All Forum Posts by: Frank L. Bridges

Hi Joe,

Let me correct what may be some misconceptions. 

First, in general, holding a real estate investment in an LLC won't necessarily, by itself, help you avoid or defer taxes. Unless you choose to have the LLC taxed as a corporation, the income and deductions (including depreciation) flow through to the LLC's owner(s).

Second, you can invest the inherited IRA as a self-directed IRA, even though you are not the decedent's spouse. (Also, the self-directed inherited IRA could hold the real estate it purchases in an LLC.)

True, you can't get the special benefits available to a surviving spouse who inherits their spouse's IRA -- e.g., treating the IRA as their own, doing a "spousal rollover" to a new account, and not being required to take minimum distributions until their required beginning date. Also, you will pay ordinary income tax on whatever gets distributed to you from the inherited IRA, so the $100,000 you are talking about "pulling out" from the inherited IRA (assuming you mean as a distribution) will be taxable ordinary income this year.

However, you do have the option to invest the inherited IRA in real estate with a self-directed (inherited) IRA. To do that, you would transfer all or part of your current IRA account to a new custodian that allows you to self-direct investments. First, you open a new "inherited" IRA account at the new self-directed custodian, and then do a "custodian to custodian" transfer of some or all of the liquid funds from your existing inherited IRA to the new, self directed, inherited IRA. This is not a "60-day rollover." Then you instruct the current custodian to transfer funds directly to your new account at the new custodian. (Both custodians will have forms for you to fill out and submit.) Then you can do your real estate investing directly from the new self-directed inherited IRA.

One thing to watch out for with self directed inherited IRAs, is that you will be required to take minimum distributions from both inherited IRAs described above now, based on your life expectancy. (IRS provides tables to calculate the amount(s) based on your life expectancy each year.) Depending on your age, that may be a small amount at the beginning, but it gets to be a bigger percentage of each account as you get older and your life expectancy gets shorter (according to the IRS table). 

Minimum distributions from any IRA are hard to do with non-liquid assets like a real estate investment held in a self-directed IRA. In order to calculate the required amount, you have to value the account itself, which includes valuing its specific investments, e.g., the real estate held by the account. That means you have to have a reasonable method of valuing the real estate holdings at market value as of 12/31 each year so that you take out the required minimum distribution amount. The self-directed custodian will ask you to value the real estate held each year, and will report that value to IRS. The minimum distributions you take and report on your income tax returns have to be based on the values reported by the custodians to IRS, so it's important to be accurate. You need to be comfortable that the value of the real estate you report to the custodian will pass an IRS audit. IRS is beginning to look more closely at valuation of self-directed retirement accounts, and they don't like it if you "under distribute."

For a bunch of reasons you won't want to take minimum distributions "in kind" as a percentage of the real estate held by the self-directed IRA. So, you should hold back enough liquid assets in the inherited IRA(s) to cover your estimated required minimum distributions from them over the expected life of the real estate investment. If you retain the original inherited IRA in liquid investments at the current custodian, but transfer only the amount you expect you will need for the real estate investment to the new self-directed inherited IRA account, you can take the required minimum distributions for both accounts from the one holding the liquid investments.

Anyway, the whole point of all this is to enable you to invest your inherited IRA in real estate and defer taxes on the income until you have to take out taxable distributions. Otherwise, you pay income tax at your current marginal rate on the $100,000 distribution you mentioned, plus income tax on subsequent profits from the investment (which you would own personally).

Consequently, I'd compare your projected returns net of all taxes on the real estate investment (1) based on taking a current distribution of $100,000 and holding the real estate personally, and (2) based on holding the real estate investment in the inherited self-directed IRA. Be sure to factor in the effect of Unrelated Business Taxable Income (UBTI) if you borrow money (non-recourse loans only) to purchase the property by the self-directed IRA. Since you can take depreciation against other income on property you hold personally, but only against UBTI in your self-directed inherited IRA, #(1) may be your best option. Be sure to do the numbers.

I hope this helps clarify your options. Happy investing!

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Hi @John Dombrowski. I just saw this thread. Sorry you lost your job.  

