Prohibited Transactions with a Self-Directed IRA/LLC

[Tim Criswell]

Is it "IRS legal" to buy a distressed property with a self directed IRA-LLC, hire a contractor to do all of the rehab., hire an atty., a realtor and other third party services to process the documents, and put every penny of profit back into the IRA the money came from without disqualifying my IRA? And if the answer is yes, is the line to do it properly/legally so tight, that I'd be better off doing it with funds that won't get the tax benefits?

[Brian Eastman]

@Tim Criswell

There is nothing that would violate the tax rules in what you outline.

You are allowed to administer your IRA, which includes making decisions, hiring vendors, paying the expenses of acquisition and maintenance of IRA assets, and receiving the income produced from investments into the plan.

So long as all of your actions are via the plan, and for the exclusive benefit of the plan. You are OK. You cannot personally benefit from the IRA, such as by paying yourself a management fee or living in an IRA owned property. Likewise, you cannot inject value into the IRA via the provision of goods or services above and beyond basic administration. That means you should not be working on the property personally or turning yourself into a delivery person making daily trips to the hardware store.

But, while flipping houses can be done within the IRS rules... there is a potential catch.   

An IRA is tax-sheltered when it receives passive investment income such as interest, dividends, royalties, rent from real property, or the capital gain on a passively held asset. Flipping houses is not such a passive activity, and is considered a trade or business - think manufacturing or maybe "re-manufacturing" property for sale. When a tax-exempt entity engages in a trade or business on a regular or repeated basis, the gains are treated as taxable Unrelated Business Taxable Income (UBTI). The trust tax rates that an IRA pays can ramp up to 37% pretty quickly.

As such, the occasional and infrequent flip in an IRA (in a hand's off fashion) can work. A focused strategy of buy/fix/sell/repeat would expose the IRA to taxation that negates the benefit of deploying the IRA into the opportunity.

Alternatives without the UBTI exposure include:

Using the IRA as a bank and lending money to unrelated flippers for passive interest income.

Buy/fix/hold as a rental for at least 12 months before selling. (What I like to call a Hybrid Flip).  The year of passive income usage recharacterizes the transaction as passive so there is no UBTI concern.