Flipping a house with a Self Directed IRA

[Michael Outar]

I am purchasing a SFR with a self-directed IRA along side a non-recourse loan. Much question is this. This home has flipping potential but I will not have enough reserves in the IRA to do all the improvements. Is there any way of getting the funds to do the upgrades without making a contribution into the IRA? Is there any loopholes or possibilities of using my own money without having to make a contribution to do the improvements. Any ideas would be greatly appreciated. Thanks.

[Frank L. Bridges]

Hi Michael,

Although I agree with Brian Eastman that co-investing with your IRA is less than optimal because of the increased risk that you might inadvertently commit a prohibited transaction, it is, nevertheless, possible to do so under certain limited conditions.

Most custodians follow the theory that if you invest "simultaneously" with your IRA, the entity is not a disqualified person at the time the IRA makes its investment (based on a Tax Court case that doesn't actually hold that). Recent tax court cases also suggest that it is possible to "subscribe" for the full amount to be invested and then add installments to meet the subscription obligation over time.

Since your financing is non-recourse, there will be no prohibited transaction arising out of a personal guarantee. However, you will receive debt financed income on the "flip" as a result and owe unrelated debt financed income tax from your IRA's portion of the financed profits. You have to do the numbers to make sure that the after tax return is enough to make the investment worthwhile.

Whether the profits from the "flip" are unrelated business taxable income (regardless of debt financing) is a little unclear under the law. Individually you and I would incur short term capital gain if we didn't hold the property long enough, or if we are "dealers" in real property. The unrelated business taxable income rules are different, however. There is no long-term or short-term gain provision. Although income from the sale of inventory or property held for sale in the ordinary course of business is taxable, gains from the sale, exchange or other disposition of property otherwise is not. There are literally hundreds of cases on the distinction between inventory and property held for long term gain under the personal income tax provisions of the Code (following a fact-based case by case analysis), the provisions relating to UBIT are not so well elaborated. If this is a one-time "flip" project and your IRA doesn't become a "dealer" in real estate, you'd have a stronger argument that the profits are exempt from UBIT because they are not inventory and not property held in the ordinary course of business. On the other hand, if you are in fact a "dealer" and will incur short term gain income on the "flip" yourself, there would be a strong argument that your co-investing IRA could end up with UBTI as well.

One other important issue is whether the IRA's co-investment in the LLC is really a "personal benefit" to you. Receiving a personal benefit other than a distribution is a clear prohibited transaction. That would occur if you are unable to make the full investment yourself, so you need your IRA"s funds to do the project. If you are able to do the project yourself without the use of the IRA funds (and can clearly demonstrate that you could), and you are really cutting the IRA in on an opportunity it would not otherwise have, most custodians and many professionals would argue that's not a personal benefit to you.

I have set up LLC co-investment arrangements for a number of clients, using two classes of LLC interests to permit the individual (not the IRA) to make additional investments later if circumstances arise that require it, while the IRA is not "assessable" because it has no more resources and therefore makes no additional investments. After the initial investment, current interpretations of the prohibited transaction "attribution" rules suggest that a later investment by the IRA under these circumstances would be a prohibited transaction anyway. (Department of Labor regulations also appear to permit loans from an IRA owner to the IRA under limited circumstances to avoid losses to the IRA, but these regulations are very new, and most self-directed custodians don't know how to do it technically or administratively, so I'd be less inclined to base the transaction on using the DOL's loan regulations for now.)

In short, co-investing with your IRA is more complicated and more risky than keeping your IRA's investments completely separate from your personal investment and/or entrepreneurial activities, but it's not impossible. The transaction costs are higher, too, so the investment opportunity (expected profit) needs to be sufficient to support the out of pocket costs.

I hope this helps.