Could some help me out to understand this. I saw somewhere in one of the forums last night about this. Correct me if I am wrong but you use you IRA or 401k as collateral without actually move monies from it?
No, that is not correct. You would instruct your IRA custodian to purchase a piece of real estate using funds from your IRA, much the same way you would use IRA funds to purchase stocks, bonds or mutual funds. Money comes out of the IRA and goes to the buyer, the title to the property is transferred to your IRA. The property is now owned by the IRA, titled as, for example "Acme Trust Company, Custodian FBO (for the benefit of) Chris Sukala IRA". All expenses for the property - taxes, repairs, HOA fees, utilities,etc are also paid with IRA funds, and any rental income generated flows back to your IRA. You cannot buy from yourself or any disqualified parties (your parents, your spouse, your children), nor can you let any of those people live in the property. You also can't put any personal "sweat equity" into the property - you can't go mow the lawn or change a lightbulb or make a repair. You must hire outside, unrelated 3rd parties to perform these tasks. If you buy the property outright with 100% IRA cash. then when the property is sold, proceeds return to the IRA - tax deferred until retirement, or even tax free if in a Roth.
A lot our buyers use this method. There are specific non-recourse lenders that will finance real estate purchases using your IRA that we work with to allow for more cash flow to the investor.
Leveraging a Real Estate purchase inside an IRA will result in a tax called UBIT -Unrelated Business Income Tax. This means a percentage of the income generated by the property will be subject to taxation (paid by the IRA). This percentage is roughly equal to the percentage of the purchase that is financed. So if the IRA put down 60% and financed 40%, roughly 40% of the net income generated would be subject to this tax. As the mortgage loan is paid down, the amount of income subject to UBIT decreases accordingly. Investors are always advised to check with a knowledgeable accountant to determine what impact UBIT may have on their investment returns. Non- Recourse loans are generally 3 - 5 year ARM's, and most non-recourse lenders will require the IRA put as much as 40% down and have a cash reserve, and be able to demonstrate the property is income-producing. There are some property types they will not lend on - generally raw land and mobile homes.
Doreen is correct about the UBIT (UDFI) for an IRA. If you are eligible for a Solo 401k, there would be no Unrelated Debt Financed Income tax on those investments with non-recourse financing.
@Justin Windham could you define solo 401k please.
A Solo 401(k), (also known as a Self Employed 401(k) or Individual 401(k)), is a 401(k) qualified retirement plan for Americans that was designed specifically for employers with no full-time employees other than the business owner(s) and their spouse(s).
In order to qualify for a Solo 401(k), an individual must claim some self-employed income. However, he/she does not need to work full-time in a self-employed capacity. A common example of part-time self-employed income is an individual who works for an employer, but also does a little consulting on the side.
@Doreen Chaisson @Justin trying to follow. I understand having a third party work on the house. Could you create a business and have your own business to the work.
So the IRA owns the house. Any rent goes back into the IRA. All taxes and costs come out. Do you then write a check to the IRA for rent minus costs once a year.
So then technically I would not see any profit in my pockets until I am able to draw from it.
Sorry I am a newbie just hearing about this. Want more info.
I guess I'll need to talk to my accountant.
There are actually two options, but it sounds from your interest in a rental property that only one is realistic.
With a self directed IRA, the IRA owns the house, is responsible for the expenses of maintaining the property and receives the income. The net profit is tax-sheltered into the IRA. When you take distributions, those distributions are taxable. It is exactly like an IRA invested in stocks, but with the ability to diversify into real property instead.
The IRA may not intersect with you, lineal family or family owned businesses in any way. It is not "you investing in real estate with IRA money", but rather you "directing your IRA to invest in real estate."
There are different ways to structure such a self directed IRA -either managed by a trust company as custodian or having the IRA own a LLC that you can manage with "checkbook control", but in either case all investments are purely for the benefit of growing the IRA and your role can be administrative in nature only. Think of yourself as a fund manager - not a contractor or landlord.
There is a platform somewhat related to an IRA known as a Rollover as Business Startup (ROBS). This allows you to form a new active business (real estate development, restaurant, etc. - but not passive rental holdings) as a C-corporation and have a retirement plan tied to that corporation purchase parent company shares as an employee stock option purchase (ESOP). The business operates in the taxable realm, but you can capitalize the business using retirement funds without penalty and can be involved in the operations of the business - including drawing a salary.
I bring the ROBS plan up more to cross-reference some of what you may be reading on the internet and to draw a distinction between that option and the arms-length, tax-sheltered nature of a self directed IRA. They are two very different programs with different usages.
Brian did a great job explaining some of the logistics with his last post.
If you are considering a self directed IRA (I generally recommend an IRA LLC with checkbook control) or a Solo 401k, know that the Solo 401k is the better structure if you are eligible. Eligibility requires that you have self-employment activity and no full time employees. On this forum, it is often useful to point out the need for contributions to the plan to come from earned income from self employment since a lot of members here have self employment only from rental income and that, by default, doesn't qualify.
I don't recommend the ROBS structure for anyone, but even those that do usually recommend it only in specific situations depending on the type of investing you intend to do with the plan.
To simplify things a bit and possibly help narrow your focus for additional due diligence:
1. If you have earned income from self employment and no employees in any businesses you own, look into the Solo 401k as a possible solution for what you intend to do to.
2. If you do not qualify for a Solo 401k as outlined in item 1 above, look into a self directed IRA LLC as an alternative.
It's important to remember that when you invest your IRA or Solo(k) funds into any investment, the purpose is to grow your retirement nest-egg, and not for any personal benefit. If you are looking to get into rental properties for immediate personal income, then you should not be involving your retirement dollars.
As an aside, many custodians won't accept ROBS as they interpret this structure to be a form of self-dealing, which is a prohibited transaction.
Following are some good resources on retirement account topics.