Key Takeaways

  • For many individuals, the centerpiece of their retirement planning is a tax advantaged savings/investment account known as an Individual Retirement Account or “IRA” for short.
  • Traditional IRAs allow traditional investments like stocks and bonds.  However, there is a subset of investors who would prefer to use their retirement funds to invest in so-called “alternative” investments like commercial real estate.  This is possible through the use of a Self-Directed IRA.
  • A Self-Directed IRA is a specialized type of individual retirement account that allows the owner to use their retirement funds to invest in non-traditional assets like real estate, gold, or LLC membership interests.
  • There are a specific set of IRA rules that govern the use of a Self-Directed IRA and they must be adhered to, otherwise taxes may become due.
  • The benefits to using a Self-Directed IRA to invest in commercial real estate include tax deferred growth, protection from debt collectors, and passage of the assets to heirs.  However, there also risks that primarily involve engaging in a “prohibited transaction.”

An Individual Retirement Account is a specialized type of savings/investment account designed to encourage savings for retirement by offering unique tax advantages.  For many individuals, the IRA is the centerpiece of their retirement plan and the funds within it are invested in a mix of stocks and bonds.  This investment approach is just fine for many individuals, but there may be a certain subset of investors who wish to diversify their IRA investments beyond the traditional mix of stocks and bonds and into other asset classes.  This is possible through the use of a “self-directed IRA.”  

What is a Self-Directed IRA?

A Self-Directed IRA (SD IRA) is a specialized type of Individual Retirement Account (IRA) that allows the owner to use their retirement funds to invest in a variety of alternative investments that are normally prohibited in a “traditional” IRA.

Where traditional IRAs typically contain stocks, bonds, money market accounts, and mutual funds, a SD IRA may contain these in addition to other privately held investments like:

  • Commercial real estate, including undeveloped or raw land 
  • Promissory notes & tax liens 
  • Gold, silver, other precious metals, and cryptocurrency
  • LLC Membership interests 

So, for individuals who wish to gain exposure to these so-called “alternative” asset classes, the SD IRA is the vehicle through which they can do it.  However, SD IRA account holders must abide by a specific set of rules that govern the account’s use.

Self-Directed IRA Rules

Self-Directed IRAs rules are set by the Internal Revenue Service (IRS).  They include:

  • Type:  A self-directed IRA can be a Traditional IRA or a Roth IRA.  In a Traditional IRA, money is contributed to the account pre or post tax and the money grows tax deferred until retirement age, when withdrawals are taxed as current income.  In a Roth IRA, money is contributed post tax and it can grow tax deferred until retirement age, when withdrawals are tax free.
  • Contributions:  Self-directed IRAs are subject to contribution limits.  In 2020, the annual limit is $6,000 for individuals under the age of 50 and $7,000 for those over 50.  Tax deductions for contributions may be subject to income limits.  
  • Custodians:  Self-directed IRAs must be administered by an IRA custodian.  Under IRS Publication 590-A, a custodian must be a bank, federally insured credit union, savings and loan association, or other entity approved by the IRS to act as a trustee or custodian.  Under IRS rules, the trustee or custodian generally can’t accept contributions of more than the deductible amount for the year.
  • Prohibited Investments:  A self-directed IRA cannot be used to make an investment in a prohibited asset class.  Under IRS Publication 590-A, prohibited investments include: artwork, rugs, antiques, gems, stamps, coins, alcohol, and other tangible property.
  • Prohibited Transactions:  In addition to prohibited investments, there are also a number of transaction types that are prohibited with self-directed IRAs.  They include the transfer or use of IRA assets by or for the benefit of a disqualified person, excess contributions, early distributions, and the accumulation of excess amounts.  

Despite the rules and restrictions on investments, opening a Self-Directed IRA is a relatively simple process.

Opening a Self-Directed IRA

In many ways, the steps needed to open a self-directed IRA are the same as those for a traditional IRA.  They are as follows:

  1. Find a Custodian:  Self-directed IRAs must be administered by a custodian and the first step in the account opening process is to find one.  Again, the custodian could be a bank, federally insured credit union, savings & loan association, or any other entity that has been approved by the IRS.  Qualified custodians can be found through a simple internet search or through a recommendation by a trusted financial advisor.
  2. Open the Account:  Once the custodian has been identified, the next step is to work with them to open the account.  In some cases, this may include a significant amount of paperwork so it is best to be prepared and to allocate the necessary time for completing it.
  3. Fund the Account:  Once opened, the account must be funded.  In most cases, this involves an initial deposit of funds that may come from a different account, followed by a series of regular contributions over time.  Again, available tax deductions are subject to contribution limits of $6,000 for individuals under the age of 50 and $7,000 for individuals over 50.

Once the account is open and funded, the owner has wide discretion over what to invest the funds in, hence the “self-directed” moniker.  Because commercial property and LLC membership interests are allowable investment types, they present an attractive option for account owners.

How a Self-Directed IRA Can Be Used to Invest in Commercial Real Estate

When the broad benefits of the commercial real estate asset class are combined with the tax deferral advantages of an IRA, it can create a powerful investment vehicle.  The following steps describe how to use a Self-Directed IRA to make a commercial real estate investment:  

  1. Find an Investment:  Once the account is opened and funded, the next step is to begin searching for an investment.  IRS rules allow for the direct purchase of a property and/or the acquisition of LLC membership interests which are common in private equity commercial real estate transactions like the ones we originate.  In the latter scenario, it is important to work with an established transaction sponsor that has a long history of delivering stable, consistent investment returns.
  2. Commit to the Investment:  Once a suitable investment has been identified, the next step is to commit to it.  In the case of a direct real estate purchase, this means placing the property under contract.  In an indirect investment scenario, it means working with the transaction sponsor to complete the needed documentation (like the subscription agreement) to formally commit capital to the investment.
  3. Complete Due Diligence:  In a direct investment, the purchase and sale agreement should allocate a specific amount of time to complete due diligence on the property to ensure it is as advertised.  This includes reviewing property surveys and environmental reports in addition to analyzing the property’s financial records.
  4. Communicate with the Custodian:  When property and/or sponsor due diligence has been completed, the last step is to communicate the specifics of the transaction to the custodian.  The specifics include how much money is needed, what documentation is required, and where to send the funds.  Investment funds can be used to purchase the entire property or a portion of it.

