Rental Property Investor · Potomac, MD · Member since 2016 · 115 posts · 64 votes
The way I see it, there are basically two ways to use an IRA to finance investments:
1) Have the IRA "buy" the property and ALL income and expenses are paid to/from the IRA. If financing is used in the purchase of the property, the IRA is subject to pay UBIT taxes. It really bothers me that my IRA would have to pay taxes, but perhaps the benefits outweigh this one negative.
2) Have the IRA be a private money lender and finance OTHER people's deals. You can't finance your own deals through your IRA because it would be considered a "prohibited transaction"
a) Form an investor group which lends each other money from their IRAs. If Sally lends Joe money, Joe lends Roger money, and Roger lends Sally money there are no "prohibited transactions". The investor group could either mutually agree on standard loan terms that all abide by or shop for the best terms within the group for each deal.
This is undoubtedly a simplified view on a complicated topic, but am I at least in the ballpark? Are there some other strategies that I am overlooking?
@Todd Magin, Perhaps I can take a bit of the sting out of your point 1. To keep the math easy, an IRA has $100k to invest (leaving a necessary amount for expenses). You find one property for $100k. You can rent it out for $1,200 / month, net ~ 12% for the year. Instead, you find two houses at $100k and buy both using a 50% loan to value non-recourse loan on each. Rent them both out. Doubled your net income and return on investment. However, 1/2 of the funds were not your IRAs money. In this example, your IRA pays unrelated debt finance income tax (UDFI, a subset of UBTI) on 50% of the income, AND is allowed to deduct a ratio of the expenses. If you run the numbers, even after paying an income tax on the portion of income generated using non-qualified money, you are still ahead of the initial 12% total ROI. Making more money using someone else's money. Not a bad deal. Those funds do not become qualified funds just because they are loaned to an IRA, so they do not get the tax deferred treatment. Does this help?
@Todd Magin, Perhaps I can take a bit of the sting out of your point 1. To keep the math easy, an IRA has $100k to invest (leaving a necessary amount for expenses). You find one property for $100k. You can rent it out for $1,200 / month, net ~ 12% for the year. Instead, you find two houses at $100k and buy both using a 50% loan to value non-recourse loan on each. Rent them both out. Doubled your net income and return on investment. However, 1/2 of the funds were not your IRAs money. In this example, your IRA pays unrelated debt finance income tax (UDFI, a subset of UBTI) on 50% of the income, AND is allowed to deduct a ratio of the expenses. If you run the numbers, even after paying an income tax on the portion of income generated using non-qualified money, you are still ahead of the initial 12% total ROI. Making more money using someone else's money. Not a bad deal. Those funds do not become qualified funds just because they are loaned to an IRA, so they do not get the tax deferred treatment. Does this help?
@Todd Magin, as to your point number 2, there are no prohibited transactions as long as the people are not disqualified persons (DP) in relation to each other. The list of who is a DP is broader than just one's self. See this IRS list.
@Todd Magin summed it up perfectly I think. One of the expenses you can count is depreciation on the portion that is financed (50% in his example). With that in mind, there might now even be any tax in the early years. One option to avoid that issue, if you qualify is a SOLO401K, which is not subject to taxes in the case of borrowing. We are doing all of our new purchases in our SOLO401Ks for that purpose, along with the much more generous contribution limits.
I also look at it I can make say 18% owning a rental in a SDIRA or 12% loaning money, Ill take the 18% ;-)
A lot of folks panic when they see that tax applies to a leveraged investment in an IRA. With a little research, it becomes clear that the result is a net positive. Would you pay $200 in taxes to make an extra $1000? The ability to use leverage in an IRA and create a higher cash on cash return as a result can be a real benefit, and if at the end of the day the return on investment is better than other options you have with the IRA, then you have come out ahead.
There are other ways to invest IRA money in real estate, including establishing a partnership of several investors (IRA funds or otherwise) to purchase a larger property. Your IRA can also purchase an option on property. There are also real estate related investments such as tax liens or deeds and distressed notes that can be profitable if you know what you are doing.
I would urge caution with a lending circle. If I lend you money from my IRA, and you lend me money back, then the IRS could view you as a straw man I am using to access my own IRA funds.
@Todd Magin summed it up perfectly I think. One of the expenses you can count is depreciation on the portion that is financed (50% in his example). With that in mind, there might now even be any tax in the early years. One option to avoid that issue, if you qualify is a SOLO401K, which is not subject to taxes in the case of borrowing. We are doing all of our new purchases in our SOLO401Ks for that purpose, along with the much more generous contribution limits.
I also look at it I can make say 18% owning a rental in a SDIRA or 12% loaning money, Ill take the 18% ;-)
Dan Dietz
How does that work in the case of the solo k? Are you saying you can borrow money on a property and not pay UBIT?
