Although the national real estate trend is cooling, real estate in the Northwest is still a solid investment. Many of our clients are looking for ways to invest their own retirement funds in real estate. Unfortunately, this is not a simple legal process to navigate.
Other than restrictions on life insurance contracts (IRC 408(a)(3)) and collectibles (IRC 408(m)(1)), an IRA can invest in anything, including real estate. Truly self-directed IRA investing comes with additional rules and regulations that apply whether one invests in real estate or mutual funds.
First, IRC § 4975 stipulates that an IRA can’t do business with any “disqualified person.” A disqualified person would be a client, spouse, anyone up or down a client’s bloodline, their spouses, the IRA fiduciary (the trustee, administrator or custodian), or any entity owned 50% or more by a disqualified person. Hence, an IRA-acquired investment property can’t be rented, sold or purchased by or from anyone on that list. An IRA owner may take the property as a distribution.
Second, IRA investments must be “passive.” They can gain income and appreciation on their own, but one can’t make a day job out of, say, flipping IRA properties or developing IRA-held land. That could trigger the unrelated business income (UBIT) tax under IRC 511. The tax is 15–35% of the gains (the first $1,000 is exempt), but it applies only to the profit after deductions and expenses.
Third, if an IRA needs a mortgage or outside loan to fully pay for the real estate, the profits made as a result of the loan are considered unrelated debt-financed income (UDFI) under IRC 514 and are taxed at 15–35%.
When it comes to self-directed investing, the most frequent questions are about what kinds of investments and transactions are acceptable and which are not. Both the Internal Revenue Code and ERISA have sections pertaining to self-dealing and “prohibited transactions.” Most prohibited transactions are the result of commerce between the retirement account and a disqualified party.
The retirement account cannot, directly or indirectly, sell, exchange or lease any property to or with you or a disqualified party. Some examples of prohibited transactions include, but are not limited to:
Using the retirement plan to buy a home for you to live in now.
Pledging assets of the retirement plan as collateral for a loan.
Selling personal investment property to the IRA.
Buying collectibles, such as rugs or gems, with retirement funds.
Lending money to a child.
Owning/purchasing stock in an S Corporation.
Using a traditional IRA to benefit a ROTH IRA.
The purchase of life insurance.
One of the most difficult, yet important, tasks an investor faces when looking to participate in a self-directed IRA is finding the right IRA custodian. In most cases, the custodian or trustee also will serve as the administrator for the retirement account. There are very few non-traditional IRA custodians, simply because the business is not as profitable as it is for the brokerage houses and it requires more service to complete a real estate purchase. Because their systems, for the most part, cannot be automated, custodians charge asset fees just for having the account and then transactional fees for every investment. This is not unlike fees charged by high-end brokerages instead of commissions for trades.
Traditional brokerage houses don’t compete because it doesn’t fit within their business objectives. They make money by leveraging money. For example, a bank will charge very little to administer the IRA (which can only buy bank products) because it will take those deposits and lend them at a higher interest rate.
The IRA custodian’s ability to react and service the request in a timely manner is crucial to the success with a “traditional” self-directed retirement account. The custodians who have the capacity to provide effective service can be more expensive.
Assuming a client finds an ideal real estate investment, they could have a Realtor write up a purchase-and-sale-agreement for the property. The purchase would need to be written up as being purchased by the retirement account. They would then have to download or request a non-publicly traded asset investment authorization form and fill it out.
The agreement then needs to be faxed to the custodian for review, complete with the authorization form, escrow wiring instructions and contact information. There may be a fee for this review and there will be a fee for the custodian to wire the earnest money to escrow.
The time it takes the money to get to escrow depends on the custodian, i.e., how long it takes to review the purchase, fill out the necessary documents and whether or not you paid an expedited fee. The closing agent (escrow or attorney) will forward the appropriate documents to the custodian to sign and fund the purchase of the home. There may be fees involved for a notary, wiring, recording, safekeeping and more. Once a purchase is recorded and funded, the deed will need to be forwarded to the custodian for safekeeping.
There are several companies that create self-directed IRAs and take care of the entire process, including Guidant Financial of Bellevue, CheckBookIra and Pensco. Attorneys who become familiar with the process could also help clients create these products.
