As our life expectancy is getting longer and longer, properly planning for a lengthy retirement is even more important. I believe investment real estate is critical in building wealth and should be part of most retirement portfolios. It can be a wonderful source of cash flow. Maximizing cash flow from your retirement investments can slow or eliminate the need to liquidate your assets.
Everyone is aware that you can buy stock, bonds, mutual funds, and other wall street instruments in your IRA. Not many realize you can also buy real estate. Here you can get an overview of how this works and determine if this might fit into your plans.
Before we get started not the small print but the…..
THE BIG PRINT. I AM NOT A FINANCIAL PLANNER. I AM NOT AN ATTORNEY. I AM NOT A TAX PROFESSIONAL. I AM A REALTOR. THIS INFORMATION IS INTENDED AS A GENERAL OVERVIEW OF THE TOPIC. YOU ARE STRONGLY ADVISED TO CONSULT WITH FINANCIAL, TAX, AND LEGAL PROFESSIONALS BEFORE MOVING FORWARD. YOUR RETIREMENT MONEY IS PRECIOUS AND WE ARE DEALING WITH IRS GUIDELINES. YOU MUST BE CERTAIN THIS IS THE RIGHT PATH FOR YOU AND THAT THE TRANSACTION FOLLOWS IRS RULES. IT MAY BE THAT YOUR SPECIFIC SITUATION IS NOT WELL SUITED FOR THIS STRATEGY. I CAN NOT MAKE THAT DETERMINATION. ONLY A FINANCIAL OR LEGAL PROFESSIONAL CAN HELP YOU WITH THAT. IF IT IS THE RIGHT PATH FOR YOU, I STAND BY READY TO HELP YOU GET STARTED.
Throughout this article, I refer generically to a Self Directed IRA. (SDIRA) Know that you can buy through any self-directed retirement vehicle – traditional IRA, Roth IRA, SEP IRA, solo 401K, and so on. So, whenever you see SDIRA, know that it applies to all self-directed retirement vehicles.
I will address this topic via blogs and a series of FAQs. (Jump here for the blog list)
FREQUENTLY ASKED QUESTIONS
I have outlined the questions below but not all are currently highlighted. As time permits, I will answer more and more of these, occasionally, asking other professionals to supply the answer. Check back every week or so for more information. However, if a particular topic is of concern to you and want an immediate answer, call me at 703-281-2785 any time and I will be happy to help you in any way I can.
1. What is a SDIRA?
- Can I buy real estate using my regular stockbroker?
- The difference between an IRA custodian and a financial adviser or stock broker?
- Where can I get information on SDIRA custodians
- Investment goals that do not work well in an IRA
- Investment goals that work inside an IRA
- Tax differences between inside the IRA and outside the IRA
- What is a non-recourse loan?
- How do these loan terms differ from traditional loan terms?
- The tax issues related to financing a property is an IRA
- What is UBIT?
- An example of the UBIT tax implications on a leveraged property
8. Should I buy in my market or elsewhere in the country
9. Do I need a Realtor to do this?
- Buying in Northern Virginia
- Buying outside of the Northern Virginia market
A self-directed IRA (SDIRA) is really just what it states – an IRA in which the investment decisions are made solely by the account holder The choices are unlimited. Anything the IRS allows to be in a retirement plan can be purchased in a SDIRA. Just because you see IRA in the title does not mean this applies only to IRAs. You can have a self-directed SEP or a self-directed 401K. It can be a traditional IRA or a Roth IRA. The key is that you are directing the investment choices.
Self-directed may not be for everybody. Some are either unsure what to do or don’t have the time or desire to make these decisions and prefer to have someone direct their investments. You will not get any investment advice from a SDIRA custodian. If advice on where to put your money is what you want, a SDIRA is likely not the right platform for you.
If you open a SDIRA, there is no need to do all of your investing in that account. In fact, it might be more economical fee-wise to do stock investing with a traditional broker and open a SDIRA for their alternative investments such as real estate.
Most likely not. Almost all traditional brokerages and company-sponsored plans are limited to wall street products such as stocks, bonds, mutual funds, ETFs, and the like. The IRS is very clear that any IRA trustee can limit their offerings and is not required to offer all allowable investments.
If you ask your traditional broker what they think about using an IRA for real estate, please analyze their response carefully. If they tell you it can not be done, they are misinformed. If they tell you that it is possible but discourage the investment, analyze their objections. They may be pointing out legitimate reasons why it is not right for your situation and that could be valuable to hear. But on the other hand, realize that for you to buy real estate in an IRA, you will be taking money from their company and transferring it to a SDIRA custodian. Does this impact their advice? I hope it does not but this could influence their response.