The use of a self-directed "Solo(k)" plan may be the correct vehicle for you, but you are right, you do need to have a sole proprietorship or LLC in which you (and potentially your spouse) are the only employee, that is throwing off earned income to you. If you are looking for another job with a new employer instead of starting your own business, the Solo(k) is not really an option.

If you are interested in the real estate market only to enhance the investments in your retirement account, and you don't plan to work for your self otherwise, the self-directed IRA is probably your best option. You can establish an IRA with a qualified custodian, transfer your 401(k) money at the former employer over to the new account (don't do a 60-day rollover, do a direct trustee to custodian transfer), and then instruct them to make the investment. It's worth it to do the due diligence to choose the right custodian. According to a recent GAO report there are approximately 26 qualified custodians to choose from who provide various services and permit specific types of investments.

If you are planning to buy and hold property, you can do it directly in the self-directed retirement account (I call all types of self-directed retirement "SDRAs"). Owing the properties directly in your SDRA means you have to instruct the custodian to write checks to vendors (like the plumber, contractors, etc.) and your tenants have to pay rent directly to the custodian. All the transactions can end up costing extra fees from the custodian and be a bit inconvenient for you. You have to compare the costs and charges.

Alternatively, you can establish a single member LLC to be owned by your SDRA in which you are the manager and then manage the investments owned by the LLC yourself. That's what people refer to as a "check book LLC."

There are, of course, disadvantages to a check book LLC. For example:

• There are restrictions on what you can do as manager of your SDRA's LLC to avoid prohibited transactions (e.g., services you can provide as manager are limited, avoid reimbursing yourself for expenses and never pay yourself compensation), 
• IRAs are subject to debt financed income tax if you borrow money (has to be non-recourse -- meaning you can't personally guarantee the debt) to purchase or renovate a property, and 
• There are transactional costs to establish and maintain an LLC that you don't have if you purchase properties directly in your SDRA,

to name a few key ones to consider. 

However, if you avoid the pitfalls and keep yourself informed of the rules and new developments, the IRA owned LLC is often the most convenient and efficient way to make real estate investment with your SDRA.

I hope this helps.

There is no workaround for this. 

Without getting into the details, if your LLC were owned more than 50% by unrelated third parties, it's theoretically possible for your father's SDRA to loan to the entity, but not under the circumstances you describe.

By the way, @Vikki Baumler, your posts suggest that you may be self-employed. If so, you might consider transferring your 403(b) money to a "Solo(k)" instead of a SDIRA. The Solo(k) is a 401(k) qualified plan for sole-proprietors or entities where the only employee is the owner. The contribution limits are much higher, you can use it fore self-directed retirement investing, and Solo(k)s are not subject to unrelated debt financed income tax, whereas IRAs (including Roths, SEPs, SIMPLE plans as well as traditional IRAs) are. Just something to consider.

Unfortunately, under current interpretations you are correct. There is a theory asserted by the Tax Court, but never followed directly, that a retirement account can be a disqualified person with respect to itself. It's not a theory that makes obvious sense, but at the present we generally abide by it because of the risk of disqualifying an IRA if it turns out to be correct. Lending money to your own business venture, particularly if there are other investors, is a common enough practice in the real world of small business (outside of self-directed retirement account investing), though.

If your IRA is the only investor, I wonder whether you are gaining anything by lending, as opposed to simply adding more investment money to the project from your IRA.

First thing is to choose a custodian for your SDIRA. There are between 20 and 23 self-directed custodians. 

• If you plan to use a single member LLC (in other words, a "check book LLC", of which you are the manager), you want to make sure the custodian is one that will allow that. Many don't.
• Another factor is how the custodian will charge. Some charge a small annual amount, but charge you for every transaction, while others charge you a larger annual fee, but charge you less for transactions. 

Next, of course, you set up you new IRA at the custodian and transfer the funds (after liquidating the current investments) from your 403(b) to the new account. When you transfer to the new account, make sure that the transfer is done from the custodian or trustee of your 403(b) to the SDIRA custodian. Don't do a rollover. Just do it directly between the two.

