​I won’t invest in rental property in my Self-Directed IRA!

[Chuck VanDyne]

I won't invest in rental property in my Self-Directed IRA!

Yes, I said it! In most cases, it isn't advantageous to invest in rental property in with my Self-Directed IRA. Since there are a number of prohibited transactions and disqualified members it is a lot more difficult to maximize my return on investment.

With a SDIRA, I have to obtain a non-recourse loan which can mean a 35%-50% down payment. According to the IRS, I cannot manage the property myself, I cannot conduct any repairs myself, I cannot find my own tenants, I can’t even have my parents, spouse, children, or grandchildren do anything related to the property. It seems that unless you have a large amount of cash in your SDIRA and planned on having other people manage the property entirely then it isn't worth using your SDIRA.

In my case, I did not have a ton of money to start investing so it was hard to justify paying a 40% down payment for a single family home when I could just get a loan with a 15% down payment from MB Financial in Rochester NY with my personal money. I could also save myself 10% a year on property management, $1000 for tenant placement, and other expenses I would have paid not doing repairs myself.

I have found that the best method for investing in real estate in your SDIRA is when you are flipping properties. I can flip 10 houses a year and not pay capital gains tax on any of the proceeds until I withdraw it. I can even have checkbook access to the SDIRA so i can readily pay contractors to perform improvements. If I converted to a Self-Directed Roth IRA then I wouldn't have to pay capital gains tax at all! I would only have to pay taxes at the point of converting it to a Roth IRA.

I believe the tax advantages for investing in rental properties in my SDIRA are minimal considering my rental property already have a lot of tax deductions. At the end of the year the only money I pay taxes on is principal, capital improvements, and net income. I write off depreciation, depreciation on capital improvements, repairs/maintenance, interest payments, property management (my LLC manages), insurance, taxes, garbage removal, and utilities. After all my deductions I am left with a small amount of taxable income and certainly not enough to justify paying a larger down payment and extra expenses.

How do you guys feel? Am I missing something? Anybody flip properties in their SDIRA?

[Brian Eastman]

@Chuck VanDyne

I'd agree with a few of the other posters here that your information regarding the ability to administratively manage rental property is off the mark. You can negotiate, sign contracts and administer expense and income transactions. What you cannot do is receive a benefit or add value to the IRA through sweat equity.

That said, comparing investing in real estate with an IRA is an entirely different thing than investing in real estate personally. The IRS rules for an IRA are what they are, and the tax treatment of the IRA is entirely different than for you personally. What makes more sense is to compare investing in rental property with an IRA with other types of investments you can make with the IRA, as that is more of an apples-to-apples case.

Rental property - whether you manage to some degree or not - does allow you to use leverage (try doing that in the stock market) and can produce consistent returns. You likely will not hit a home run, but can really build your tax-sheltered IRA savings over time this way.

Flipping houses is also something where no sweat equity is allowed, so you would have to have a 3rd party contractor who is not lineal family do the work as a vendor do your IRA. Flipping houses, if conducted with any regularity or frequency (more than a few a year) will subject the IRA to Unrelated Business Income Tax (UBIT), which can be as high as 39.6%. That said, I have clients who flip houses, pay the tax, and receive a higher net ROI for their IRA after-tax than they would with other type of investments, because they know their market and how to properly flip homes there.

Lending money to flippers is a very common approach, and it sounds as if this may be what you have settled on. The points and interest are passive income and therefore not subject to UBIT as would be the case when the IRA has an equity stake in the flip profits.

An alternate, hybrid approach, is to buy a property in need of rehab, clean it up, rent it for a legitimate period of time (at least a year) and then sell it.  By turning the asset into a passive rental, there is no UBIT implication on that future sale.

All of the above strategies can be done with a self-directed IRA and produce good returns in a fashion that is arm's length and conforms to IRS rules. You just need to work with qualified counsel to ensure you understand the rules.

An entirely different approach that may appeal to you is to establish a Rollover as Business Startup. In that structure, the IRA can be rolled into a profit sharing plan or 401k that can own shares of an operating business (C-Corporation) that you are directly involved in. The business will operate in the taxable world as a real estate development company, but there are no taxes or penalties for using the retirement funds to capitalize the business in the first place. As you note it is your desire to create such a business for yourself, you might want to check this out.