An individual retirement account (IRA) owner with a few hundred thousand dollars in their IRA may direct, manage and control the investment of funds to buy and own real estate. To invest IRA funds in income property, the IRA owner simply establishes and transfers accumulated IRA funds to a separate self-directed IRA (SDIRA).
Holding a real estate investment in an SDIRA is unlike using an IRA to invest in a real estate investment trust (REIT). In an REIT, the IRA participation is similar to holding stock in a corporation. An SDIRA, on the other hand, gives the IRA owner direct and continuing control over the management of IRA funds, and the selection and operation of the real estate acquired with those funds.
An SDIRA permits the flexibility of asset diversification outside ownership of the traditional Wall Street selection of stocks and mutual funds. SDIRAs allow their owners to delve into real estate, property tax liens and trust deed notes selected by the IRA owner and purchased with SDIRA funds.
Cash vs. mortgaged deals
All cash transactions are the rule. Thus, before establishing an SDIRA to fund an investment in real estate, the IRA is to have sufficient funds to purchase and carry the investment property.
Mortgage financing may help fund the purchase of larger dollar value properties. Yet financing SDIRA deals carries its own set of rules and consequences.
First, the prohibited transaction rules state that the IRA owner – as a disqualified person – may not extend credit to an IRA or IRA asset. This means that if the SDIRA purchase is financed, the IRA owner cannot personally guarantee the loan. [Internal Revenue Code §4975(c)(1)(B)] This means that purchase-assist mortgages used to fund the purchase are to be nonrecourse. On any foreclosure of a nonrecourse loan, the lender is limited to taking the secured property as the sole source of recovery. Thus, the IRA owner and the SDIRA do not have personal liability for the loan.
Second, leveraged SDIRA real estate ownership generates taxable income, known as unrelated debt financed income (UDFI). The property’s net operating income (NOI) is allocated pro rata between the amount of IRA cash invested and the annually remaining mortgage principal. The income attributed to the borrowed money is reported and the tax paid by the SDIRA, not the IRA owner.
So, the earnings allocated to the mortgage principal are both taxed and retained by the SDIRA. Thus, all income generated by the SDIRA investment remains with the SDIRA, since monies in the IRA may not be disbursed to the IRA owner until retirement. Of course, the IRA owner will be taxed on distributions when they are taken. Thus, all earnings attributable to the leveraging will ultimately be double taxed; once when earned, and again when withdrawn from the SDIRA. [IRC §514]
Shifting control of the IRA
A real estate broker knowledgeable about the use of IRA funds to buy real estate expands their practice to new clientele. They are able to advise IRA owners on diversifying their retirement funds into self-controlled real estate investments. In turn, client awareness opens up fee-generating opportunities for the broker and their agents.
In an SDIRA, an IRA custodian’s primary duty is to administer and manage the IRA account on the IRA owner’s behalf. However, it is the investor who is responsible for locating the income property to be purchased and negotiating the terms for acquisition by the SDIRA. Thus, establishing an SDIRA shifts the control of the investment from the IRA custodian to the account owner. This shift in responsibilities significantly reduces custodial fees and cost associated with the IRA custodian’s management of the IRA.
IRA custodians are not likely to advise account owners on how to establish self-directed investments. Moreover, most custodians don’t offer the option to establish an SDIRA to shift funds from an IRA out of their control. To do so will eliminate the need to provide custodial services to the account owner, and with that the various fees charged for servicing IRAs.
The SDIRA LLC
When investing in real estate, a prudent investor practices management and asset preservation. As a shield against remote liabilities, they place title to their real estate ownership in the name of a limited liability company (LLC). To this end, establishing an SDIRA LLC provides this LLC title protection. The SDIRA LLC entity shields the owner’s other IRA funds and personal assets held outside of the LLC from a loss resulting from the ownership of the property vested in the LLC, and vice versa.
The primary IRA benefit of forming an SDIRA LLC is the IRA owner gains “checkbook control” in addition to investment selection and acquisition control. Checkbook control gives the owner, as the managing member of the SDIRA LLC, direct checkbook access to the IRA funds.
Thus, purchasing a property using an SDIRA LLC allows the owner to simply write a check from the SDIRA LLC bank account opened to hold the IRA funds to close transactions. On acquisition, title to the property is vested in the name of the LLC. The same owner access to IRA funds applies for the payment of any expenses, including:
Again, no fees are due the IRA custodian since they are not involved in these operating disbursements.
The SDIRA LLC is generally a single-contribution-member LLC. The LLC’s sole ownership member will be the IRA which contributed capital to the LLC. The IRA owner contributes no capital to fund the LLC. Rather, the IRA owner is limited to acting as the managing member of the LLC, with no contribution and no percentage ownership interest in the LLC.
Since an IRA is a tax-exempt arrangement and an LLC is not taxed, all income and profits of the LLC from ownership, rental operations and sale of the real estate (and not allocated to any mortgage leveraging) are initially received tax free by the IRA. Thus, any profits from NOI or gains on sale of the property allocated to the SDIRA are not taxed until withdrawn from the SDIRA. [IRC §408]
Setting up the LLC
To begin the process of investing IRA funds, the IRA owner needs to locate and appoint an IRA custodian who provides support for SDIRAs. Once the custodian is appointed, an LLC is formed to accept IRA funds from the IRA custodian. The funds are then deposited into a bank account opened in the name of the LLC. SDIRA custodians have specific guidelines they establish for setting up SDIRA and LLC management arrangements.