All real estate being purchased in an IRA must be purchased through a SDIRA that allows real estate investments. Do not make the assumption that because you have an account at Schwab, you can buy a piece of real estate using that money and have Schwab hold it. Mr. Guy Dabney did and it turned out to be a costly blunder. (Guy M. Dabney et ux. v. Commissioner; T.C. Memo. 2014-108; No. 14566-12 June 5, 2014)
A do-it-yourself lesson in how not to buy real estate in an IRA
Mr. Dabney had a retirement account with Schwab. He saw a piece of undeveloped land for sale that he thought was underpriced. He called Schwab to see if they would let him buy it using his IRA. They said they do not allow real estate investments in their IRAs. He then talked to his accountant who was not familiar with buying real estate in IRAs but after researching the topic, told Mr. Dabney it was allowed (correct) and that he could use the Schwab IRA to do that (incorrect.)
Mr. Dabney thought he figured out a way to make this purchase using Charles Schwab as the custodian. In 2009, he told Charles Schwab to send $114,000 to the settlement company. He told the settlement company to title the property “Guy M. Dabney Charles Schwab & Co, Inc IRA contributory.” In, 2011 he sold the property for $127,000 and returned all proceeds to his Charles Schwab account.
Now, when you take money out of an IRA, it is considered taxable income in the year it is received. (Unless it is a Roth IRA) Furthermore, if you are under 59 1/2 you must pay a 10% penalty of the amount received. Mr. Dabney was under 59 1/2 in 2009.
Since he did not think he was making a withdrawal but using his IRA for a tax-deferred investment, he did not report the $114,000 as income in 2009. However, Charles Schwab considered the $114,000 as a taxable distribution and reported that to the IRS as they are required.
Mr. Dabney’s 2009 tax return and his reported income did not match and he was fined. He has 4 issues. One, he did not report the $114,000 as income in 2009. Second, by not reporting the income and not paying taxes on it, he had underpaid his taxes by more than 10% which initiates another set of penalties. Third, since he is under 59 1/2, he needed to pay a 10% penalty. And 4th, the $127,000 contribution in 2011 exceeds the maximum allowable IRA contribution for the year so he owed taxes on the excess.
Fortunately for Mr. Dabney, he got a sympathetic judge who reduced some of the fines. He did have to pay taxes on the $114,000 withdrawal in 2009. And he did have to pay the 10% early withdrawal penalty. The court waived the fines for underreporting in 2009 and I am not sure how the excess contribution in 2011 was handled.
All this is a lesson in making sure you follow the rules and do this right. In the court’s opinion, it is mentioned several times that all of this would have been fine if he used a SDIRA custodian that allowed real estate investments. It also clearly stated that Schwab is not obligated to allow all legal IRA investments. Had Mr. Dabney simply asked Schwab to send the money to a SDIRA custodian, bought the property, and then sold it for a profit, not $1 of tax would have been owed.
An IRA custodian is just that – a custodian. They will hold your funds and invest them as you direct. They will not give you advice on investments. Whatever you direct them to do, they will do. If the transaction violates one of the key principles of SDIRAs such as self-dealing or a transaction involving disqualified persons, they have no obligation to stop the transaction. All responsibility for the transaction and tax consequences are yours. Now, the reality is that the better among the bunch will point out when they think a transaction is not allowed but if you want to proceed, they are obligated to honor your instructions.
A traditional stockbroker or financial adviser may call or email you from time to time stating that a certain investment opportunity may be right for you. You will never get such a call from your SDIRA custodian. On their website, they will likely have examples of investments that work well in a SDIRA but they will never contact you saying should do this or that. All decisions are yours.
Many stockbrokers have the authority to make trades on your behalf. Unscrupulous stockbrokers and advisers have been accused of making excessive transactions (churning the account) to create extra fees and commissions. Or they have directed investors into products that pay higher fees to their firm. With a custodian that can not happen. They have absolutely no authority to make transactions without your express written approval.
Of course, most stockbrokers and financial advisers are reputable and do have your best interests in mind. They can have tremendous value by developing a financial plan for you. An SDIRA custodian will not develop a plan for you. Again, they are there only to invest your money as you see fit.
So, a SDIRA is not for everyone. If you are not comfortable making decisions on your own you are best off with traditional advisers. However, everyone is an expert in something. If you would like to invest in your area of expertise and it is not available at a traditional brokerage, you have the option of taking some of your funds from that brokerage and setting up a SDIRA to invest in what you know.
I hope it is real estate and you call me for guidance on that investment. But perhaps you know restaurant operations from top to bottom and are aware of the new restaurant concept you want to invest in. An SDIRA allows that. Or you want to lend money to a young entrepreneur starting a business out of their garage which you believe will be the next Apple. You can’t do that at Schwab but can with a SDIRA.
