When creating a financial plan, the general strategy for many individuals is the same – to save a little bit of money from each paycheck over a very long period of time (30+ years) to obtain enough money to fund retirement. To encourage this behavior, IRS rules provide tax incentives for individuals as long as they place the money in a certain type of account known as an IRA or Individual Retirement Account.
In this article, we are going to define a specific type of Individual Retirement Account: a self-directed IRA. We’ll explain how they work and how a self-directed IRA can be used to invest in real estate assets. By the end, readers will have the information needed to determine if utilizing an IRA to invest in real estate is a good fit for their own investment strategy.
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What Is An IRA?
“IRA” is an acronym for Individual Retirement Account, which is a special type of tax-advantaged retirement account that can be utilized to save money for retirement. The key advantage offered by an IRA is that individuals can deposit money in it “pre-tax,” meaning they do not pay taxes on deposited funds, up to certain contribution limits each year. By doing this, investors can grow their retirement savings tax-deferred over time, only incurring taxes when funds are withdrawn. In order to obtain these benefits, there are a few rules that must be followed:
- Limit: The contribution limit for an IRA is $6,500 (subject to change annually) per year.
- Withdrawals: Individuals cannot withdraw money from the IRA until they reach age 59 1/2. Funds withdrawn prior to this age may be subject to a 10% penalty in addition to whatever income taxes are assessed.
- Distributions: Individuals are not permitted to keep funds in their IRA indefinitely. Beginning at age 70 1/2, savers must take “required minimum distributions” equal to a calculation provided by the IRS.
- Investments: IRA holders are allowed to allocate money to certain types of investments, like collectibles, otherwise their funds may become taxable.
It is important to note that the full suite of IRA rules is very complex and frequently changing. For those considering opening or investing in an IRA, it is always a good idea to consult with a CPA and/or tax advisor to ensure that all necessary rules are being followed.
IRAs can be managed by a third party, like a bank or brokerage firm. Or, they can be managed (“self-directed”) by the individual account holder. This second scenario is known as a self-directed IRA.
What is a Self-Directed IRA?
A self-directed IRA (SD IRA) is a specific type of IRA that allows the owner to invest in a variety of alternative investments/alternative assets that are normally prohibited in a “traditional” IRA.
Whereas traditional IRAs typically contain investments like stocks, bonds, money market accounts, and mutual funds, a self-directed IRA may contain these in addition to other privately held investments such as: commercial real estate, including undeveloped or raw land; promissory notes and tax liens; gold, silver, other precious metals, cryptocurrency, and LLC membership interests.
Like a traditional IRA, there are also a set of specific rules that govern Self-Directed IRA use.
General Guidelines for Using a Self-Directed IRA
Self-directed IRAs rules are set by the Internal Revenue Service (IRS). Key rules for investors to be aware of include:
- Account 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 the age of 59 1/2, when withdrawals are taxed as current income. In a Roth IRA, money is contributed post tax and it can grow tax deferred until the age of 59 1/2, when withdrawals are tax free.
- Account Contributions: Self-directed IRAs are subject to contribution limits. In 2022, the annual limit is $6,500 for individuals under the age of 50 and $7,000 for those over 50. It should be noted that tax deductions for contributions may be subject to income limits.
- Custodians: Self-directed IRA accounts must be administered by a 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.
The key point here is that, under self-directed IRA rules, individuals can use funds held within the account to invest in commercial rental property as long as all other restrictions are complied with.
Using a Self-Directed IRA To Invest in Real Estate
Using a self-directed IRA to invest in commercial real estate is not as simple as just finding a property and making an offer. There are four specific steps that investors must take to ensure a transaction complies with the necessary rules.
1. Find the Investment
Once a self-directed IRA is opened and funded, the first 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. In an indirect investment, investors should complete their due diligence on the deal sponsor to ensure they are reputable and experienced, in addition to the normal due diligence on the property and market.
4. Communicate with the Custodian
This is the part that is unique to working with a self-directed IRA. When property and/or sponsor due diligence has been completed, the last step is to communicate the specifics of the transaction to the IRA 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.
These rules are the same regardless of what type of property real estate investors wish to purchase. Again, it is critically important to work with a financial advisor, tax attorney, and/or CPA to make these types of investments to ensure that all rules are followed and tax benefits are fully realized.
Investments Methods for Using a Self-Directed IRA
Within the rules defined above, there are three ways/investment options that self-directed IRA account holders can buy real estate assets.
1. Direct Purchase
A direct purchase is exactly what it sounds like. With it, the self-directed IRA owner uses account balances to purchase a commercial investment property. In doing so, they have sole discretion over which property to purchase and they are the sole beneficiary of the rental income and profits that it produces.