To complete the process successfully, and to ensure the transaction qualifies for the appropriate tax deferral benefits, there are a series of rules that must be adhered to.  

Real Estate Specific Self-Directed IRA Rules 

In addition to the broad set of rules that govern Self-Directed IRAs (described earlier), there are another set of rules that are specific to investing in real estate.  Their overarching principle is that the account owner and the account must be treated as separate entities.  To that end, compliance with the following guidelines is critical when using a Self-Directed IRA to invest in commercial real estate assets:

  • Self Dealing:  The IRA cannot purchase a property from its owner and cannot sell it back to the owner or any other disqualified person. 
  • Title:  The property must be uniquely titled in the name of the IRA.
  • Indirect Benefits:  The owner of the IRA may not receive any indirect benefits from the investments within it.  For example, if the IRA owns an investment property in a popular resort, the owner cannot spend the night at the property, it would be considered an indirect benefit.
  • Financing:  The financing used to acquire the property can be a mix of debt and equity.  
  • Income/Expenses:  All expenses for the property owned within the Self-Directed IRA must be paid from the IRA.  In addition, all income earned from the property must be kept within the IRA.
  • Taxes:  If the purchase is financed, all Unrelated Business Income Tax must be paid.

It is a best practice for individual investors to work with their custodian and/or transaction sponsors if there is any doubt about compliance with the above rules.   

Benefits and Risks of Using a Self-Directed IRA To Invest in Commercial Real Estate 

In addition to the benefits of investing in commercial real estate generally, there number of additional benefits from using a Self-Directed IRA to do it specifically:   

  • Investment Options & Portfolio Diversification:  Self-Directed IRA funds can be used to invest in a variety of alternative assets, including commercial real estate that can add an element of diversification to a portfolio.  
  • Tax Free or Tax Deferred Earning:  Because the investment is held in a tax advantaged account, earnings are allowed to grow tax free or tax deferred.  
  • Safeguarded From Debt Collectors:  Investments held in a self-directed IRA are safeguarded from debt collectors, which means that they cannot be accessed to pay other past due debts. 
  • Can Be Passed on to Heirs:  As long as a beneficiary is named, funds in a Self-Directed IRA can be passed to heirs with the tax advantages in place.  
  • Easy to Open:  Self-Directed IRAs are easy to open and there are a number of different options from which to choose a custodian. 
  • Regular Contributions:  Like traditional IRAs, Self-Directed IRA can be funded with regular contributions to the account.  They are, however, constrained by annual contribution limits and may be subject to income restrictions.
  • Rollovers:  Funds from an existing retirement account, such as a 401k, can be transferred or rolled over into a Self-Directed IRA. 

Despite the significant number of benefits, Self-Directed IRAs are not risk free.  In addition to the risks of investing in commercial real estate generally, there are a number of additional risks that should be considered when using a Self-Directed IRA to do it specifically:

  • Prohibited Transactions:  The primary reason for using a Self-Directed IRA to invest in commercial real estate is the tax benefits afforded by it.  However, these can be negated if account funds are used in a “prohibited transaction.”

IRS rules define a prohibited transaction as one made between the IRA and a “disqualified person,” who is a:  fiduciary of the plan, person providing services to the plan, employer, or an employee organization whose members are covered by the plan.  Transactions involving a disqualified person are prohibited and taxable if the rules are not followed. 

  • Prohibited Investments:  Although there are a wide variety of options for Self-Directed IRA investment, there are a number that are specifically prohibited.  They are defined in IRS Publication 590 and they include: artwork; rugs, antiques, metals, gems, stamps, coins, alcohol, or other tangible property. If IRA funds are used in a prohibited investment, it may become taxable.
  • Custodian Experience:  Self-Directed IRAs must be administered by a custodian, but the experience, advice, and level of customer service can vary widely from one custodian to another.  It is important to select a custodian with a significant amount of experience and expertise in administering Self-Directed IRAs. 
  • Fees:  The fees charged for the administration of a Self-Directed IRA can be expensive.  When combined with the fees charged by investment managers, they can materially impact returns. 
  • Illiquidity:  There are two levels of illiquidity when investing in commercial real estate with a Self-Directed IRA.  First is the illiquidity of the investment itself, which could require a funding commitment of 5-10 years.  Second is the funds within the IRA, which cannot be distributed until the owner has reached a certain age.  If funds are distributed before this age, they are taxed, which negates the primary benefit of using the IRA in the first place. 
  • Transparency:  When working with an investment sponsor, the Self-Directed IRA owner may have a limited amount of transparency into the exact structure, fees, and valuation used in the proposed transaction.  It is important that investors actively seek out answers to their questions to ensure they have complete clarity on the investment. 

Despite the risks, using a Self-Directed IRA as a vehicle for commercial real estate investment can provide lucrative, tax deferred returns.  However, it is important that each investor perform their own due diligence to ensure the transaction is a good fit for their risk tolerance and time horizon.

Interested In Learning More?

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in. 

If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.

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