Your next decision is how you want to hold the new investments. Depending on state law, you can hold the new investments in your IRA, or you can establish an LLC (of which you are the manager) to be owned by your IRA and buy the investment in the name of the LLC. There are a number of factors to consider for this. Without going into all the complexities here, the short scoop is that the LLC is more efficient from a transaction point of view (you don't have to instruct the custodian every time you want to pay a bill, and parties to the transactions don't have to send money to the custodian), but is more expensive generally with setup costs, annual filing fees and registered agent fees. If you don't have a lot of money in your IRA, you'll probably opt to avoid the extra expense for a transaction or two, and then when you understand the ins and outs of what you are doing, maybe upgrade to an LLC.

Finally, you will need to choose your investment and negotiate the terms of purchase. Then you instruct the custodian to make the investment. 

I hope this helps. Best of success in your investments.

@Karen F. You mentioned that the account you are talking about is an "inherited IRA" so the option to convert it to a Roth IRA is not available to you.

However, you can still use the IRA to invest as discussed above. If your IRA does Flips often, the IRA may incur unrelated business income tax (UBIT), but in general the sale of property for gain is exempt from UBIT unless the property is inventory or property held for sale in the ordinary course of business. If your personal business is not flipping houses, the argument about whether property purchased and flipped by your IRA probably wouldn't come up with IRS unless you do it repeatedly. IRS is just now beginning to take a look at self-directed retirement accounts and tax compliance. So far as I know, it hasn't issued much guidance in the UBIT area relating to flips for self-directed IRAs, and doesn't have any systems to gather information about it independent of the IRA filing the required return, or auditing your personal returns. That said @Brian Eastman's point on the taxation of IRAs is important to consider. If you really want to know more about this area, I'd suggest you read the December 2016 GAO report on self-directed IRAs and guidance for self-directed IRA owners at this link: http://www.gao.gov/products/GAO-17-102.

On the convenience side of things, you have two options. 

One is to hold the property in the IRA with the custodian writing all the checks, and the other is to have a single member LLC owned by your IRA. As mentioned by @Anthony Dooley, having the property owned by your custodial IRA does require the custodian to write checks every time you want to pay someone, and that can get irritatingly expensive and cause delays and errors, depending on the way your custodia charges. Also, you have to have your tenants, if any, write their checks to the custodian/IRA.

The single member LLC owned by an IRA is a second option. The single member LLC is convenient because you can be the manager, write checks and pay bills for the property the LLC owns. Some custodians do not allow you to be the manager of such an LLC (which makes it unfeasible because you have to pay the independent manager), but others do. Although a single member LLC owned by your IRA may be quite a bit more convenient, operating through a single member LLC may be a little more expensive than having the IRA hold the property, because there is the cost of setting up the LLC, and there are usually annual state registration requirements, the amount of which depends on the state requirements where the LLC is registered (which should be where the real estate is located).

In any event, Anthony Dooley's  cautions about what you can and can't do are absolutely correct. In general, you can hire others to service the property, write checks, keep track of the money and make decisions about what is to be done, but you can't provide any of those services yourself. 

If you are planning to be involved in a flip with your IRA, you should take all of these expenses into account before making the investment decision so you have an accurate idea of the actual returns your IRA will experience.

Just to make it clear, since I'm an attorney, this post is not a tax opinion and can't be relied upon to avoid taxes and tax penalties. I just thought you could use the information.

Hi Michael,

Although I agree with Brian Eastman that co-investing with your IRA is less than optimal because of the increased risk that you might inadvertently commit a prohibited transaction, it is, nevertheless, possible to do so under certain limited conditions.

Most custodians follow the theory that if you invest "simultaneously" with your IRA, the entity is not a disqualified person at the time the IRA makes its investment (based on a Tax Court case that doesn't actually hold that). Recent tax court cases also suggest that it is possible to "subscribe" for the full amount to be invested and then add installments to meet the subscription obligation over time.

Since your financing is non-recourse, there will be no prohibited transaction arising out of a personal guarantee. However, you will receive debt financed income on the "flip" as a result and owe unrelated debt financed income tax from your IRA's portion of the financed profits. You have to do the numbers to make sure that the after tax return is enough to make the investment worthwhile.

