Sweat equity is a general financial concept that has important ramifications in the context of an IRA LLC. Let’s get a quick overview of what sweat equity is and then we’ll discuss applications for self-directed investing.
What is sweat equity?
Sweat equity refers to non-monetary contributions to a company. When a new company is being started it requires both investment capital and a lot of manpower to get it off the ground. Much of that manpower will come in the form of paid employees. However, especially in the case of smaller companies, that manpower will come from the company owner. They will put in the hours necessary to make the company successful and will often not be explicitly compensated for that work. Similarly, many start-ups will be founded by a group of people who are each willing to donate their labor to get the company off the ground. This kind of unpaid contribution is known in the industry as sweat equity.
- Sweat Equity refers to non-monetary contributions made to a company or retirement account.
- For real estate owned by an IRA, Sweat Equity includes activities like painting, mowing the lawn, and personally performing routine maintenance.
- Sweat Equity is treated as a Prohibited Transaction with consequences including immediate tax liability and fines.
Sweat Equity in an IRA LLC
If you open a new Real Estate IRA as an IRA LLC, then sweat equity can be a major factor. This is because an IRA LLC is in essence a small company that you manage for the benefit of your IRA. You can add value to the IRA LLC by funding it (via contributions to your IRA account) and by sweat equity in managing the assets it contains. However, as you most probably already know, the IRS regulates contributions to a retirement account. There are explicitly defined contribution limits to an IRA and one may not add to those limits. That being the case, sweat equity in an IRA LLC is viewed by the IRS as a non-cash contribution to the IRA. Although it is hard to define quantitatively, the IRS has declared it off-limits in a retirement asset. In most cases, it will generally be classified as a Prohibited Transaction.
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This is a great question as it directly impacts the involvement you can have with your IRA LLC’s assets. You are certainly allowed to actively manage your IRA LLC. This includes doing paperwork, hiring workers for the property’s needs, and taking care of any tax filing. Activities that are considered true sweat equity and thus not permitted include doing renovations yourself, personally mowing the lawn, or using your vacation to give the property a new coat of paint. The general distinction made is that “desk labor” is permitted in an IRA LLC but physical labor needs to be outsourced. There is a grey area in between these two poles, but in general, investors should look to play it safe. It is usually not worth risking your retirement account in an effort to save a few dollars.
Since sweat equity in an IRA LLC is viewed as a Prohibited Transaction, the consequences are the same as well. Here’s what can happen if an account holder gets caught having violated the sweat equity mandate.
- The IRA account is considered as being distributed. The date of that distribution will be assigned to the first day of the year that the sweat equity transaction took place.
- If the account holder is not yet 59 1/2, then they would be penalized for making an early distribution. The standard penalty for an early distribution is 10% of the value of the account.
- An additional 15% fine would be assessed for the assets that received the sweat equity transaction.
- As with any distribution, the tax bill comes due on the entire amount distributed.
If one does engage in sweat equity but catches it in time, there are actions that can be taken that can “fix” the situation. However, it is almost always better not to engage in sweat equity to begin with.