Using a self directed IRA for rehab.

49 Replies

Has any rehabber used a self directed IRA for rehabbing houses? How do you handle the profit. Does it have to go back into the IRA which would seem to defeat the purpose as you couldn't make any money to live off. If you keep the profit out does it get taxed at a higher rate than normal or is there a penalty? Thanks for any input.

An IRA is an Individual Retirement Account, @Greg Wright. The money invested grows tax-free or tax deferred until you retire. You can't use IRA investment returns "to live off" until that time. These must stay in the account.

The general rule is that you cannot personally profit from your IRA until you retire. While a Roth IRA allows you to withdraw your initial investment anytime, since you already paid taxes on these funds, you generally can't withdraw any profits or traditional IRA contributions until age 59 ½. Early withdrawals can result in substantial penalties and interest.

@Greg Wright

There are two options. With a "self directed IRA" (or 401k), the plan is the investor, not you. You can choose to diversify your retirement savings into real estate, but everything must be done at arm's length and you may not derive any income personally. You can have your IRA flip houses, but you would need to hire 3rd party contractors (or JV with a contractor). The gains go back into the IRA or 401k, and in the case of flipping houses - which is considered a trade or business activity - there is a tax implication on the profits from the flip through UBTI (look it up).

Flipping houses and paying UBTI can still be more profitable for your IRA than investing in stocks, or even passive real estate options such as holding rentals or being a hard money lender. So, do not dismiss the strategy out of hand. Do some research by contacting a professional self directed firm and your tax advisor.

The other option is what is referred to as a Rollover as Business Startup (ROBS) plan. In this structure, you form a company personally and that company sponsors a profit sharing or 401k plan. You can rollover a prior IRA or 401k into the plan, then the plan can purchase shares of the parent company with an Employee Stock Option Purchase (ESOP). In this format, you have used your retirement plan to capitalize your business, and you can be directly involved in flipping houses, take a salary etc.

Yes, you can use a SDIRA to invest in houses for rehab/flipping or rehab/renting.

There are plenty of forum topics here regarding using your Self Directed IRA to invest in real estate.

The topics you'll want to research are Prohibited Transactions and Disqualified People.  

However, the short version is - you are unable to do any of the rehab work yourself.  In other words, no sweat equity allowed.  There are those who interpret the IRS regulations to mean that you can't even go over and change a light bulb, so be very careful about this.

Secondarily, there are others who also cannot have any financial gain, including going over to change light bulbs, such as pretty much every family member you have.  But do your research on this as well.

To answer your questions directly - yes, all profits have to go back to the IRA and that's sort of the point. Your IRA isn't a fund for you to invest and make money off of to live - the IRA is there for your retirement, so all profits and other income go back into the fund for that purpose and that purpose only.

There are people who have tried to circumvent this by "hiring" themselves or a family member through any number of layers of legal entities to either rehab the property or manage it after it is a rental.  Those people end up disqualifying their entire account and end up in a world of tax mess.  Be careful.  Make sure you understand all the rules.  This is a truly passive activity.  Many would say the only thing you're permitted to do is check your account periodically to make sure all the deposits are coming in.  Self Directed IRAs are under extra scrutiny from the IRS these days - or at least as much as they can be with reduced personnel and budget.

I'm in the process of converting my father-in-law's 403(b) account into a Self Directed IRA. He has Alzheimer's and my wife is POA. His wife passed away last year so she is the sole beneficiary of all his accounts including this 403(b) account. With that said, we can use our new SDIRA to fund a rehab project. But like stated above, all work must be done and documented by 3rd party sources which means invoices from all trades.

Our advantage is that we can as needed pull funds out without penalty to move money under his name to his bank account that we use as needed to care for him. All other retirement funds he has including his social security check, are already taxed with exception to profits from the investments and we use that money as his income.

The penalty for withdrawals from an IRA or 401K are 10% penalty plus ordinary income taxing if taken out before you turn 59 1/2 years old. Having a father-in-law that we take care of and is over 59 1/2 helps us use funds as needed as long as we don't go over his 15% tax bracket at the end of the year.

