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Mar 01, 2021

3 Things to Know About Vacation Rentals and Your Real Estate Self-Directed IRA

It sounds like a dream come true:

Living at the beach – full or part-time. Waking most mornings to the gentle sounds of the waves and the shorebirds, spending the evenings walking along the water’s edge and embracing the beauty of the sunset. You’ve found your place, and you’re thrilled every second you spend there.

If this sounds like paradise to you, you’re not alone. In fact, more than 5 million Americans owned a vacation home – often referred to as a “second home” in today’s pandemic-influenced market – in 2020, and that number is climbing daily thanks to travel restrictions and remote-work options that were not part of the equation prior to the COVID-19 pandemic. More often than ever, Mainstar is hearing from our clients that they want to invest in vacation homes, but their vacation-home dreams come with some pretty serious misconceptions that must be set straight before they can start living their beachside dreams.

Self-Directed IRA Funds Come with Caveats

If you have ever attended a real estate investing conference, odds are you have met at least one person who invested in a vacation home, rented it out whenever they were not using it themselves, and planned to live in it full-time once it was paid off. This is a time-honored way of “saving” for retirement, and it comes with two big potential advantages:

1. Equity, since many investors sell their primary residence when they move into the vacation home full-time; and

2. “Automatic” savings, since the investor cannot access the funds going into the vacation home for other purposes and, as a result, ends up “saving” money by paying down the mortgage.

Because the idea of the vacation home as a retirement strategy has been part of the real estate investing mindset for so long, it is not unusual for self-directed IRA investors thinking of retirement to assume they can use capital in their self-directed account to enact this type of strategy. Unfortunately, there are some particularly important details that self-directed investors must not overlook regarding the acquisition of vacation rentals and future use of those rentals for personal use. Failure to understand exactly what the IRS will permit when it comes to this valuable type of investment can be catastrophic.

3 Things You Must Know About Buying Vacation Rentals in Your Real Estate Self Directed IRA

First things first:

Vacation rentals are a great investment for self-directed investors.

In fact, in 2020, vacation rentals located in areas with plenty of outdoor recreation options like beaches, ski areas, or national parks skyrocketed in value. In fact, in 2020, Airbnb bookings were more than four times higher than they were in 2016. So, there is no question that a well-considered vacation-rental investment can be a big earner in your self-directed IRA. However, there are a few additional facts to consider before you make the purchase using self-directed IRA capital:

1. The IRS does not permit Self-Directed IRA owners to vacation in properties held by the account.

This means you cannot, under any circumstances, buy a vacation home using IRA funds and then spend a weekend in that home. Ever. Period. The IRS strictly enforces its prohibited transactions rules (IRC Section 4975), and benefiting directly from your IRA’s holdings prior to the distribution of those holdings is most definitely a prohibited transaction.

In layman’s terms: Your self-directed IRA’s vacation home is not available to you for vacations!

2. You cannot just move in when you reach retirement age.

Most real estate investors are okay with the first caveat we just discussed. They think they’ll just wait to enjoy the vacation home in retirement. However, it’s not that simple. Although there are ways to “distribute” a vacation home out of your self-directed IRA so that you can live in it during retirement, you must work with an expert self-directed account attorney to help you handle this process.

In layman’s terms: Just because you hit the “magic number” of 59½ years of age does not mean you can move into that property. If you do, you run the risk of fully distributing your IRA and losing all the hard-won tax advantages you have accumulated by using that self-directed account wisely for so many years.

3. Some short-term rentals are considered active business enterprises (this could mean taxes on your revenues).

Traditionally, the IRS has excluded rents from UBIT (unrelated business income tax) when those rents are long-term and flow into a self-directed retirement account. However, short-term rentals may be subject to this tax, depending on when you acquired the vacation rental and just how short a period of time for which you usually rent the property out. For example, if your renters stay for seven days or less, you likely will not be accruing “tax-free” rental income in your self-directed account but, instead, will owe money on that revenue. (Note: that does not mean you can’t do it, but it does mean you need to plan to pay.)

Recently, the IRS went farther, saying that even longer stays of 30 days or more might still be subject to UBIT if the rental comes with “personal services” that are, at present, still being clarified and updated. You must work closely with an accountant or legal advisor who can keep you updated as these regulations evolve over time. Currently, providing basic necessities like light, heat, water, and interim cleanings does not trigger UBIT, but that could change. For example, regular maid services can now trigger UBIT, as can providing breakfast.

 

Next to Nothing is Impossible for a Creative Self-Directed Investor

If you are reading this and thinking to yourself that you will just have to take your vacation-investment-home dreams elsewhere, take heart! There are many self-directed investors who find ways to make vacation rentals work for their self-directed IRAs very productively and profitably. In fact, you have been wise to consider this type of asset for your self-directed portfolio. However, it is important to understand exactly how your vacation rental would function in the grander scheme of your retirement investing and experience before taking the leap.

At Mainstar Trust, we pride ourselves on providing the best education possible for self-directed investors, including telling you when you need additional, personalized advice from other experts in the field. In the case of vacation rentals, consult your preferred professional advisor before making the acquisition using your self-directed IRA to make sure that your goals are compatible with the IRS regulations. Then, take action, having confidence that you have done your homework and are investing in a great asset for your future!

Please note: Not all alternative investments require Accredited Investor status. Please review the private placement memorandum, subscription agreement, or prospectus for purchase. 

Always take the time to consult with trusted, professional advisors to ensure you understand tax, legal, and investment issues related to the use of IRA funds in LLCs.

 

Additional Resources:

IRS 590

IRS 598

IRS Code Section 4975 (UBTI)

DOL Plan Asset Rules

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