If you google SDIRA custodians you will get many hits – not as many as general brokerages but definitely a growing industry. I can list 2 here that I have interacted with and will share my relationship with each.
I am not endorsing either one but simply suggesting that they may be a place to start gathering information. I listed them here because I have had a positive interaction with them. However, that does not mean they would necessarily be the right one for you.
1. Mid Atlantic IRA, LLC Frederick MD 240-575-3880 or 800-607-0145 www.midatlanticira.com My relationship? I have an account with Mid Atlantic
2. Equity Trust Westlake OH 855-233-4382 www.trustetc.com My relationship? I have attended one of their 3-day seminars. It was a weekend packed with solid speakers and tons of useful information. It is open to the public and if you have a serious interest in the topic or want to become an active investor, watch their website for the next conference. It is well worth attending.
Both have websites that offer additional information on SDIRAs, their use, and restrictions.
The first question folks often have is whether or not investing in real estate inside a SDIRA is legal. It is if done properly. Here is an excerpt from the IRS.gov website. The link to the page is here
What types of investments can I make with my IRA?
The law does not permit IRA funds to be invested in life insurance or collectibles.
If you invest your IRA in collectibles, the amount invested is considered distributed in the year invested and you may have to pay a 10% additional tax on early distributions.
Here are some examples of collectibles:
• Metals – with exceptions for certain kinds of bullion,
• Coins – (but there are exceptions for certain coins),
• Alcoholic beverages, and
• Certain other tangible personal property.
Check Publication 590, Individual Retirement Arrangements (IRAs), for more information on collectibles.
IRA trustees are permitted to impose additional restrictions on investments. For example, because of administrative burdens, many IRA trustees do not permit IRA owners to invest IRA funds in real estate. IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option. (emphasis added)
So you are not limited to stocks and bonds and mutual funds. You can loan money to others. You can invest in start-ups. You can invest in a restaurant or retail store. You can buy notes. You can be an angel investor. And of course, you can buy real estate.
You can buy any type of investment real estate. It does not need to be income-producing. You can speculate on land or any other type of property. You can fix and flip. You can buy it in the name of the IRA or you can partner with others as long as they are not disqualified individuals.
You can not do any deals with disqualified individuals. The first and most important disqualified individual is you! That means if you own rental property outside your IRA, you can not sell it to the IRA. You also may not sell to or buy from your spouse, ancestors, descendants, spouses of descendants, or anyone providing services to the IRA trustee or custodian or an entity in which you have a 50% or greater interest.
So your brother, sister, and wife’s uncle are not on the list. Please, please talk to a CPA before your get anywhere close to this line. The penalties for involvement with a disqualified person are severe. To me, it is not worth getting anywhere close to the edge.
Remember, this applies to people providing services. Say your brother is a licensed contractor. Be very, very careful and get good advice if you want him to work on any self-directed property. And if someone “official” tells you that you can, you absolutely must pay him his full rate. No “family discount” on SDIRA properties.
No. No. No. In case you didn’t get it – NO! You can not do work on your own property. You can fix and flip but all of the work must be done by others. Any work you do on the property is considered a personal benefit and can cause the whole transaction to be considered taxable.
As a Realtor, when I buy for my own account, I can not receive a commission. That would be benefiting from the IRA and would taint the transaction.
The interesting question is can you manage your own properties? Some advisers say yes as there is no written prohibition against that. Others say it is too close to the line. If you are self-managing, it is very tempting to do the “little things” yourself and not hire out for lawn cutting when the home is vacant or drop off extra light bulbs from your home. No. No. No.
Tread extremely carefully here.
The answer is complicated and depends on your personal goals and financial situation.
First, remember, real estate is not a liquid asset and in an IRA, all expenses for the property need to come from the IRA. There always needs to be enough liquid assets to cover unexpected repairs and/or vacancies. Furthermore, while I think real estate is an important component of a diverse retirement portfolio, I believe most financial advisers would suggest that it not be the largest part of the portfolio. Having too high a percentage of your portfolio in one asset is never a good idea whether real estate or similar classes of individual stocks. Talk to your financial adviser to get an opinion as to how much, if any, you can or should devote to a real estate purchase.
Second, whether to buy real estate inside or outside the IRA depends on your goals. Following this answer are types of goals that work well with a SIDRA and those that don’t.
Last are tax considerations. I think an investment should be considered because it is a good investment, not for tax reasons. But if it is good, it should be executed in the most tax-efficient manner. Real estate is, in my opinion, a good investment. How can it be done in the most tax-efficient manner?
