IRA Investments in Real Estate
Real Estate is one of the most popular investment assets for self-directed IRA and Solo 401(k) retirement plans. Since our founding in 2005, Safeguard Advisors has established thousands of self-directed plans for investors wanting to own a rental property, flip houses, lease out farmland, or participate in a syndicated commercial real estate deal. There are many reasons that self-directed investors are attracted to real property investments, and a myriad of ways an IRA or 401(k) can invest in real estate. Let’s take a look at some of the primary considerations that go with this type of investing.
Why Real Estate?
Real Estate has always been looked at as one of the best investments for wealth creation. As the saying goes; “they are not making any more land”. We do seem to continue to make more people, however, so demand is a given. Real estate has several unique dynamics, most notably that it is a real asset and therefore not exposed to the risk of total value loss one can experience in paper assets. Generally speaking, real estate values are a lot less volatile than other market-based asset classes, so there is an inherent stability over time. Real estate also provides an avenue for both asset appreciation and generation of operating income such as rents. And not insignificantly, real estate is everywhere and is an asset class that most folks understand fairly well. Being able to invest in something you can physically see in your own community is a big draw for a lot of people.
What Kind of Real Estate Can be Held in an IRA?
An IRA or 401(k) retirement plan can invest in real estate in many different ways. There are no restrictions from the IRS related to the type of real estate that may be held. Following are some of the common types of real estate investments:
- Residential rental properties
- Commercial properties & apartments
- Industrial or storage properties
- Raw land, farm land, ranches & timber land
- Real estate development projects
- Property flipping
- Real estate partnerships, joint ventures, or syndicated investments
- Real estate crowd funds
As with all plan investments, IRS rules prohibit any kind of direct or indirect benefit between a retirement plan and a disqualified party. So, any real estate deal has to first and foremost be done exclusively by and for the benefit of the IRA or 401(k).
- The plan will purchase the property and be on title
- All expenses for the acquisition and maintenance of the property must be paid for with plan funds
- Any contracts such as leases, insurance, or construction services should be executed via the plan and not in your own name
- All income produced by the rental or future sale of the property must go to the plan, and will be tax-sheltered to the plan.
You or a disqualified party may not benefit from the plan, such as by compensating yourself for the management of the plan, using plan held property, or renting property to a family member or family owned business. The reverse is also true, in that you or a disqualified party may not add value to the plan through the provision of goods, services or facilities.
You as the IRA LLC manager or Solo 401(k) trustee have the authority to administer plan investments. When it comes to rental real estate, this includes things like identifying opportunities and deal negotiations, signing contracts, paying the bills and receiving income into the plan account.
Within reasonable limits, you can safely perform some of the basic administrative activities associated with property management, including screening tenants, signing leases and collecting the rents. You could also choose to have the plan hire a professional property manager and therefore be ensured of remaining fully within the arm’s length requirements of the tax code. Even basic administration could be construed as providing services to the plan (which is prohibited) if it becomes excessive in nature. Self-managing a handful of single family homes may not be an issue. On the other hand, doing all the paperwork associated with a 30-unit apartment complex is a whole lot more work, and could be viewed by the IRS as providing services.
You or a disqualified party should refrain from performing any work on plan-held properties. If your self-directed IRA owns a rental and there is a tenant turnover event, with a need for some cleaning, painting or other repairs, for example, the plan needs to hire unrelated 3rd parties to do that work. You cannot perform work on the property yourself and be compensated, nor can you give your time and labor to the plan for free, as doing so would effectively be making undocumented contributions into the plan and artificially boosting the tax-sheltering benefits of your IRA.
A self-directed IRA or Solo 401(k) may use debt financing such as a mortgage to acquire property and is not restricted to all cash purchases. In keeping with the rules related to self-dealing, any mortgage must be non-recourse, meaning no personal guarantee may be pledged by you or a disqualified party to the IRA. You cannot pledge your assets as security for the IRA’s debt.
In an IRA, the use of debt-financing creates tax exposure. The tax is on Unrelated Debt Financed Income or UDFI, and is assessed on the percentage of the income that the IRA derives based on the borrowed, non-IRA capital.
The impact of UDFI taxation is generally not significant. A $100K property with a $60K mortgage that produces 10% return would likely only see an annual tax bill of $100-$200 at most, depending on the available write-offs for expenses. The small cost of the tax will be far outweighed by the overall benefit of using leverage. The IRA should receive a higher cash-on-cash return for each dollar deployed into a leveraged property investment.
Solo 401(k) plans are exempted from UDFI taxation on debt associated with the acquisition of real property. So, if you qualify for such a plan and intend to use leverage in your real estate investing, the Solo 401(k) option greatly simplifies things and reduces the tax cost.
Active Deals and UBTI
Among the key considerations with respect to deal type is the potential exposure to Unrelated Business Taxable Income (UBTI). Per the tax code, income that a tax-exempt entity like an IRA receives from passive sources is fully sheltered. However, if a tax-exempt entity engages in a trade or business activity on a regular or repeated basis, and is therefore viewed to be substantively competing with taxpaying businesses, then UBIT applies. This tax is designed to protect tax-paying businesses from unfair competition.
Passive activities not subject to UBIT would included interest, dividends, royalties, rent from real property or the sale of an asset held over time to produce passive income.
In the real estate sphere, active business deals would include any kind of development or dealer activity, such as new home construction or flipping of houses. One should use caution and discuss their strategy with a licensed tax professional if their investment goals include such deals. It may be necessary to adjust your investment strategy to become passive to ensure profitability and minimize tax exposure.
Joint Ventures and Syndicates
Another way to leverage your IRA or 401(k) into potentially larger deals than the capital your plan may have available can achieve is to team up with other investors. This can be done in many ways, including:
- Simple joint ventures between the IRA and one or more partners to purchase a property as tenants-in-common. An IRA may partner with anyone not viewed as a disqualified party, whether that party is also using IRA or non-IRA funds.
- Participating in a real estate syndicate or private placement such as a LLC or LLP formed to bring many investors into a large deal like an apartment, commercial project, golf course, etc.
- Investing in real estate crowd funds.
With any of these deal types, the same rules and considerations apply as to a deal the IRA may do on its own. One must avoid disqualified parties, and there may be tax exposure if the deal involves leverage or the underlying income producing activities would be considered a trade or business.
We have only touched on the surface, but hope the information provided here helps you to better understand some of the potential and limitations that come with self-directed IRA or 401(k) investments into real estate. If you have an interest in diversifying your tax-sheltered retirement savings to include real estate, please feel free to contact us. One of our expert advisors will be happy to evaluate your specific situation and goals and provide guidance as to what may or may not work, as well as the best self-directed plan structure to apply. At Safeguard Advisors, investor education is job one.
As with any investment, there is risk associated with investing in real estate. Before investing, you should ensure you have the financial ability and experience to gauge and understand the risks, perform the necessary diligence, and properly administer such investments in compliance with both local real estate laws and the federal tax code relating to IRA and 401(k) retirement plans.
Safeguard Advisors, LLC is not an investment advisor or provider, and does not recommend any specific investment. We provide properly structured self-directed retirement plan platforms that provide you as the investor with full control over investment decisions. The information above is informational in nature, and is not intended to be, nor should it be construed as providing tax, legal or investment advice.