Real Estate Investing With a Self-Directed IRA
A self-directed IRA is an individual retirement account held with a custodian that permits investments beyond publicly traded securities, including real estate. The account buys the property, holds title, pays expenses, and receives rent and sale proceeds. Its tax advantages depend on compliance with rules governing transactions involving the owner, family members, and other disqualified persons.
Milvidskiy Law Group P.C. structures real estate investments held in self-directed retirement accounts, forms the entities the accounts invest through, reviews proposed transactions against the prohibited transaction rules before they are signed, and integrates the account with the client’s estate plan.
Key Takeaways:
- The IRA is a separate investor. The owner and the owner’s spouse, parents, children, and their spouses may not buy from it, sell to it, lend to it, borrow from it, work on its property for pay, or use its property, even briefly. A violation disqualifies the whole account as of the first day of the year.
- Every dollar in and out runs through the account. Purchase money, closing costs, repairs, taxes, and insurance are paid from IRA funds, and rent and sale proceeds are deposited to the IRA. An owner who pays a contractor personally has made a prohibited contribution.
- Financing and active business inside an IRA can produce taxable income and require the account to file its own return. Debt-financed real estate and operating businesses are reviewed with the accountant before the account invests.
How an IRA Holds Real Estate
Direct ownership through the custodian
With direct ownership, the custodian takes title for the IRA and signs the contract and deed at the owner’s direction. Payments are processed through the custodian, which adds processing time and transaction fees. This structure can suit a property purchased for cash and managed by a third party.
An IRA-owned LLC
The IRA forms and owns a limited liability company; the LLC opens a bank account, buys the property, and pays its expenses; the IRA owner serves as the LLC’s manager. This is the structure most investors use for active real estate, because the manager can sign contracts and pay bills without the custodian’s involvement. The prohibited transaction rules still apply. The manager is a fiduciary of the IRA, the LLC’s operating agreement must prohibit the transactions the tax code prohibits, the manager may not be paid, and the manager’s personal use of LLC property or funds is also a prohibited transaction. An IRA-owned real estate holding company therefore has restrictions that an ordinary holding company does not.
Partnering with others
An IRA may co-invest with unrelated investors, and with the owner’s own funds or the owner’s other retirement accounts in some circumstances, through a tenancy in common or an LLC. Co-investment with the owner or with disqualified persons is the most litigated area of the rules, because it can be structured properly at the outset and cannot be corrected afterward. It is reviewed transaction by transaction.
The Prohibited Transaction Rules
The tax code bars an IRA from engaging in certain transactions with a disqualified person. Disqualified persons include the IRA owner, any fiduciary of the account, the owner’s spouse, ancestors, lineal descendants, and the spouses of lineal descendants, and entities those persons control. Prohibited transactions include a sale, exchange, or lease of property between the IRA and a disqualified person, a loan in either direction, the furnishing of goods or services between them, the use of IRA property by a disqualified person, and a fiduciary’s dealing with IRA income or assets for the fiduciary’s own benefit.
In practice, the rules mean that the owner may not sell a property the owner already owns to the IRA, may not buy a property from the IRA, may not live in or vacation at an IRA property, may not let a child rent it, may not personally guarantee a loan the IRA takes, may not perform repairs on the property for pay and generally should not perform them at all, and may not pay the IRA’s expenses from personal funds. Custodial processing does not establish compliance with the prohibited transaction rules; the owner remains responsible for that review.
The consequence of a prohibited transaction by the owner is that the account stops being an IRA as of the first day of the year in which the transaction occurred. The entire balance is treated as distributed at fair market value, with income tax due and, for an owner under age fifty-nine and a half, the additional tax on early distributions. There is no correction procedure for an IRA comparable to the one available to employer plans. Reviewing proposed transactions before signing helps identify compliance issues before the account is committed.
Taxes Inside the Account
Rental income and gain on sale of real estate held by an IRA are generally not taxed as they are earned. Two exceptions matter for real estate. Income from property financed with debt is treated in part as unrelated debt-financed income and may be taxable to the IRA, which must then file its own return and pay the tax from account funds. Income from an active trade or business conducted by the IRA, such as flipping houses or operating a hotel, may be unrelated business taxable income.
Whether either applies, and whether a structure such as a corporate blocker or a different account type changes the result, is worked out with your accountant before the investment is made. Loans to an IRA must be non-recourse, since the owner may not guarantee them, and the lenders who make such loans are few and their terms reflect it.
Required Distributions and Illiquid Property
A traditional IRA holding real estate is still subject to required minimum distributions once the owner reaches the applicable age. The distribution is a percentage of the account’s value, which requires an annual valuation of the property, and it must be paid in cash or by distributing a fractional interest in the property. An account whose only asset is a building, with no cash reserve, can be forced to sell or to distribute interests in the property at an inconvenient time. The plan for the account includes a cash reserve and, where appropriate, a Roth conversion strategy that removes the distribution requirement during the owner’s life.