What we do with the money we take out is put in a Roth IRA periodically. I leaned a lot from these webinars in Dallas:

www.questira.com/all-events/dallas-events/

@Greg Wright no one mentioned the self-dealing rule, so I'll add the following: if a person buys a property in their name (or that of an entity they or a disqualified person own) they cannot use their SD-IRA funds for the rehab portion of the financing. That would be considered self-dealing and it is a prohibited transaction. That's my $.02!

Any self directed IRA must be formed as an LLC before investing else you'll be subject to penalties.

@Rodney Marcantel

Your statement is not correct. Self dealing is determined by how one transacts with IRA funds, not how the IRA is deployed.

An IRA held by a trust company serving as custodian may transact in real estate. The Trust Co will hold the funds and pay for expenses per your instructions.

Alternately, that IRA may be invested into a specially formed LLC where the IRA is the sole member and the account holder or someone they designate serves as the manager. That manager has to be careful to follow the rules against self dealing - just as would an account holder transacting via a custodian - but they are allowed to administer the LLC and do things like sign contracts, pay for expenses and receive income into the LLC on behalf of the IRA.

The LLC is not a requirement, simply a way to gain more direct control over the administration of the IRA's investments.

In either case, one may not have any direct or indirect benefit - in either direction - between the IRA and a disqualified party (which I will simplify somewhat as the account holder, their spouse and lineal family). Benefit would include financial transactions, lending of capital or provision of goods or services, among other things. I'm staying high level to make the basic point that the LLC does not change the underlying nature of the IRS rules.

@Robert Leonard

I did not specifically detail self-dealing, but did in my prior post indicate that the use of a self directed IRA/401k must be done "at arm's length". Thank you for your extra emphasis on this point however, as it is critical.

Bottom line is that when you invest using IRA funds, you are really serving as a fund manager for those funds, not adding them to your pool of real estate investing capital. Self directed IRA & 401k plans are about having different choices to diversify your retirement savings into alternatives such as real estate - but that retirement savings is very much bundled up in the tax code so as to be reserved for your post 59 1/2 future. But, an IRA or 401k of the Wall Street variety (common model) is equally tied up as far as your access, and even more restricted because of the limitation on publicly traded investments only.

If you are looking to use retirement funds to finance a real-estate rehab business (for example, a real-estate operating company), then a ROBS 401k/PSP (rollover as business startup plan) might be a good fit as you will be able to draw a salary. 

@Brian Eastman , you are right but my point was that to protect you as the investor, an LLC is very much required, else you risk "self dealing" and IRA scrutiny. IRS penalties can be as high as 40% on top of ordinary income if they find that you've been self dealing.

Jim Hitt American IRA is your man. Google him. He has managed and built funds, invested in real estate extensively. He manages over $300,000,000.00 in these types of accounts.

He helps many of my clients get set up.

I also like Brians input. He is spot on.

Thanks for all the advice. Does anyone know if the UBTI tax is on top of regular income tax? Example I rehab a house sell for $20000 profit pay UBTI tax do I still owe regular income tax on the $20000?

@Greg Wright if you do a fix and flip inside your IRA and it earns $20K on the deal, your IRA will need to pay UBIT on the $20K of gain. That works out to $6228.70 (quick and dirty, may be a little less.) That leaves you $13,771.30 in your IRA. When you withdraw that $13,771.30 from your IRA it will be subject to your ordinary income tax, the same as if you had earned that money.

This may seem like double taxation. And it is. But this is no different than any other business. If your IRA owned stock in a business that did fix and flips, that business would be paying income tax before it distribute any dividends to its shareholders. The UBIT tax is specifically intended to level the playing field and avoid entities like IRAs (IRAs are not the only entity subject to this tax) from having an unfair advantage over normal businesses.

Jon,

Can I keep that $13771.30 out of the IRA.

Any income derived by an IRA-owned asset must flow back to the IRA. If you purchase the property outright with IRA funds, rehab it with IRA funds and then sell it at a profit, ALL proceeds from the sale flow back to the IRA. Your IRA can do this process directly or insert a single member LLC, but it is not a requirement and makes no difference in the prohibited transaction rules.