But, it also means that the account holder is 100% responsible for acting as the property manager and overseeing the upkeep of the property. Of course it is possible to outsource this responsibility, but it is still necessary to “manage the manager”, which can be time consuming and requires a significant amount of expertise. For this reason, some account holders may prefer a more passive approach.
In a partnership approach, the account holder may partner with one or more other investors to utilize IRA funds to purchase a property.
The benefit of this approach is that it requires less upfront capital for each individual investor and less individual time to devote to managing the property. In some cases, there may even be a lead partner who handles all major property management and investment decisions, allowing the other partners to have completely passive involvement.
The downside of the partnership approach is that investors have to split the profit with the others. In addition, there can be occasional disagreements over property management decisions like whether to do some renovations or when to sell the property.
Remember, one of the allowable investment types is shares in an LLC. As such, there are certain types of real estate investment structures, like a private equity syndication, that utilize an LLC to purchase and manage the property. In such a structure, there is a deal leader that is responsible for finding, financing, and managing the property and individual investors who purchase shares in the LLC and benefit from the cash flow and profits produced in proportion to their share of ownership.
The benefit of this approach is that it is a completely turnkey investment opportunity for account holders in the sense that the deal leader does all of the leg work, while all investors have to do is collect their distribution income. In addition, it may provide investors with a chance to gain fractional ownership of an institutional quality asset that they may not be able to afford on their own.
The downside of investing in LLC shares is that individuals may not have any say in which properties their funds are used to purchase and/or in major investment decisions – these are all left up to the deal leader. In addition, the deal leader may charge fees that can cut into profits over time or they may require holding periods of 5-10 years during which time investors are unable to liquidate their shares.
Of these three methods, one is not necessarily better than another, but one may be a better fit for an individual’s circumstances. For example, a direct purchase may be a good fit for investors with significant account balances, a long investment horizon, and the time and expertise needed to manage the asset. Or, the LLC approach may be a better fit for investors who have smaller account balances and a preference for working with a third party to manage the property.
Pros & Cons to Investing in Real Estate with a Self-Directed IRA
As with any investment opportunity, there are both pros and cons to using a self-directed retirement account to invest in commercial real estate assets.
In addition to the benefits of investing in commercial real estate generally, there are a number of benefits to 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. Even within the commercial real estate asset class, there are a wide variety of investment options that include rentals, fix and flip properties, land, mortgages, REITS, and non-publicly traded ownership interests in LLCs that own commercial property.
- Tax Treatment: Because the investment is held in a tax advantaged account, earnings are allowed to grow tax free or tax deferred. Over time, this can be a significant contributor to the investment’s overall return. In addition, the account owner can control the tax liability on the back end through the timing of distributions once they reach a certain age.
- Estate Planning: As long as a beneficiary is named, funds in a Self-Directed IRA can be passed to heirs or family members with the tax advantages in place. Heirs include spouses, who can take ownership of the IRA and use it as their own, and non-spouses who can keep the funds in the IRA for a certain period of time.
- 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 IRAs 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.
While these benefits can be significant, there are also a number of downsides that potential investors must consider.
The key downside to using a self-directed IRA for investment is that a mistake in the handling of the transaction can negate the tax benefits of the retirement plan in the first place. So, investors should keep the following in mind:
- 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. A complete list of prohibited transactions is defined in IRS Publication 560, but they include: the transfer of IRA income or assets to a disqualified person, any act of a fiduciary by which he or she deals with plan income or assets in their own interest, and selling, exchanging, or leasing the property to a disqualified person.
- 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/provider 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.
Summary of Using a Self-Directed IRA to Invest in Real Estate
A self-directed IRA is a specialized type of tax advantaged retirement account that allows individuals to place their retirement funds in the account on a “pre-tax” basis.
The key rules to a self-directed IRA is that there are annual contribution limits and investors cannot withdraw funds until they reach a certain age. In addition, there are limitations on which types of investments can be pursued. Fortunately, real estate is allowed.
Within a self-directed IRA, investors can invest in real estate via a direct purchase, partnership, or through shares in an LLC. There are pros and cons to each approach so investors should determine which is a best fit for their own circumstances.
Primary benefits of using a self-directed IRA for real estate investment include portfolio diversification, the favorable tax treatment, and their ability to be used in estate planning.
The primary drawbacks are the prohibited investments, prohibited transactions, and the limited transparency into deal structures.
Each investor should evaluate their risk and benefits individually to determine if this investment strategy is a good fit for their own circumstances.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, 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 would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.