The IRA and the Estate Plan
An IRA passes by beneficiary designation, not by will or trust, and the designation controls regardless of what the estate plan says. A retirement account holding real estate raises additional questions: whether the named beneficiaries can manage the property, whether the account should be split among them or the property sold, what the required distribution rules will require of them after the owner’s death, and whether a trust should be named as beneficiary to control the property for a beneficiary who should not hold it outright. Our estate planning attorneys coordinate the designation with the rest of the plan, and our tax planning practice addresses the income tax consequences for the beneficiaries.
Reviewing and Structuring Your Investment
- Review of the proposed investment, the parties, and the financing against the prohibited transaction and disqualified person rules before any document is signed.
- Formation of the IRA-owned LLC with an operating agreement that incorporates the tax code’s restrictions, and coordination with the custodian on funding and ownership.
- Purchase contracts, deeds, leases, and loan documents in the correct name and form for an IRA or IRA-owned entity, and handling of the closing through our real estate practice.
- Structuring of co-investments with unrelated parties, other accounts, or the owner’s non-retirement funds where the rules allow.
- Coordination with your accountant on unrelated business and debt-financed income, valuations, and required distributions.
- Beneficiary designations and trust provisions that fit the account into the estate plan.
- Guidance on operating the property in compliance with the rules, and review of later transactions as they arise.
When a Self-Directed IRA Is Not the Right Vehicle
An investor who intends to live in the property, rent it to family, manage it with their own labor, or use their own credit to finance it should hold the property outside a retirement account, where the tax rules permit all of those things. An account must have sufficient funds for property expenses and a cash reserve to reduce the risk of a forced sale. And an investor who values the basis adjustment at death, which real estate held outside a retirement account receives and real estate inside one does not, may find that a taxable account or a holding company serves the family better. We compare the alternatives before recommending the account, including structures for protecting real estate investments held outside it.
Discuss a Proposed IRA Real Estate Investment
If you are considering buying real estate through a retirement account, or already hold property in one and want the structure reviewed, bring the custodian’s account documents, the property information, and any financing terms. Our attorneys practice in New York, New Jersey, and Connecticut. Contact Milvidskiy Law Group P.C. to schedule a consultation.
This page is provided for general informational purposes only and does not constitute legal advice. Laws differ by state and change over time. For advice about your situation, consult a qualified attorney.
Frequently Asked Questions
Can an IRA own real estate?
Yes. An IRA held with a custodian that permits alternative investments can buy real estate directly, with the custodian holding title for the account, or through a limited liability company the IRA owns. The account pays for the property and its expenses and receives the rent and the sale proceeds.
Who is a disqualified person?
The IRA owner, any fiduciary of the account, the owner’s spouse, ancestors, lineal descendants, and the spouses of lineal descendants, and entities those persons control. Siblings are not on the list, though transactions with them are still reviewed for other problems.
What is a prohibited transaction?
A sale, exchange, or lease between the IRA and a disqualified person, a loan in either direction, the furnishing of goods or services between them, the use of IRA property by a disqualified person, or a fiduciary’s dealing with IRA assets for the fiduciary’s own benefit. Living in an IRA property, renting it to a child, paying its expenses personally, or guaranteeing its loan are common examples.
What happens if a prohibited transaction occurs?
The account stops being an IRA as of the first day of the year in which the transaction occurred, and the entire balance is treated as distributed at fair market value. Income tax is due on the deemed distribution, and an owner under the early distribution age owes the additional tax as well. The penalty applies to the whole account, not only to the offending transaction.
Can I manage the property myself?
You may make investment decisions and, as manager of an IRA-owned LLC, sign contracts and pay bills from the LLC’s account. You may not be compensated, and performing repairs or improvements with your own labor is treated by many advisors as furnishing services to the IRA. Hire third parties for the physical work and pay them from account funds.
Can the IRA take a mortgage?
Only a non-recourse loan, because the owner may not guarantee the IRA’s debt. Income attributable to the debt-financed portion of the property may be taxable to the IRA as unrelated debt-financed income, which requires the account to file its own return. The lenders who make non-recourse loans to IRAs are few, and their terms reflect the risk.
What is an IRA-owned LLC?
A limited liability company owned by the IRA and managed by the owner, sometimes called a checkbook IRA. It lets the manager transact without the custodian’s involvement in each payment. It does not relax the prohibited transaction rules, and its operating agreement should incorporate them.
Does real estate in an IRA get a step-up in basis at death?
No. Distributions from a traditional IRA are taxed as ordinary income to the beneficiary regardless of what the account holds, and the basis adjustment that real estate held outside a retirement account receives at death does not apply. This is one reason a long-term hold intended to pass to heirs is often better outside the account.
How are required minimum distributions handled when the IRA owns a building?
The distribution is a percentage of the account’s value, which requires an annual valuation of the property, and it must be paid in cash or by distributing a fractional interest in the property. An account with no cash reserve can be forced to sell or to distribute interests at a poor time, so the plan includes a reserve.
Can I name a trust as beneficiary of an IRA that holds real estate?
Yes, and it is often advisable where a beneficiary should not hold the property outright. The trust must be drafted to qualify under the retirement account rules, and the plan must address who will manage the property and whether it should be sold after the owner’s death.