To form an LLC, the IRA owner:
IRA custodians also require the IRA owner to appoint a “special advisor” to the LLC. The LLC operating agreement contains a special advisor provision to implement this requirement along with tax consequences and information regarding prohibited transactions. [IRC §§408, 4975]
A special advisor is a state-licensed certified public accountant (CPA) or attorney in good standing. This person is to be knowledgeable in IRA tax provisions and prohibited transactions. The special advisor appointment is also to be in writing, on a form provided by the custodian.
An example of a special advisor provision incorporated within an LLC operating agreement is:
“SPECIAL ADVISOR” TO THE LLC:
The LLC will engage and maintain at all times an unrelated Special Advisor, a Certified Public Accountant (CPA) (or attorney), who will be consulted with respect to any proposed exchange, transfer, provision of goods and services, purchase, sale, income allocation, or other transaction involving the LLC or its assets.
a) The purposes for engaging the Special Advisor is for determining whether, with respect to any investing IRA, the transaction may be a “prohibited transaction” or “listed transaction,” may generate “unrelated business taxable income” or “unrelated debt-financed income,” or violate any requirement of Section 408 of the Internal Revenue Code.
b) The Special advisor will be: [name].
The LLC Managing Member has the right to appoint, remove, or upon resignation, replace the Special Advisor.
a) Upon the termination of services of the Special Advisor, the LLC will notify [custodian], and submit a new special advisor engagement and representation letter, naming a replacement Special Advisor.
b) The LLC agrees not to engage in any transactions, etc. as outlined above until a replacement Special Advisor has been appointed. The appointment shall be in writing, and an executed copy of which shall be provided to [custodian].”
Editor’s note — first tuesday’s LLC Operating Agreement – For Self-Directed IRA is designed to meet custodians’ requirements for SDIRA LLCs, giving IRA owners a boilerplate form to easily assist in the creation of the LLC. [See first tuesday Form 372-3 and 372-4]
LLC operating agreement management provisions provide for the LLC to be operated by the IRA owner, not the IRA or the custodian. On the custodian’s approval of the LLC, a bank account is opened in the name of the LLC (in line with the custodian’s guidelines).
To fund acquisitions of LLC investments, IRA funds are transferred from the IRA managed by the custodian to the LLC checking account as the capital contribution the IRA. Thus, the investor has checkbook control over acquisition disbursements, income receipts and expense disbursements in the operation of the income-producing real estate acquired by the LLC.
Since the investment property will be owned by the SDIRA LLC, offers are simply made in the name of the LLC, properly vesting the property in the name of the LLC. As the managing member of the LLC, the IRA owner signs all contracts, disclosures and escrow documents for the acquisition of the property. The purchase, good faith deposit and acquisition closing costs are also funded through the LLC’s checking account.
All operations of the property at this point are also handled by the managing member of the LLC. Accordingly, property acquisitions, income and expenses all pass through the LLC with ease by means of an LLC bank account.
Managing the investment
IRA owners may choose to “self-manage” their IRA-owned properties or hire a property manager. Self-managing can be cost-effective, but caution: IRA owners are classified as “disqualified persons” for some activities.
When self-managing IRA-owned property, the IRA owner may screen and select tenants, collect rent checks payable to the SDIRA LLC and deposit them with any credit card or cash receipts.
The IRA owner may also perform maintenance and minor repairs. However, the efforts may not contribute a sweat equity increase to the property’s value. Maintenance and repairs of a magnitude that increases the property’s value are considered capital improvements. Value adding improvements may not be performed by a disqualified person. Thus, if the IRA owner is a licensed contractor, neither they nor their company may make any capital improvements to the property owned. The purpose is to bar the conversion of the IRA owner’s time and energy into tax-deferred IRA value. [IRC §4975(c)(1)]
Also, the furnishing of other goods and services between a plan and a disqualified person is a prohibited transaction. To avoid these personal contribution issues, an IRA holder may hire a third-party broker as a property manager to handle the day-to-day management of the IRA-owned real estate investment. The managing broker keeps the investor 100% clear of prohibited transactions. [IRC §4975(c)(1)(C)]
SDIRA LLC monies or assets are never distributed directly to the IRA owner. If this occurs, the LLC is liable for any tax penalty incurred on the distribution of monies or assets directly to the IRA owner from the LLC. Worse, the distribution jeopardizes the IRA’s tax-deferred status.
An IRA owner investing IRA funds in real estate needs to be cautious not to over-commit IRA funds. In addition to funds to acquire the property, an IRA needs to have sufficient cash reserves to cover emergency expenditures incurred by ownership of property. These funds are to be in the IRA prior to the property acquisition. Otherwise, any advance (loan) or payment from personal or business funds of the IRA owner of any LLC setup costs, capital requirements or operating expenses is deemed a disguised contribution of money to the IRA, a prohibited transaction. Payment of LLC set up costs, property acquisition costs or operating expenses are limited to being paid solely by way of disbursements from LLC IRA-contributed funds. [IRC §4975(c)(1)]
Permitted is the deposit of additional funds annually by the IRA owner into an IRA with the custodian, limited of course to the maximum annual contributions allowed for traditional IRA tax accounting. [IRS Publication 590]
