How does Self-Directed IRA work?

Question

Steven Hamilton II · Answer

I can happily explain it to you. UBIT can be a good and a bad thing.  A good thing because you are making money and bad thing if there is too much income taxable through it.(the tax burden can be significant).  This is why I am such a big fan of Solo 401ks.

Jon Holdman · Answer

Yes, you can roll your money from your existing account to a SDIRA.  No penalties.

No, most banks and traditional custodians do not offer this type of IRA.  But there are companies that do.  I'm currently using IRAServices.

There are some serious rules to follow.  The IRA is a completely separate entity from YOU and the two of you can never, ever do any sort of deal together.  You can't sell a property to your IRA.  The IRA cannot loan you money.  And not just you, but your spouse, descendants and ancestors, any entity controlled by one of those persons and certain other persons with a fiduciary duty to your IRA.  If the IRA does buy a property, you cannot in any way benefit from that.  All the money that goes into the property must come only from the IRA.  Any profits must go back into the IRA.  You cannot do any work on the property.  I was advised by an attorney to avoid having the IRA even own property near properties I personally own.  Your IRA can get a loan, but you cannot personally guarantee it.  It must be a "non-recourse loan".

Even though your IRA is a tax-deferred entity, some transactions can cause it to pay taxes.  For real estate, fix and flipping, wholesaling, developing a property, or any other sort of "active" business will trigger UBIT - unrelated business income tax.  If your IRA owns a rental, there is an exemption for rental income.  As long as it is not financed.  A financed rental inside an IRA will owe taxes, too.  A special form of UBIT called UDFI - unrelated business debt financed income.

IMHO, actually owning real estate inside an IRA is not a great plan.  The lack of leverage and the taxes are troublesome.  The rules are also troublesome.  Break a rule and your IRA is considered to be fully distributed and you will own taxes and penalties on the full amount.  If your property needs a new roof, the IRA doesn't have the cash, and the IRA cannot borrow the cash, you're not getting a roof.   You cannot buy the roof, or borrow money personally to buy the roof.  So, you MUST always keep significant reserves in place to deal with such a problem.  A better strategy, I think, is making or buying loans.  No UBIT on interest income.

Mark Nolan · Answer

@Sheba Shimoji

If you are self-employed, also take a look at the self-directed solo 401k as it is generally more advantageous.

Loren Whitney · Answer

While I agree with the others about consulting with your tax adviser, you should hear both sides of the story because so far "UBIT" is being portrayed as a terrible obstacle and deterrent.

When and if you choose to leverage your IRA and obtain a non-recourse mortgage (no personal guarantees), that mortgage is NOT reported on your own personal credit report. This is because the non-recourse is taken out in the IRA's name, not your own identity. This may have it's own benefits if you're trying to acquire other financing personally as it doesn't effect your DTI ratio in any way.

Also, you do not lose your ability to deduct depreciation, mortgage interest, and other expenses when you leverage. If your IRA is subject to UDFI (unrelated debt financed income), it's because you're making a profit on non-retirement dollars taken from a bank or lender. In this situation, you can deduct all normal (prized) real estate expenses in proportion to your debt ratio. It actually gets more complicated than this but you should know that expenses can in fact offset income and in some cases, even result in a net loss for the IRA to offset future UBIT. In the event you conduct an operating business inside the IRA, all income is subject to UBIT.

Lastly, if you're able to pay off your mortgage a full 12 months prior to the sale (zero debt ratio calculation at time of filing) of your real estate, you can avoid UBIT taxation on any of the gains you derive at sale. You don't have to recapture depreciation but instead receive all profits back to the IRA on a tax-advantaged basis.

The bottom line is that you should learn about the rules and strategies for yourself in an effort to make educated financial decisions (with the help of your financial team of course).

Cheers!

John Thedford · Answer

@Sheba ShimojiI agree with

@Jon Holdman

talk to your tax advisor BEFORE you put RE into your IRA or similar investment plan. There are lots of companies promoting self directed plans (they make more money) BUT....they are not tax advisors and don't give you the pros and cons of putting RE into one. Here is why NOT to:You lose the ability to depreciate. So, you are giving up 27.5 years (residential) write offs.You lose the ability to write off your taxes.You lose the ability to write off your insurance.Etc....ALL writeoffs (which are tax benefits) are gone! As an option, if you set up a self directed plan, you can always do money lending. If you don't choose to enter into something such as HML, or invest in gold, etc I see no reason to set up a self directed plan.  Having RE inside of a retirement account sounds so sexy, but it may not be the best plan all things considered. Talk to your tax guy.

Loren Whitney · Answer

Welcome to BP @Sheba Shimoji

You'll find lots of resources about SDIRAs here on BP. Here are a few blogs I've posted on the BP site regarding real estate IRA investing.

Wait... My IRA Can Get A Mortgage And Buy Real Estate Too?

3 Ways to Invest in Real Estate with IRA/401k Funds

Dmitriy Fomichenko · Answer

@Sheba Shimoji

Jon pretty much covered the basics. You can buy a property in your IRA using leverage, but it can not be a conventional loan since you are prohibited from providing personal guarantee, the loan has to be non-recourse. Typically you will need 30-40% down. There is just a handful of nationwide lenders offering these loans, but many private investors will consider that as well.

Yes, you can use your IRA as a bank and become a lender to someone else (or someone else's IRA) who wants to buy real estate with leverage. This is very common. With SD IRA you have almost limitless investment choices.

How does Self-Directed IRA work?

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