Real Estate Rules in a Self-Directed IRA: How to Avoid Prohibited Transactions
Purchasing real estate through your self-directed IRA is one of the best ways to start building a passive income stream for your retirement. And in today’s economic environment, a retirement savings strategy that focuses at least partially on income replacement assets is especially important.
But because the funds in your IRA are tax-advantaged, the IRS has strict rules regarding the investments you purchase in a self-directed IRA, especially when it comes to physical real estate. These rules are known as prohibited transactions. Prohibited transactions are any transactions that exist between a retirement plan and a disqualified person (more on that below.)
What Will Happen If You Engage in a Prohibited Transaction?
Nothing good comes from engaging in a prohibited transaction. And while many of these rules can seem arbitrary (even illogical!), you’re expected to know and abide by them as a self-directed investor. If you do engage in a prohibited transaction, a number of unpleasant consequences may occur.
For instance, your account may lose IRA privileges altogether. In that case, you’d be responsible for paying any penalties and income taxes on the assets held in the account the year the prohibited transaction occurred. Many people simply wouldn’t be able to absorb the tax consequences.
Any self-directed IRA must be administered by a custodian, and a good self-directed IRA custodian should, at a minimum, be able to help you avoid prohibited transactions.
So today, we’re focusing on six prohibited transactions that are pertinent to real estate investors. As you’re building your retirement savings with income-producing assets, make sure to avoid these situations so you don’t run the risk of violating IRS regulations and missing out on the tax advantages of your IRA.
1. Purchasing Rules
One of the most basic prohibited transactions dictates which people or entities your self-directed IRA can purchase property from — or in other words, who your self-directed IRA cannot purchase property from.
For example, many people wonder if they can purchase investment properties they already own. Unfortunately, the answer is a resounding no.
You cannot purchase any properties you already own — or that a disqualified person already owns — with your self-directed IRA. In addition to yourself, disqualified persons include:
Family members including your spouse, your ancestors, and your children and their spouses (for whatever reason, siblings are not considered disqualified persons)
Your IRA beneficiaries
Your IRA fiduciary or custodian
Your investment advisors
Any businesses or other legal entities you have a stake in
Purchasing property from yourself or any other disqualified person is considered “self-dealing” by the IRS. Self-directed IRA investments may not be used to benefit you or any disqualified persons in any way, as the funds are set aside only for your future use in retirement.
2. Use Rules
Additionally, the IRS is very picky about who can use the property. Self-directed investments cannot, under any circumstances, be used as vacation homes by the owner of the IRA or any other disqualified persons — even for a 10-minute bathroom break!
When you purchase a property with your self-directed IRA funds, it must be purely used as an investment property. As stated above, these investments cannot benefit you in any way besides allowing you to build wealth for your retirement.
This also means that for any investment properties owned by your self-directed IRA, you can’t rent out space for yourself or a disqualified person to be used as an office, as personal storage, or for any other reason. It can only be rented to or used by nondisqualified persons.
3. Work Rules
Similarly, you and disqualified persons can’t perform any work on the property itself. Any physical labor, including maintenance work, home improvements, and repairs must be completed by a third party who has no other interest in the property.
This may be problematic for some investors who prefer to pour “sweat equity” into their real estate investments. But for those who are more than happy to pay someone else to do the work, the self-directed IRA is a great vehicle to purchase real estate and build wealth for retirement.
4. Title Rules
Self-directed IRA investments are owned by the IRA — not by you. This means that the property title will list your IRA as the owner, not you. All other relevant documents should list the IRA as the owner as well. Most commonly, you’ll see the name on the title as:
“Chicago Trust Administration Services FBO (for benefit of) [Your Name] IRA”
Of course, you may not always be able to purchase a property outright with your self-directed IRA funds alone. If you choose to co-invest with other funding sources such as a spouse’s self-directed IRA, your personal funds, or other investors’ IRAs, your IRA won’t be the only name listed on the title.
5. Financing Rules
Financing an investment property that will be purchased by your self-directed IRA isn’t easy, but it can be done. However, you must follow strict guidelines when financing an IRA-owned investment property.
To finance an IRA investment property, you can only use a non-recourse mortgage. A non-recourse loan means that in the case of default, the lender would only be able to recover the asset you financed — they would not be able to pursue any of your other assets as recourse for their loss.
Naturally, non-recourse loans benefit the borrower over the lender, so not many lenders are willing to provide non-recourse loans. These loans are also harder to obtain — you need to have an excellent credit history and you’ll likely pay higher interest rates.
When you finance an IRA-owned investment property, you’ll have to pay what’s known as unrelated business income tax (UBIT). UBIT is tax due on any profits that are attributable to the debt-financed percentage of the property.
6. Cash Flow Rules
Finally, it’s important to note that any income from the investment property — as well as expenses on the property — must flow into and out of the IRA. Income from the property is meant to grow the balance of your IRA funds — not your checking account. You cannot, under any circumstances, transfer any income to your personal accounts.
Likewise, you cannot pay for property-related expenses out of your personal accounts when the property is owned by the IRA. This can be beneficial for investors — it means they’ll never have to cover expenses with their own money! But there’s also a risky downside to this rule.
If the expenses exceed the cash available in the IRA, investors may have trouble covering those expenses, especially if they’ve already maxed out their IRA contributions for that year. However, this problem can typically be solved by rolling over existing contributions from other retirement accounts if necessary.
How Chicago Trust Administration Services Can Help
At Chicago Trust Administration Services, we help investors maximize their wealth by making strategic self-directed investments — and we provide the necessary knowledge and expertise so they don’t inadvertently engage in a prohibited transaction.
To see how we can help you make self-directed investments with confidence, we invite you to schedule a complimentary meeting with us by calling 312-869-9394 or emailing steve@ctasira.com.
___________________________________________________________________________
*The content and opinions in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
**CTAS professionals are not financial advisors and cannot provide advice or recommendations regarding specific investment decisions.