Have you ever thought, “I wish I could use some of the money in my 401-k, Roth, Simplified Employee Pension (SEP), or one of my tax-deferred accounts to invest in real estate? It’s just sitting there in that account and I could be investing and making money.” Well you can and this article will explain how that’s possible and still be within the IRS’s tax-deferred guidelines.
The term used for this type of funding is called a self-directed IRA a descriptive term not a legal distinction. Many tax-deferred plans are eligible for self-direction such as individual accounts: Roth, Traditional, or Health Savings Accounts (HSA) or employer accounts: 401(k), SEP, or Simple IRA.
Self-directed IRA’s are a way to use your IRA tax-deferred money and keep it tax-deferred while working for you by investing in real estate or other qualified assets. There are other types of assets you may purchase with your IRA but for the purpose of this article I’ll stick to real estate. What self-directed means is you direct what to buy, what bills to pay, what to sell, etc. in your IRA. You as the beneficiary/owner of the IRA cannot do the actual dealings with the money going in or out of the IRA; you’re required to use a custodian or administrator. There are companies that can do that for you.
The first step is to open a self-directed account with a custodial company such as New Direction IRA, Inc., or another similar company. Other companies can be found on:
http://selfdirectedira.nuwireinvestor.com/list-of-self-directed-ira-custodians. The fees for the service of maintaining your account depends on which company you use. The services a custodial company provides are usually administration and bookkeeping.
Opening a self-directed account is done by rolling, transferring from another IRA, or contributing money to a new IRA. This new account will act as its own entity holding the property or other assets for you with you or your heirs being the beneficiary.
You won’t be charged an early withdrawal penalty or taxes, when you buy an asset or property, because you’re purchasing it in the IRA’s name as its own entity and the property replaces the money in the account. Therefore you’re not withdrawing the money necessarily from the account, just exchanging it from money to property.
When you retire and you decide to take the property in your name you will have to pay taxes just as you would when you take the money out of an IRA account. By waiting until you’re 59½ you won’t need to pay any early withdrawal penalty.
The owner or a disqualified person (explained later) of the IRA cannot use, live-in, or work (sweat equity) on the investment property. The work, repair, improvements, or maintenance can be hired out and charged to the IRA along with taxes, realtor fees, etc. You, the owner, direct the custodian to pay these expenses and the IRA will receive the income i.e. interest, rent payments, or whatever profits from the property.
The IRA is identified by its taxpayer identification number (TIN) and/or account number. The earnest money must be taken out of the IRA; the offer and closing documents for the property are titled in the name of the IRA. The titling would go something like: custodians name, FBO (for the benefit of) client’s name, ROTH account #123456. You cannot put property you already own into the IRA it must be purchased by the IRA with its TIN or account number.
Once you have the self-directed IRA set up with your custodial company you begin to look for an investment property. Options for real estate include: fix & flip, fix & hold, short sales, foreclosures, tax-liens, trust deeds, improved/unimproved land, auctions, apartment buildings, condominiums, mortgages, lease options, foreign property investments, etc. An IRA can also participate in tenants-in-common, investing in an entity that is investing in real estate, lending money to a borrower who uses real estate as collateral, or holding title to real estate.
There can be no investing with any disqualified person including yourself who could benefit from the investment in a lineal relationship with you. For instance you cannot buy property from or own with a mother, father, grandmother, grandfather, son, daughter, grandchild, etc. But you can have dealings with your brother, sister, uncle, aunt, cousin, niece, nephew, friends, etc.
If the IRA doesn’t have enough money to purchase the property it may borrow it. The IRS requires it be a non-recourse loan where the lender agrees that taking the property would be their only recourse. A non-recourse loan can come from a lender private or otherwise. Some lending institutions and banks do not give non-recourse loans but there are ones out there that do. The percentage of profits, according to the percentage of debt financed, may be subject to Unrelated Business Income Tax (UBIT). It doesn’t affect the IRA holder’s personal property.
So sit back and think about what type of investment you’d like to own and what you’d be good at directing in a hands-off position. No matter whether it’s buying an apartment building, commercial property, a house to rent out, whatever your dreams are. Then hire a custodian you’d like to work with. Start funding the new IRA with funds from a rollover or contributions following IRS guidelines – a good custodian will guide you through the steps. Meanwhile start looking with your realtor for property that fits the investment type you’re interested in pursuing. Then purchase the property working along with your realtor and custodian to make sure everything is done by IRS rules and regulations.
The easiest way to buy with your IRA is if you have enough cash in it to pay for the property outright, but having partners and loans will work too. And lastly, enjoy watching your money grow tax-deferred by leaps and bounds!
Lyn Hayden is a Broker Associate with Deer Creek Realty in Bailey, CO. Her specialties are Certified Residential Investment Specialist (CRIS) and Certified Mountain Area Specialist (CMAS). Always consult your attorney and CPA for legal or tax advice.