I recently attended a Webinar dealing with the IRS which covered whether or not your IRA is operating as a true IRA providing you protection, and the advantages that come when dealing with the IRS. Before I go any further, I want to make sure and point out that a majority of these Webinars – this one included – were all about inducing fear so that the listeners rush right to a registration page to sign up for counseling and immediately get money switched over to the service provider on the Webinar. That is an unfortunate reality out there today. Fear is a highly motivating emotion and fear of getting sued or losing all of your hard earned money are two very powerful fear triggers. So now that my little disclaimer is over, I can tell you that there were several good points brought up in the Webinar and this a fantastic forum to share those precautionary notes.
In accordance with not making any assumptions, because we all know what assuming can do, right – I want to go over a couple of quick terms.
What is an IRA?
An IRA is an Individual Retirement Account. It is not an actual investment and is often times mistaken to be one. Rather, think of it as the investment vehicle that holds your investments such as stocks, bonds, mutual funds, real estate, precious metals or any other investment. IRAs are investment accounts that allow the owner to take advantage of various tax breaks and can come in many different forms – each with their own rules.
How Do You Purchase Real Estate with an IRA?
One of the most common ways that people purchase real estate with their IRA is purchasing shares in a REIT. However, an investment that has gained a lot of attention and traction with the housing bubble is the Self-Directed IRA. This is simply a characterization of an IRA where the owner makes the investment decisions for the account and not a brokerage firm. Remember that the IRA is not an investment. It is the vehicle.
Traditional vs/ Self Directed IRA
In a traditional IRA there is a brokerage firm advising you as the IRA owner and they conduct transactions for you. In a Self-Directed IRA, a custodian works on your behalf preparing the necessary paperwork to set up the IRA, but you are responsible for directing the investments. It is estimated that over 80% of the Self Directed IRA accounts that close are closed because the owner of the SDIRA has never directed a single investment transaction.
Now that we have a few basics out of the way, I will tell you that simply wanting to have a Self Directed IRA and actually putting it to good use are half the battle. Making sure you put the IRA to good use in a proper and legal way are the other half and you don’t need to hire out services or buy a do-it-yourself protection plan to get the basics down.
Self Directed IRA Key Tips
- Keep Your SDIRA Passive: A common misconception is unveiled when purchasers ask about using their IRA to purchase their own home or to purchase a second home. A key component to keeping the tax advantages for your SDIRA is to keep it passive. Arms length transactions are key and it is vitally important that investors only make purchases where they plan to use the property as an investment property that will be occupied by a tenant and not the owner themselves.
- Taking Cash Flow Distribution From Your Account: The income provided from your SDIRA is absolutely your money, but that does not mean you can bypass the IRA and take the money directly from the investment. The custodian who you choose to help set up your IRA is responsible for all distributions and all income. Deviating from that process can wipe out the tax protection and advantage and lead to taxes and penalties. It is legally your money, but you are using the SDIRA for protection and tax planning and just like a traditional IRA, there are time frames for taking withdrawals and distributions.
- Self-Dealing & Non-Arms Length Transactions: Often times investors are interested in the SDIRA for its tax advantages and they are interested in protecting their wealth and assets with entity protections. Setting up LLC’s or other legal entities to hold title and create barriers from lawsuits. Unfortunately, the two plans do not always line up. You can purchase property and title it in the name of an entity and fund it with your SDIRA as long as you do not own the property before hand. In other words, you cannot purchase property, place it in the name of an LLC and then set up a SDIRA to purchase that property from your LLC. The transactions must be arms length in nature meaning you cannot buy something from yourself or from your spouse or children or parents. There are some family member exceptions but they are not pertinent to this article and you would definitely be advised of those by your custodian. As it pertains to this article, you want to make sure that you are not using your SDIRA to create tax advantages on wealth and assets that you already own.
- Separating expenses from your SDIRA: Two big problems can occur when purchasing an asset like real estate with your SDIRA. First, from the very beginning, every cost associated with the purchase must come from the SDIRA. If an investor places earnest money on a property and writes a personal check, then the transaction could be voiced and considered outside of the SDIRA, which could mean penalties and taxes. Second, if an investor purchases a property and does not leave a proper amount of reserves in the SDIRA itself it can lead to problems. With real estate, there are always going to be scenarios where additional costs are going to be incurred. There are rules in place limiting deposits into a SDIRA just as on a traditional IRA and paying for expenses outside of the SDIRA can have major consequences. So when purchasing real estate, make sure that you have the additional funds in the account to cover any future expenses.
A quality custodian will always cover these areas with you thoroughly on the front end and take steps to make sure you avoid mistakes. That being said, knowing the rules and properly preparing to use your IRA can lead to a great investment experience without having to go through the fear mongering to protect your self.