertise to Work for Your Retirement
Rental properties are a time-tested vehicle for building wealth. Investing in rental real estate with your self-directed IRA or 401(k) can help you create stable and predictable growth for your retirement savings.
With good planning and an awareness of the IRS rules, you can administer real estate investments for your IRA with confidence and expertise.
To learn more about the potential of investing your tax-sheltered retirement savings into rental property, feel free to contact us today >