@Account Closed Thanks for your insightful comments. On point one, to be picky, you won't double your return because you have to service the debt, but perhaps you'll increase your return to 18% instead of 12%. After a bit of further reading, you can also take advantage of depreciation to offset income so in the first few years you are not likely to be paying any UDFI. Bottom line, option 1 (IRA owning property) is not as bad as I once thought.
As for option 2a (investor group providing loans to each other), as long as the investors are not related (parents, siblings, etc) and they are not part of a formal structure which ties the IRAs together (partnership, LLC, S-corp, etc), there would not be a prohibited transaction.
Are there people out there doing this kind of thing or is it just a pigment of my imagination? :)
The Solo 401k is exempt from the specific type of UBIT (UDFI tax) on debt leveraged real estate investments. So, while a SD IRA would pay UDFI on profits from a real estate investment using a lender, the Solo 401k would not.
I agree with @Brian Eastman's comments regarding the lending circle. There is a risk that a prohibited transaction could be found to have taken place in situations like this.
If Person A is a disqualified person with respect to Plan A, no transactions can occur between the 2.
If Person B is a disqualified person with respect to Plan B, no transactions can occur there either.
If Plan B transacts with Person A (assuming they are not DQP), that is likely not a problem.
However, if Plan B transacts with Person A and Plan A transacts with Person B, there could be some issues if the IRS/DOL is looking at all the facts involved.
Getting creative to accomplish what is essentially prohibited is risky and, in some specific cases, clearly prohibited as well.
@Brian Eastman@Daniel Dietz WOW, I've been on BiggerPockets for one day and it's already paid for itself ... oh right, it was free!! :) Seriously, thanks for the input. You have confirmed my hopes, alerted me to dangers, and guided me to other avenues to explore.
Educate me, what is a SOLO401k and where can I find more info on it?
@Mike Reynolds I am just finishing up setting up my SOLO401K as we speak, but yes that is my understanding after talking to several professional providers here on BP and reading extensively on it too. I have never read or heard WHY the difference, but it is there. Kind of like about the only kind of retirement plan you cant roll into a SOLO401K is a ROTH IRA, which happens to be where all of my funds sit :-( You can make a NEW contribution, just not roll existing funds.
A Solo 401(k) is an employer sponsored retirement plan designed for owner-only businesses. If you are self-employed and have no full time employees, you qualify to establish such a plan. A Solo 401(k) is a great vehicle for self-direction.
As noted, a 401k is not subject to Unrelated Debt Financed Income (UDFI) taxation when the debt is for acquisition of real property.
A Solo 401k is an IRS-approved qualified plan that can be setup by a self-employed individual or business owner with no full-time W2 employees. The self-directed variations allow for investment into alternative assets such as real estate, just as a self-directed IRA would. There are many advantages to the Solo 401k (over the IRA) however, if you are eligible. You can research these plans here on BP (there are a lot of threads about them) or by searching the web for providers of these plans that can help. At least a couple providers have posted in this thread as well.
The Solo 401k is exempt from the specific type of UBIT (UDFI tax) on debt leveraged real estate investments. So, while a SD IRA would pay UDFI on profits from a real estate investment using a lender, the Solo 401k would not.
@Brian Eastman@Daniel Dietz WOW, I've been on BiggerPockets for one day and it's already paid for itself ... oh right, it was free!! :) Seriously, thanks for the input. You have confirmed my hopes, alerted me to dangers, and guided me to other avenues to explore.
Educate me, what is a SOLO401k and where can I find more info on it?
What a great forum!!
BP is not your normal cyber community. These people here have saved me thousands of dollars. I try and do the same to those I can help too.
@Mike Reynolds I am just finishing up setting up my SOLO401K as we speak, but yes that is my understanding after talking to several professional providers here on BP and reading extensively on it too. I have never read or heard WHY the difference, but it is there. Kind of like about the only kind of retirement plan you cant roll into a SOLO401K is a ROTH IRA, which happens to be where all of my funds sit :-( You can make a NEW contribution, just not roll existing funds.
Dan Dietz
I am setting one up also. I was going with an sdira but after further looking at it going with a solo.
All very interesting there are so many way to take advantage with SDIRA. My situation:
Admitting to being stuck in SDIRA analysis over the last couple of months, it could be that I found a really great option for me (keeping in mind my own strengths and weaknesses):
Here locally I found an investment adviser who focuses on RE focused SDIRA. This organization is the "keeper" of the IRA account with custodian. It may not be for everyone but here is what is attractive for me:
Transfer my IRA to this organization, I still control where and how the money is invested
At my request the adviser organization distributes the money as instructed while confirming the transaction aligns with all regulations
No LLC required
Any payments out of the IRA (property maintenance, Taxes, any qualified expense) does not have a check fee attached to it as long as it is paid via ACH
There is a network of non-recourse lenders attached to this organization which will lend 50% ltv (local) -- yes UBIT but as others of said if it cost a little money to get a significantly greater Net return why not...you have to see the forest and not let the trees get in the way
As an added bonus for non-IRA business this organization seems to have a fair amount clients with SDIRA that do not purchase RE but they lend / create notes for RE investment -- of course I will need to establish credibility but this could open a lot of doors
Downside depending on total $ amount the fee is ~ 1% annual but for me this is big piece of mind
Not my intention but I am told you CAN flip in this type of arrangement without issue/tax, just can't do the work -- even though I don't plan on doing flips it does make me nervous that everyone else says no can't do it
I still have a fair amount of due diligence to do but this seems like a good fit for me as the one major hurdle for me is my own ability to keep records which are beyond reproach for the IRS.