In a SDIRA, all trades are tax-free and there is no obligation to replace real estate with real estate. You can sell real estate and buy a smaller piece of real estate and invest the rest in stocks or not buy real estate at all. Outside an IRA, the only way to defer taxes is to do a 1031 exchange, and to completely avoid taxes, all proceeds must be reinvested in real estate within very strict time periods. No time periods exist in a SDIRA. You can let the proceeds sit in cash until the right opportunity comes along.
Like any investment, you must identify your goals, and buying inside an IRA is not the right choice for everybody. Here are some common goals and approaches to real estate investment that do not work with an IRA.
1) USING AS A COLLEGE FUND: I have a client who bought 2 rental properties when his daughters were young. The plan was to sell them when they were 18 and use the money to pay for their college. If you will be less than 59 ½ when the money is needed, this may not be the way to go. The same rules that apply to traditional IRA withdraws apply to SDIRA withdraws. If the money is withdrawn before 59 ½ there is a penalty.
2) PERSONALLY PUTTING IN SWEAT EQUITY. I have many clients who enjoy getting their hands dirty and instead of hiring out for repairs to their rentals, they do everything themselves. That is strictly prohibited in a SDIRA real estate investment. IRS regulations are very clear. All repairs, maintenance, and updates must be done by 3rd party contractors at market rates and paid for by the SDIRA custodian. You can not use your personal funds. Doing work yourself could blow up the IRA and the IRS could consider the whole investment as income to you in the year of the violation. Do not even change a light bulb if the property is in an IRA. While people have done fix and flips in an IRA, one must tread very carefully.
3) RENTING TO FAMILY MEMBERS Outside of an IRA, I have clients who have bought a rental property and then rented it out to family members – children, parents, their grandchildren in college, etc. Strictly prohibited. You cannot do business with family members in the IRA. They are considered “disqualified persons.” This also applies to you personally. You cannot “sell” property you currently own outside the IRA to the IRA.
4) BUYING WITH PLANS TO MOVE IN LATER Outside of an IRA, I have had clients decide to sell a rental in Vienna Virginia, and exchange it for a beach rental with plans to retire there in a few years. You cannot personally use a property in a SDIRA or it becomes a taxable event. (Not even the 14-day rule for vacation rentals.)
The asset will be considered distributed in the year you move in. That will drastically increase your income in that year!! Plus you will incur a penalty if you are not 59 1/2. It can be done but plan accordingly
Investment goals that work inside an IRA
Tax differences between inside the IRA and outside the IRA
You absolutely can get a loan. It must be a non-recourse loan. (see the next question.) For a detailed article on non-recourse loans click here.
If you are rehabbing a property, you will need to find private money. But if you are a buy-and-hold investor, getting a SDIRA loan is far easier than getting a traditional mortgage loan. Since the IRA and not you are not responsible for the loan, the application is quite simple. They do not ask what you do for a living. They do not ask about your income and debts. You do not need to even be working. They will run a credit report to make sure you are not a deadbeat but that is about it for the personal information. This loan is all about the property. It must cash flow. If it appraises, it cash flows and you are not a deadbeat, you get the loan. No bank statements. No w-2s. As simple as that on the front end.
On the back end, for settlement, the logistics are complicated. You need to sign the loan docs as read and approved. Then they get sent to the SDIRA custodian for official signatures as you can not personally guarantee the loan. The SDIRA custodian sends it to the lender for review and if all is fine they release the funds. So it is not like you are approved Tuesday and close Wednesday. The approval process is easy, the end-game logistics can make your hair fall out.
A non-recourse loan means that the only recourse the lender has is the property. They can not come after you personally in the event of a default. They can not access other IRA funds to make up for any loss in the event of a default. The loan is recorded in the public records and they can foreclose. but they can only get the property. While, as mentioned above, the application process is a breeze, the property requirements are very specific. See the next question.
The loans I have seen are a minimum of 40% down. Again, because the property is the only recourse, the risk is high for the lender. High risk means a slightly higher rate. At this writing, a typical non-IRA 30-year fixed-rate investor loan would be about 4.5%. For a SDIRA loan, the amortization term is 20 to 25 years and while there are fixed rates, most buyers use an adjustable. For comparison purposes at the time of this writing, a sample loan might be a 5/1 ARM with a 20-year amortization and a start rate of 4.5%.
The anticipated rent needs to be 1.25 times the PITI. The lender will do an appraisal to value the property and the appraiser will also present the lender with an estimated rent range.
The above is a rough example. Each lender will have variations on the requirements. And these are guidelines for buy and hold properties.
The tax issues related to financing a property is an IRA
What is UBIT?
An example of the UBIT tax implications on a leveraged property
Should I buy in my market or elsewhere in the country
What is a turn-key property?
Positives of working with a turn-key operator
The downside of working with a turn-key operator.
Do I need a Realtor to do this?
Buying in Northern Virginia
Buying outside of the Northern Virginia market