An Individual Retirement Account (IRA) is a type of investment account that encourages investors to plan for retirement by allowing them to defer taxes on the funds contributed, up to a certain amount. With certain types of IRAs – like the 401k – an individual’s employer may even make a matching contribution to the account.
IRAs are a very effective retirement savings tool, but they also come with certain limitations. In a non-self-directed IRA, account funds are managed by a brokerage house or asset manager, which results in a limited number of investment choices for account owners. For many, this is not an issue. But, there is a certain subset of investors who desire more freedom and a larger number of investment choices. For these individuals, a specific type of IRA known as a “self-directed IRA” may be a more suitable account option.
In this article, the rules for using a self-directed IRA to invest in commercial investment property are described. By the end, readers will understand what a self-directed IRA is and what rules they are required to follow when using account balances to make a commercial real estate investment.
At First National Realty Partners, we have a great deal of experience working with investors to place self-directed IRA capital into real estate investments. To learn more about our current property offerings, click here.
What is a Self-Directed IRA?
A self-directed IRA (SD IRA) is a specialized type of Individual Retirement Account that provides the owner with more control over how their funds are invested. In addition, IRS rules allow the owner to invest in a number of alternative investments that are not normally available in a “regular” IRA. For example, a regular IRA typically contains stocks, bonds, money market accounts, ETFs, and mutual funds while a self-directed IRA may contain these assets as well as other options like:
- Commercial real estate – including undeveloped or raw land and rental properties
- Promissory notes and tax liens
- Gold, silver, cryptocurrency, and other precious metals
- LLC membership interests
As the name suggests, self-directed IRA investment decisions are made by the individual account owner, not a broker or asset manager. However, they must adhere to a number of rules, set by the IRS, to ensure the benefits of this account type remain intact. They are discussed in detail below.
Rule #1: The Property Purchased Cannot Be Owned By The Account Owner or Other Disqualified Person
Self-directed IRA funds cannot be used to purchase a property from or sell a property to the account holder. In addition, they cannot be used to purchase property (or any other asset type) from an individual or group of individuals designated as a “disqualified person.” The IRS defines a disqualified person as “fiduciaries, family members, spouses, or a lineal descendant.”
For example, suppose that John Smith has a self-directed IRA with $1,000,000 in it. Outside of the IRA, his company owns a small warehouse that was recently placed on the market for sale. Under this rule, Mr. Smith cannot use the funds in the IRA to purchase the warehouse. This is considered to be “self-dealing” and it is prohibited under self-directed IRA rules.
Rule #2: The Property Must Be Uniquely Titled
From a legal standpoint, an individual and a self-directed IRA are considered to be separate entities. This means that any investment made with self-directed IRA funds must have a unique title. In other words, they can’t be in the name of the account holder. Account holders should always seek the advice of an expert or attorney when titling a real estate asset. However, in many cases the correct title for self-directed IRA real estate investments is “Equity Trust Company Custodian For Benefit Of [Account Holder Name] IRA.”
For example, if John Smith used his $1,000,000 in account funds to purchase a property, it cannot be titled in the name of “John Smith.” It should be titled as “Equity Trust Custodian For the Benefit Of John Smith IRA.” Again, always consult a real estate attorney or tax professional as individual circumstances vary.
Rule #3: The Account Holder Cannot Receive Indirect Benefits
If self-directed IRA funds are used to purchase a commercial real estate property, the account holder cannot receive indirect benefits from that property. To illustrate this point, two examples at opposite ends of the spectrum are provided.
At one end, suppose that self-directed IRA funds were used to purchase an interest in a retail shopping center. Rents from the shopping center provide a steady stream of income for the account holder. This transaction is considered arm’s length and it is permitted.
At the other end of the spectrum, suppose an investor used self-directed IRA funds to purchase a small office building where a business they own is a tenant. The rent paid by that business is part of the rental income received by the account holder, which makes it an “indirect benefit.” This type of transaction is not permitted and could threaten the tax-deferred status of it.
Rule #4: Real Estate Purchases Do Not Need To Be Financed With 100% Funding From The Account
Real estate can be purchased outright with self-directed IRA funds, but it does not have to be. Under IRS rules, one of the allowable investment options is “LLC membership interests,” which means that self-directed IRA real estate investors could purchase an interest in an LLC that owns real estate. When we deal with self-directed IRA investors, this is usually how the transaction is structured. An example may be helpful.
When we identify a property that we would like to purchase, we form a limited liability company and use it to complete the transaction. To raise the needed equity, we sell shares or “membership interests” in the LLC to individual investors. Self-directed IRA account holders can use funds to purchase this interest.
Rule #5: Expenses Must Be Paid From the IRA
A typical commercial property has many day to day operating expenses that must be paid. These include things like: property taxes, insurance, maintenance, and admin. For investment properties or vacation homes owned within the self-directed IRA, the expenses required to maintain them must also be paid from the self-directed IRA. Typically, this is done by requesting the needed funds from the IRA custodian.
For example, when it comes time to pay the property tax bill annually, the account holder may need to request the funds from the self-directed IRA custodian and use them to pay the tax bill.
Rule #6: Income Generated by the IRA Must Stay Within the IRA
Any income that is generated by the assets owned within the self-directed IRA must be returned to the IRA custodian to go back into the account. If it is not, the tax benefits may be nullified.
For example, if an individual receives dividend income from a real estate investment funded by a self-directed IRA, that income must be sent to the custodian to be returned to the account. Otherwise, it could be considered taxable.
Rule #7: Self-Directed IRA Investments That Use Financing Must Pay UBIT
Self-directed IRA funds can be combined with debt to purchase a commercial real estate property as long as it is a non-recourse loan. If this type of financing is used, account holders must pay “unrelated business income tax” or UBIT.
Given the number of rules that must be followed, it makes sense to ask, why would anyone want to use a self-directed IRA to invest in commercial real estate?
Benefits of Using a Self-Directed IRA To Invest in Commercial Real Estate
When the rules are followed and the transaction is structured correctly, there are a number of benefits that can be realized from using a self-directed IRA to invest in commercial real estate
- Tax-Free or Tax-Deferred Earning: Investments within the IRA are shielded from taxes until the funds are withdrawn from the account.
- Diversification: Because self-directed IRAs can be used to invest in alternative assets, they allow for a greater level of diversification in an investment portfolio.
- Protection: Investments held in a self-directed IRA are safeguarded from debt collectors. In addition, IRS rules allow for balances to be transferred to account owner heirs.
- Easy to Get Started: All that needs to be done to get started is to open an account and fund it.
Investors considering using a self-directed IRA to make a CRE purchase should always complete their own due diligence and make use of tax experts and/or real estate attorneys to ensure their transaction stays within the bounds of IRS rules.
Summary & Conclusion
Self-directed IRAs are specialized types of individual retirement accounts that allow commercial real estate investors a greater degree of control over how their funds are deployed. Specifically, they allow for a number of alternative investments – like LLC membership interests, real estate, and cryptocurrency – that aren’t available in a traditional IRA.
However, to benefit from the tax advantages offered by a self-directed IRA, investors must adhere to a number of rules defined by the Internal Revenue Service (IRS). For example, account holders cannot receive indirect benefits from the transaction and they cannot engage in prohibited transaction types.
When all of the rules are adhered to, investors can benefit from tax deferred earnings, greater portfolio diversification, and the ability to transfer their assets to their heirs.
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 are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.