Whether the profits from the "flip" are unrelated business taxable income (regardless of debt financing) is a little unclear under the law. Individually you and I would incur short term capital gain if we didn't hold the property long enough, or if we are "dealers" in real property. The unrelated business taxable income rules are different, however. There is no long-term or short-term gain provision. Although income from the sale of inventory or property held for sale in the ordinary course of business is taxable, gains from the sale, exchange or other disposition of property otherwise is not. There are literally hundreds of cases on the distinction between inventory and property held for long term gain under the personal income tax provisions of the Code (following a fact-based case by case analysis), the provisions relating to UBIT are not so well elaborated. If this is a one-time "flip" project and your IRA doesn't become a "dealer" in real estate, you'd have a stronger argument that the profits are exempt from UBIT because they are not inventory and not property held in the ordinary course of business. On the other hand, if you are in fact a "dealer" and will incur short term gain income on the "flip" yourself, there would be a strong argument that your co-investing IRA could end up with UBTI as well.

One other important issue is whether the IRA's co-investment in the LLC is really a "personal benefit" to you. Receiving a personal benefit other than a distribution is a clear prohibited transaction. That would occur if you are unable to make the full investment yourself, so you need your IRA"s funds to do the project. If you are able to do the project yourself without the use of the IRA funds (and can clearly demonstrate that you could), and you are really cutting the IRA in on an opportunity it would not otherwise have, most custodians and many professionals would argue that's not a personal benefit to you.

I have set up LLC co-investment arrangements for a number of clients, using two classes of LLC interests to permit the individual (not the IRA) to make additional investments later if circumstances arise that require it, while the IRA is not "assessable" because it has no more resources and therefore makes no additional investments. After the initial investment, current interpretations of the prohibited transaction "attribution" rules suggest that a later investment by the IRA under these circumstances would be a prohibited transaction anyway. (Department of Labor regulations also appear to permit loans from an IRA owner to the IRA under limited circumstances to avoid losses to the IRA, but these regulations are very new, and most self-directed custodians don't know how to do it technically or administratively, so I'd be less inclined to base the transaction on using the DOL's loan regulations for now.)

In short, co-investing with your IRA is more complicated and more risky than keeping your IRA's investments completely separate from your personal investment and/or entrepreneurial activities, but it's not impossible. The transaction costs are higher, too, so the investment opportunity (expected profit) needs to be sufficient to support the out of pocket costs.

I hope this helps.

You can either move your funds to an IRA at a qualified self-directed custodian, or establish a "solo" 401(k) for your business.

You can establish a self-directed IRA (Roth, traditional, SIMPLE, SEP) (in general I call any type of self-directed retirement account a "SDRA") and then direct the custodian to invest the amount you want to use for self-directed investment into an LLC to be owned 100% by the retirement account. You would be the manager of the LLC and have check book control.

You mentioned that you have an LLC, which suggests that you have a business. If you own your own business and have no employees (other than your spouse), you can adopt a "solo" 401(k) plan for the business. The "solo(k)" plan would be a plan to which your business make plan contributions as the employer on behalf of yourself as the employee, and you could also take "elective deferrals" from your personal earnings as an employee. Your elective deferrals can be either into a "traditional" bucket (pretax) or to a Roth bucket (after tax). You can use a Solo(k) plan as a SDRA.

If you set the Solo(k) up with a self-directed custodian, the custodian will provide the plan documents for you to establish the plan and your accounts in the plan, and will keep track of contributions, distributions and account values (other than hard to value assets). They will also provide a third party administrator to prepare the annual reports to IRS that are required.

Another option would be to establish a Solo(k) plan yourself without a custodian, and hold the funds yourself as the plan's trustee without a custodian. However, this option is dangerous if you don't have the right plan documents, you don't keep track of the contributions and account values correctly, and/or you don't make the right annual reports to IRS. If you establish the plan with a qualified custodian that offers self-directed Solo(k) plans, you will have them as a safeguard for compliance purposes.

By the way, the advantage of a Solo(k) plan over a self-directed IRA is that Solo(k) plans are not subject to unrelated debt financed income tax. IRAs, Roths, SEPs and SIMPLEs are subject to the tax.

Also, please note that in no case can you provide services to any type of SDRA, including a Solo(k) plan, other than fiduciary services. You can hire others to fix the plumbing, make renovations, etc., but you can't provide those goods and services.