IRS Rules For Retirement Accounts

Typically retirement plans invest in Stocks, Bonds and Mutual Funds. Retirement plan investments are restricted by the plan document. If you work for a large company, there is probably no flexibility in investment types. Most retirement plans are not self-directed and the investments are limited to those approved by the plan created by your employer, Bank or Brokerage firm. However, if your plan is self-directed you can invest in anything but Life Insurance Policies, Collectibles (Art, Coins, Cars, etc.).

What Is A Self-Directed Plan?

You make all the investment choices. You are responsible for all profits and losses. The structure of the self-directed IRA is such that you are a separate entity and the IRA is a separate entity. You will have a third party administrator that completes the record keeping and tax reporting. You have a Custodian/Trustee that holds the money. This Custodian/Trustee must be IRS approved. Typically the Administration firm and Custodian/Trustee are the same company that you use to complete the task. There are only a handful of recognized nationwide firms that truly handle self-directed accounts. At the time of writing, one such firm charges $250/annum per asset, which really considering what they do, is quite reasonable.

Restrictions On Real Estate Held In A Self-Directed Plan

The real estate must be held for investment purposes only. You cannot rent the property to ascendants ( parents, grandparents, you or your spouse, children or grandchildren). However, you may rent to aunts, uncles, cousins, brothers, sisters, nieces, nephews. You may not let disqualified people use or live in the property.

Prohibited Transactions

Neither you or any disqualified people may benefit from the IRA. You cannot buy, sell or exchange property between the plan and yourself or disqualified people. It cannot provide goods, services or facilities for the benefit of disqualified people.

Who Is A Disqualified Person?

Yourself, spouse, lineal ascendants, lineal descendants, employer of the plan, fiduciary, anyone providing services to the plan, if you are a 50% owner of a corporation, partnership or trust owning or benefiting from the plan.

Advantages Of Owning Real Estate In A Plan

Capital gains are tax free or tax deferred. Positive cash flow generated by the investment is tax free or tax deferred. There is no time limit for holding the property. The IRA can borrow money, leveraging your investment. You have the potential to earn a larger rate of return on invested capital.

Disadvantages Of Owning Real Estate In A Plan

There are no tax advantages of owning real estate. There is no deduction for capital losses. You are solely responsible for all gains or losses.

Your IRA Can Take Out A Loan

You can take out a loan to purchase real estate. The loan must be a non-recourse loan (upon default the lender can seize the property. Upon default the lender cannot seize other IRA plan assets or seize your personal assets. There are few lenders to choose from as it must be a portfolio loan and the loan cannot be sold on the secondary market. It just so happens that 1st Bank will do these loans, so we are lucky here in Summit County! A larger down payment is required, typically 25-35%. You cannot personally guarantee the loan. The IRA must cover the costs of ownership, so if this is a rental property, generally speaking, in Summit County you would need to put down approximately 60% so that the property reaches a positive cash flow situation for the IRA to meet the lending requirements.

Personal Guarantees

Personal guarantees by the IRA owner are not permitted, however, a personal guarantee can be held by a third party as long as they are not a “Disqualified person, “ (ascendants, descendants, spouse or self, etc.).

Investment Options

Lease options, Notes, 2nd Deeds of Trust, Single Family Homes, Condos, Townhomes, 2-4 units, Vacant Land, Mixed Use Properties, Commercial Property, Multi Unit Properties, Foreclosures, Re-Model Projects (fix and flip), Tax Liens, LLC’s, Businesses.

Types Of Self-Directed Plans

IRA’s (Traditional, Roth, SEP, Simple, Spousal)

Qualified Plans (401K/457/403b, Defined Benefit, Profit Sharing, Individual K)

Other (Coverdell, Health Savings Account)

Move Money Between Accounts

Rollover –One type of account moves to a different type of account, e.g. 401k rollover to traditional IRA. The thing to remember is that you do not want to receive the funds directly to yourself to then transfer over. Have the assets sent directly to the new Custodian.

What If There Is A Shortage of Money?

If the property investment held in the IRA makes a loss and there is a shortfall in the account, you can make your yearly contribution, liquidate other assets within the IRA, transfer money from other retirement accounts, bring in a partner (as long as they are not a disqualified person), IRA can get a loan, sell the asset.

The Miracle Of Compound Interest And Leverage In An IRA

As we all know, when done correctly leverage on a real estate investment can yield a much greater return. All the profits on that investment can be re-invested. If pre-tax money is invested, the money grows tax-deferred. If after-tax money is invested, the money grows tax free.

Real Estate Vs. Other Investments

Let’s say that you have starting capital of $250,000. You put that $250,000 into a traditional investment and it appreciates at 8% per annum, it is only the value of the initial $250,000 that is compounding and appreciating per year.

If you used the $250,000 as a downpayment within the IRA for a $400,000 property (remember it has to cash flow). That $400,000 property appreciates at about 8% per annum (Summit County Statistics). Your loan of $150,000 is at 7%, therefore your net interest gain is already at 1%. Then you will be reaping the benefit of appreciation compounded based upon $400,000, not the $250,000 you put down!

Search for homes in the local real estate market

I am not a Certified Public Accountant or a Tax Attorney; however, if you are interested in learning more about this, I would be happy to point you or your attorney or accountant to the financial institutions and advisers that specialize in managing these types of retirement plans. Please don't hesitate to contact Andrew Biggin at Breckenridge Associates for more information about the Summit County real estate market.