Real Estate IRA
Self Directed IRA Real Estate Rules
5 Important Rules For Real Estate in a Self Directed IRA
The IRS has a number of rules that can affect a Self Directed IRA investing in real estate. These are general ERISA rules and are not specific to real estate or to self direction. However, the situations where these rules apply tend to happen more often when a Self Directed IRA invests in a property. Here we will get a general overview of the rules. If you’re interested in more details about a specific rule, you can schedule a call with a Specialist to ask your question directly.
- Holding real estate in an IRA requires familiarity with the ERISA rules that govern asset transactions.
- It is possible to get a mortgage for an IRA property, but it has to be done in the form of a non-recourse loan. If you do get a loan you need to be aware the tax liability in the form of UDFI (Unrelated Debt Financed Income).
- The real estate may not be bought or sold to a Disqualified Person, and any work done on the property has to be done by an unrelated third party.
How To Get a Mortgage
Many investors who purchase real estate with their Self Directed IRA don’t have sufficient funds to complete the purchase. Or, even if they do, they might want to employ leverage in a bid to increase their profitability. That starts the process of looking for a loan for the property. In the context of a Self Directed IRA, that search has a unique regulation. The only kind of loan you are permitted to obtain for the property is a non-recourse loan. In a typical mortgage, the loan is secured by the property that it was used for. If the borrower at some point can not pay back the loan, then the lender can collect the property instead. If the property itself isn’t valuable enough to cover the loan (e.g. real estate prices fell), then the lender will come after the borrower’s personal funds. This would be a problem for a Self Directed IRA because it would mean that the borrower is offering a benefit to the retirement asset in an unsanctioned manner.
A non-recourse loan gets around this problem by allowing the lender to collect only from the specific piece of real estate. If the real estate in question doesn’t cover the loan, the lender will be stuck. They are not allowed recourse to the borrower’s other assets. Because of this limitation, when a Self Directed IRA applies for a real estate loan, the terms for the loan will typically differ from a standard mortgage in two key components. The first is the amount necessary to put down as a down payment. Since the lender is taking a bigger chance on this kind of loan, they want to see the borrower putting more money down up front. Secondly, the interest rate will be higher. This is also to compensate for the greater potential loss. If you’re interested in having your Self Directed IRA purchase real estate with a non-recourse loan, ask your Custodian for a list of non-recourse lenders.
If you’re managing real estate in a Self Directed IRA, the rule that has the most day-to-day application is Prohibited Transactions. The IRS defines the rule like this: “Prohibited Transactions are certain transactions between a retirement plan and a disqualified person.” Let’s break that down so we can get a practical understanding.
The first question is who qualifies as a disqualified person? In short, anybody who would have a personal interest in the retirement account. That includes:
- The Self Directed IRA account holder
- A linear relative of the account holder (e.g. father, mother, son, daughter)
- Spouse of the account holder
- A fiduciary for the account
Next, what kind of transactions may a disqualified person not do? Simply put, any transaction that benefits the Self Directed IRA or its assets, or any transaction that delivers benefit from the Self Directed IRA to the disqualified person. Here are some common examples:
- A Self Directed IRA account holder may not sell a personal piece of real estate to the Self Directed IRA.
- An account holder may not use an IRA-owned property as collateral for an outside loan.
- An account holder’s child may not take a personal loan from their retirement funds.
- A fiduciary may not personally lend money to a Self Directed IRA that they are involved in managing.
Possible repercussions of a Prohibited Transaction include distributing the retirement account and paying all taxes and fines.
Sweat Equity and the Rules of Asset Involvement
Sweat equity is uncompensated labor that an individual gives to a company or asset. In the start-up world it usually refers to uncompensated labor by an employee for which they will receive a certain amount of stock or equity in the company. In a Self Directed IRA it has a much different connotation. Here, it refers to free labor or services that the account holder (or other disqualified persons) will donate to the account. The most common examples with real estate assets are unpaid services like maintenance, mowing the lawn, or performing standard upkeep. The Self Directed IRA owner may not interact with the real estate asset in these kind of ways. The logic behind this rule is that the free service could be construed as a contribution to the Self Directed IRA, and as such it would need to comply with all the laws pertaining to contributions. Since it does not, it is prohibited.
This does not mean to imply that there can’t be any personal involvement with the Self Directed IRA. In fact, quite the opposite. The term “self directed” implies that the account holder is interacting with the IRA and its real estate assets. If so, where do we draw the line between self direction and sweat equity? This is actually a grey area. The most common distinction is to differentiate between physical labor and desk-oriented management. Paperwork and executive decision making would be allowed while physical labor like painting a rental unit would be prohibited.
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Taking a RMD
Real estate in a Self Directed IRA can pose special challenges when taking a Required Minimum Distribution. Unlike with stocks which can be cashed out at the push of a button, real estate is not nearly so liquid. If your Self Directed IRA has a property as its main asset, how should you go about extracting cash from that property so that you can take a distribution? There are three ways to do this.
- Cash assets – If you have other retirement assets such as savings or stocks that can easily be liquidated, then you can just use those for your RMD. The distribution doesn’t have to come from every single asset that is owned by your Self Directed IRA. Rather, you can pick and choose to hit the required sum.
- Real estate sale – If you’re prepared to go this route, you can just sell the property. The cash proceeds of the sale would be deposited into your account and you can take the RMD from there.
- In-kind distribution – This is a process where partial ownership of the real estate is transferred from the Self Directed IRA to the account holder. This requires paperwork and an authorized appraisal. Using this method avoids the need for taking out cash as the property itself is considered the distribution.
UDFI (Unrelated Debt Financed Income) kicks in when you take out a loan to purchase real estate with your Self Directed IRA. The government offers tax incentives to encourage saving for retirement, but those tax incentives only apply to retirement funds. When a Self Directed IRA purchases real estate, a common scenario is for the retirement account to cover 70% of the sale price while the remaining 30% will be covered by a loan or mortgage. From the government’s perspective only 70% of that property qualifies as a retirement asset. The other 30% is considered “unrelated”. Consequently the Self Directed IRA account holder will have a tax liability for that 30%. This tax is known as UDFI.
The rules for placing real estate in a Self Directed IRA may seem confusing at first, but they are actually quite manageable. The concepts are intuitive and self-directed investors usually become fluent within the first week of the process. If you have any questions about these rules, or about real estate and Self Directed IRAs in general, please give us a call.