With regard to UBIT - this may not always apply. If your IRA leverages the purchase and rehab of the property, it definitely will. If you purchase it outright with your IRA and rehab it with IRA funds, and only rehab one or two properties per year, you may not owe any UBIT if there's no leverage. Each state has regulations on when an IRA account that is buying/flipping reaches "dealer status" (usually more than a handful of transactions per year, check with your own state) at which point it is no longer involved in passive investing, but will be considered a real estate operating company, subject to UBIT whether or not there is leverage in the picture.

Shop around for a good custodian who knows the regulations. There are many Self-Directed IRA custodians out there. It is advisable to do your due diligence and ask about such things as how long have they been in business, are alternative assets their sole focus, are they BBB accredited and rated, are they a regulated financial institution, have they ever been sanctioned by any regulatory bodies, how many accounts and how much in assets do they administer?

@Doreen Chaisson

State dealer status does not impact whether UBTI applies.  The federal language in IRS publication 598 refers to "engaging in a trade or business activity on a regular or repeated basis".  That gives the IRS a good amount of leeway to determine that more than one flip in a few year period meets that criteria.  The idea that one or two per year does not meet this threshold is less than conservative, as two per year would certainly be both regular and repeated.  One per year would even meet that criteria in the right facts and circumstances.

If your intention is to flip houses in an continued fashion, factor in UBTI as part of the equation.  

The key thing when considering UBTI is to look at the ROI the investment creates. If you flip a house and net $30K and give up about a third of that to taxation then you are left with $20K. If your total cost on the transaction was $100K, then that still represents a 20% return. Most folks are not earning 20% in their IRA buying indexed mutual funds or even holding rental properties.

"Double taxation" is moot. When you take money out of an IRA, you pay taxes on that money, regardless of whether the IRA originally earned 1.5% from a CD or 20% post-UBTI from flipping houses. If you were flipping houses (successfully), you'll have a much bigger pot from which to draw on in retirement. Sure, you'll pay more in taxes, but in this case, that is the good news.

Originally posted by @Greg Wright :

Jon,

Can I keep that $13771.30 out of the IRA.

No you can't without paying the taxes plus the 10% additional early withdrawal penalty. Any profits or income from IRA investments must go back into the IRA account. Think of the account as another person. You certainly can not go into another person's bank account and withdraw funds without consequencs.

DISCLAIMER TO ALL READERS: There are several incorrect statements in this thread, readers should be advised to consult a tax professional knowledgable in retirement account (specifically self directed varieties) tax rules and law including UBIT.

In the example of the father in law having a 403b, your wife, the account holder's daughter, is a disqualified party and as such, these funds can not be invested into YOUR rehab projects.

You do NOT need, nor are you "required" to have an LLC for self directed IRA's where you want to invest in rehab flips or any other investment for that matter. Also, the statement that you are required to have it to avoid self dealing or scrutiny by the IRS is also incorrect.

The comments regarding "arms length transactions" is 100% correct and spot on. That means you can not self deal (invest IRA funds from your account into properties you own) and you can not invest those funds with any disqualified parties.

Originally posted by @Doreen Chaisson :

With regard to UBIT - this may not always apply. If your IRA leverages the purchase and rehab of the property, it definitely will. If you purchase it outright with your IRA and rehab it with IRA funds, and only rehab one or two properties per year, you may not owe any UBIT if there's no leverage. Each state has regulations on when an IRA account that is buying/flipping reaches "dealer status" (usually more than a handful of transactions per year, check with your own state) at which point it is no longer involved in passive investing, but will be considered a real estate operating company, subject to UBIT whether or not there is leverage in the picture.

This too is not entirely correct, though, there are situations where it could be correct. "Intent" is a major factor that comes into play. If you flipped 2 houses in a calendar year and you had no other RE investments, the IRS would consider both transactions as subject to UBIT as the intent was clear as to what you were doing, on the flip side, if you bought several rentals and sold one or two that where intended to be holds but circumstances changed and warranted to need to sell, you may avoid UBIT for that one or two that turned into flips. I do say "may" because you may still get hit with UBIT. Point is, factor in that tax to arrive at your true ROI on a flip completed inside a qualified retirement account.