@Bernie Huckestein I would suggest having a CPA who is well-versed in SDIRA & UBIT look over any deal with the organization so you clearly understand the tax implications and necessary paperwork.
If you are interested in flipping through the SDIRA, you should consider a partner and look to loan the money. My understanding is that because flips are not a passive RE investment, they are subjected to UBIT, but you can partner with someone and loan them the money to do a flip.
Regarding "To keep the math easy, an IRA has $100k to invest (leaving a necessary amount for expenses). You find one property for $100k. You can rent it out for $1,200 / month, net ~ 12% for the year."
The math may be "easy" but it isn't realistic. Making $12,000 (12%) on $14,400 in rent? You expect $2,400 (17%) in total expenses? If you do your own PM (0%), never have vacancies (0%), tenants always pay (100%), don't have or pay for insurance (why? tenants are great!), you still need to pay property tax and SDIRA custodian fees.
With the 1% rule-of-thumb for rents, and 50% rule-of-thumb for expenses, expect about 6%, unleveraged.
Regarding "...you find two houses at $100k and buy both using a 50% loan to value non-recourse loan on each. Rent them both out. Doubled your net income and return on investment." Assuming free financing, no closing costs, and the assumptions (17% expense) above, that may be true.
I agree with your deeper analysis of the numbers. That said, the principal of what that poster was saying still applies, despite the simplified example.
When you use leverage in an IRA there is the potential to generate a higher cash-on-cash return for your IRA dollars. The impact of UDFI taxation is minimal and does not negate the overall benefit of using leverage.
As with everything in investing, you need to run the numbers carefully. In this case, you will want to be sure you understand the cost and administrative overhead associated with using debt-financing in an IRA, in addition to the basic metrics of whether a rental property deal makes sense.
What I would caution against is comparing owning a rental property in an IRA to owning a rental property with non-IRA funds. The tax scenario is entirely different. When evaluating a property investment with an IRA, one should compare; A) that rental property vs other investment options one has with the IRA funds, and B) an all cash purchase as opposed to the use of leverage.
@Daniel Dietz I am looking into establishing a SOLO401K next year which is self-directed. I believe you can roll 401k monies into that plan also.
@Justin Windham Is that correct? What are the list of funds that can roll into a Solo 401k?
@Todd Magin Welcome!!! This has been an unbelievable community for me. Joined in the spring but only became active in the past 6 weeks. Having a ball, trying to learn it all!!!
@Sonny Ruckstuhl Thanks for the warm welcome. I should probably let the experts speak, but all the research that I've done indicates that any 401k or IRA can be rolled into a SOLO401k. If this is not true, it's a complete non-starter for me.
I also just read that a SOLO401k can have a sub-Roth IRA account contained within (funds kept separate, of course). Any funds that go into the Roth portion need to be post-tax, and funds that go into the main 401k portion are pre-tax. Perhaps the experts can weigh in on this topic as well.
I agree with your deeper analysis of the numbers. That said, the principal of what that poster was saying still applies, despite the simplified example.
When you use leverage in an IRA there is the potential to generate a higher cash-on-cash return for your IRA dollars. The impact of UDFI taxation is minimal and does not negate the overall benefit of using leverage.
As with everything in investing, you need to run the numbers carefully. In this case, you will want to be sure you understand the cost and administrative overhead associated with using debt-financing in an IRA, in addition to the basic metrics of whether a rental property deal makes sense.
What I would caution against is comparing owning a rental property in an IRA to owning a rental property with non-IRA funds. The tax scenario is entirely different. When evaluating a property investment with an IRA, one should compare; A) that rental property vs other investment options one has with the IRA funds, and B) an all cash purchase as opposed to the use of leverage.
I'm not following your cautionary point. The property investment, whether funded by the IRA or by cold hard cash needs to stand on its own and deliver stellar returns. Are you trying to make the point that there are additional overhead costs involved with funding the investment within the IRA and these should be factored into your analysis of the property?
@Todd Magin You can roll over most types of retirement plans into a Solo 401k, except for a Roth IRA. With a 401k, if it is with a current employer, the plan may not allow in-service distribution, meaning you won't be able to do a rollover until you leave the job.
What you also described is a Roth Solo 401k, and you are correct on the tax treatment. The funds going into a Roth Solo 401k is after-tax (you pay tax on the contributions or the converted amount), but then there is no tax when you withdraw from it after you reach 59 1/2 years old. This means your returns on investments will be completely tax-free.