Top Three Ways to Invest in Real Estate with a Self Directed IRA

Investing IRA funds in real estate used to be quite complicated, time-consuming, and expensive. Deals had to be administered by IRA custodians every step of the way, complicating the process, and fees had to be paid to the custodian every time the IRA made a move. Although, much of this is still true with many traditionally IRAs, investors can avoid a lot of unnecessary and costly steps by using a self-directed IRA.

A self-directed IRA is simply an IRA in which the IRA owner is able to make investment decisions without having to get the custodian's approval. The favorite instrument for opening a self-directed IRA is the Limited Liability Company, which allows the IRA owner to have absolute checkbook control over his or her IRA. This means every time you have to pay an expense associated with an IRA asset, you can write the check yourself and avoid custodian fees.

Making Money with Real Estate

Self-Directed IRAs are great for avoiding taxes on gains, especially for flipping properties. It is recommended that you use the SDIRA for real estate transactions that generate immediate (or almost immediate) taxable income (such as flips or options) and generally not buy and hold deals, that already shelter other income via componentizing.

There are three basic ways to purchase real estate with a self directed IRA:

• Purchase with cash
• Partner with family, friend, or business associate
• Borrow money for investment

1) Purchase with Cash

If you have sufficient funds in your self directed IRA to cover the purchase price, closing costs, taxes, insurance, etc., you can purchase a property outright. All ongoing expenses are paid in total from your self directed IRA, and all income/profits are returned in total to the IRA.

2) Partner with Family, Friend, Business Associate

If you don't have enough funds for a cash purchase, your self directed IRA can purchase an undivided interest in a property.

For example, with your self directed IRA, you could partner with a family member, friend, or business associate to purchase a property for $100,000. The friend could provide 70% of the purchase price ($70,000), and your self directed IRA could purchase the remaining 30% ($30,000).

All ongoing expenses must be paid in relation to your percentage ownership. In our example, for a $1,000 property tax bill, the friend would pay $700 (70%) of the bill and your self directed IRA would pay $300 (30%). If, the property collected monthly rent of $1,000, the friend would receive $700 (70%) and your self directed IRA would receive $300 (30%).

3) Borrow Money for Investment:

Through your SDIRA, you could get financing such as a mortgage for a real estate deal. You must consider two points when considering this option:

a) Loan must be non-recourse - Per IRS regulations, an IRA cannot guarantee a loan or be used as collateral. A non-recourse loan only uses the property for collateral. In the event of default, the lender can collect only the property and cannot go after the IRA itself.

b) Tax is due on profits from leveraged real estate - If your IRA uses debt financing such as a loan on a real estate investment, a tax will probably be due on profits. This tax is called unrelated business income tax (UBIT).

Here's a recent question I received about SDIRA benefits:

"I am looking at going with the SD 401K, mostly because I am working Fix and flips and want to have flexibility on deals by borrowing 50K from the 401K. Has anyone compared the SD 401k to the SD IRA? Are there any pitfalls I am missing on the SD 401k? Thanks for your help."

My Answer:

Well if we are talking about the solo 401k, there are a lot less restrictions with a solo 401k than with a SDIRA. The solo 401k does not incur the UDFI (Unrelated Debt Financed Income), allows you to invest in a lot more than the SDIRA.

Here is a brief overview of the main differences between these two types of plans:

FeaturesSDIRAIndividual 401(k)Employer Matching
ContributionsNot AllowedYour business can match 100% of employee deferralsProfit Sharing AllowedNot AllowedYour business can profit share in addition to, or in place of, matching contributionsRoth RolloverRollovers allowed from one plan or custodian to anotherRollovers generally not allowed, however, at retirement, 401(k) will allow rollover to individual Roth IRARoth ConversionConversions from traditional IRA to Roth IRA are allowedNot AllowedTAXATION-YBIT/UDIF
(Unrelated Business Income
Tax/Unrelated Debt Financed
Income Tax)UDFI applies to leveraged transactionsUBIT applies but with certain exemptions. UDFI is currently exempted on leveraged real estatePurchase Shares in
an "S" CorporationNot AllowedAllowedGovernment Reporting
RequirementsRecommendedYes, more specifically, form 5500-EZ is an annual requirement, other reporting may be required depending on investment choicesLoan ProvisionsNot AllowedAllowed, with certain pay back requirements and specific limits on amounts availableTax credits for low
income individualsNot AllowedAllowed, up to 50% of the first $2,000 with certain income limits (see IRC § 25B)Lease-back property
purchased by planNot AllowedAllowed, but with certain occupancy limitsPurchase of businessAllowed, but no "S" CorpsAllowed, UBIT will apply outside of any exemptions

Make sure you are getting the best tax advice. Let me evaluate your financial and tax situation, then develop a customized tax strategy just for you. Together, we will come up with a strategic plan designed to answer your questions as you build your own customized wealth-building plan. Contact me here for a consultation