Potentially Dicey IRA Situation...

[Matt Redmond]

An acquaintance of mine owns a single-family home that he walked away from 17 months ago. He stopped making mortgage payments and moved into a different home (a rental). Two months ago the mortgage company finally started the process of foreclosing on the home. Approximately $20,000 was past-due on the mortgage and this included principal, interest, escrow deficiencies and legal fees. The homeowner's primary concern was the effect of the foreclosure on his credit. I was unwilling to simply loan him the money to satisfy the mortgage company (because he clearly doesn't pay his debts!) so we entered into an agreement whereby I would pay off the past-due amount, take out a one-year option to buy the house for the remaining mortgage balance, give him $2500 cash and take out a one-year residential lease on the property, my rent being the amount of the monthly mortgage payment, to be paid directly to the mortgage company with the mortgage remaining in his name.  

We did the deal and I paid the mortgage company $20k, paid him $2500 and took possession of the house. My option agreement was recorded with the county.  I have since made two more mortgage payments and have spent approximately $2000 (and a ton of labor) rehabbing the house. I estimate I will spend another $3000 on flooring before the house is ready for rental.  Note that all of the above involved me personally, using discretionary funds.

My primary question is given the circumstances described above, is it now impossible for my IRA to get involved in this property? I understand that I cannot assign my option on the house or the residential lease from myself to the IRA - but could my IRA engage in another set of transactions directly with the homeowner? For example, could my IRA purchase an option and take out a lease with me simply walking away from the various agreements I have with him?  

I am concerned about issues regarding substance over form. By paying off the past-due balance and rehabbing the house with my discretionary (taxable) funds and labor, I have essentially increased the home's value and lowered the remaining mortgage balance. Even though this happened without the home ever being in my name personally and before any involvement by my IRA, I'm worried about whether this would cause the IRS to disqualify my IRA.

Ideally what I would like to do is use a small ($10-15k) Roth IRA to lease the house from him and re-let it to a renter, without purchasing the home but retaining the option to at a later date. This way the IRA can essentially leverage his mortgage and control the house without actually borrowing money. I *could* simply buy the house with a larger IRA but would prefer to take advantage of the mortgage since it already exists, freeing up my IRA cash to do other things.

Thanks!