@Brian Eastman's responses to this issue were spot on.

@Doreen Chaisson perhaps you know something I don't.

With regard to UBIT - this may not always apply. If your IRA leverages the purchase and rehab of the property, it definitely will. If you purchase it outright with your IRA and rehab it with IRA funds, and only rehab one or two properties per year, you may not owe any UBIT if there's no leverage. Each state has regulations on when an IRA account that is buying/flipping reaches "dealer status" (usually more than a handful of transactions per year, check with your own state) at which point it is no longer involved in passive investing, but will be considered a real estate operating company, subject to UBIT whether or not there is leverage in the picture.

Sorry, but I believe this is just flat wrong. "Doing one or two a year" is irrelevant. State laws are irrelevant. The IRS documentation on when UBIT applies is pretty clear. If you're engaged in an active business, and fix and flipping absolutely is, then your business is subject to UBIT. That's not just my opinion, that's also the opinion of the attorney I've worked with on SDIRA issues.

If you were to buy a house to be a rental and then received an offer that's too good to pass up, you could avoid having that designated as an active investment. In my case, I had a property my IRA made a loan on that ended up being repossessed. The CPA I worked with on that also advised there would be no UBIT because there was never any intent to buy and sell property. But if your intent is to fix and flip houses inside your IRA, even one or two a year, then the proceeds are subject to UBIT.

If you can provide a pointer to IRS documents or case law that supports your opinion, I'd be interested in seeing that.

Hence my use of the word "may" - as a passive SD IRA custodian and administrator, we always encourage our clients to seek the counsel of a qualified attorney and/or CPA before engaging in any transaction with their Self-Directed IRA. Based on my 14 years' experience, we have not seen anyone rehabbing 1 - 2 properties per year pay UBIT tax. However, and again, the calculation of UBIT tax is not the responsibility of the SD IRA custodian.  I was merely trying to correct some misinformation on this threat about UBIT always applying, about funneling income out of the IRA, and about LLCs being required.  I apologize if my comments added any confusion.

@Doreen Chaisson have you had one of your customers who's doing one or two rehabs a year, not paying UBIT get audited?  What was the outcome?  I do not believe any such exception exists.  As a friend once told me, "everything works until you get caught". 

As I said, custodians do not get involved with UBIT calculations. When UBIT tax calculations and tax bills are presented to us for payment, we send the tax payment out of the IRA. It is the responsibility of the IRA owner and his or her attorney/CPA to be sure they are not running afoul of any IRS regulations.

How about borrowing from a Solo 401K to invest in RE and pay it back in at the end of the first year?  For example, flip costs $50K and profited $20K for a total $70K.  Paid the loan @ 5% by the end of the first year about $41K (monthly payment about $1K).  Would I pay UBIT on $20K, $29K (20K profit + 9K left over paid off first year).

I hope I explained it right.

Originally posted by @Adam A. :

How about borrowing from a Solo 401K to invest in RE and pay it back in at the end of the first year?  For example, flip costs $50K and profited $20K for a total $70K.  Paid the loan @ 5% by the end of the first year about $41K (monthly payment about $1K).  Would I pay UBIT on $20K, $29K (20K profit + 9K left over paid off first year).

I hope I explained it right.

 If you use borrowing provisions from a 401k, then the borrowed funds become "outside the plan" and may be used for any purpose you wish. If profits are made, then you would only owe income tax on the profits. This of course is under the assumption that all principle and interest from the loan is paid back in full. If not, it would be considered a distribution and be subject to taxes and early withdrawal penalties.

Thanks for all the responses. It seems the self directed IRA is best suited for buy and hold. From the responses flipping is looked at it as a ongoing business by the IRS subjecting yourself to UBIT, 10% early withdrawal penalty and then regular taxes on top of that. Seems very little profit left if any after all the costs.

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