When it comes to real estate, there's a lot to think about as you evaluate investment prospects – from the purchase price and market value to the potential for future appreciation and cash flow.
Yet, for many investors, real estate is an attractive option for diversifying an investment portfolio and earning investment income (especially as the median rental rate has steadily increased over the past two decades). Using self-directed IRA assets to invest in real estate can add benefits to the proposition, including tax-deferred investment growth, or tax-free growth with a Roth IRA.
Because of these benefits, however, the tax laws impose certain rules to ensure these tax-advantaged vehicles are not misused. Here are some Dos and Don’ts associated with real estate investing to make sure you comply with the tax laws and preserve the tax-deferred nature of your IRA assets.
DO: Avoid Self-Dealing
IRA owners are prohibited from benefitting personally from an IRA investment (other than growing the value of the IRA). The investment must be made solely for the benefit of the IRA, not the IRA owner or their family members. The rules against self-dealing prohibit you from conducting certain transactions with your IRA and its investments. For example:
- Don’t use the real estate as your residence, vacation property, office space, or in any other way.
- Don’t rent the property to a family member.
- Don’t sell your or a family member’s real estate to your IRA.
- Don’t purchase real estate from your IRA.
- Don’t lend money to the IRA or the property.
- Don’t pay yourself or a family member to manage the property.
- Don’t make any repairs yourself or personally provide other services to the property.
DON’T: Pay Expenses for the Real Estate
Don’t pay any expenses incurred by real estate held in your IRA. Just as all proceeds of a sale, and growth in the value of an IRA investment, must stay within the IRA until you choose to take a distribution, all expenses associated with an IRA investment must be paid by the IRA. This includes costs for maintenance, repairs, and upgrades to the property.
DO: Have Liquid Assets Within the IRA
Set aside enough cash (or liquid investments) in your IRA to pay for all expenses that may be incurred by the real estate, including closing fees, taxes, insurance, utilities, and property management fees. Additional liquidity should be considered if you are age 72 or older with a Traditional IRA because you will be required to take required minimum distributions (RMDs) each year (unless you have multiple IRAs from which you can aggregate your RMDs).
DO: Obtain Accurate Valuations
To properly complete the IRS-required reporting for IRAs, IRA custodians must have accurate valuations for each real estate investment or shares of ownership held by an IRA. As the IRA owner, you will be responsible for obtaining valuations from a licensed or certified real estate appraiser at least annually, and when a distribution or other taxable transaction is made from the IRA.
DO: Be Aware of UBTI/UDFI
If you invest in an LLC or other investment that may earn income, be aware that the tax rules restrict a business operating within a tax-deferred environment like an IRA from receiving tax advantages over a business that must pay taxes each year on its business income. To prevent this unfair advantage, if an IRA investment earns $1,000 or more of “unrelated business taxable income” (UBTI), it must pay tax on that income. UBTI is defined as income from a trade or business that is not substantially related to the IRA’s tax-exempt purpose, which is saving for retirement. Additionally, if you financed an income-producing property with a non-recourse loan, the IRA would have “unrelated debt financing income” (UDFI), which is also taxable.
Seek professional advice to determine if your investment may be subject to UBTI/UDFI tax. If so, the tax must be reported on IRS Form 990-T, Exempt Organization Business Income Tax Return, and paid from the IRA.
DO: Work with an IRA Custodian Specializing in Alternative Assets
It’s essential to work with a knowledgeable IRA custodian who specializes in administering alternative assets for self-directed IRAs. Although meeting the IRA requirements are ultimately up to the self-directed IRA owner and the IRA custodian won’t advise you on the risk/rewards of your IRA investments, the IRA custodian has a vital role in guiding you with the legal requirements, handling your IRA assets, and filing the necessary forms with the IRS, based upon the information you provide. For example, at your direction, your IRA custodian will
- Use your IRA assets to purchase the property or shares in a real estate-related investment
- Sign the purchase agreement or other documents on behalf of the IRA
- Remit funds from the IRA to purchase the investment
- Hold legal title to the real estate or related investment
- Physically safeguard copies of the title and other documentation
- Pay ongoing expenses related to the investment from IRA assets
- Accept rental payments or other income on behalf of the IRA
Real estate can be an attractive investment option for self-directed IRA owners. Just make sure you understand what you can and cannot do with your investment to preserve the tax benefits of your IRA. Most investors engage financial, tax, and real estate experts to help them evaluate all the considerations associated with investing in real estate through a self-directed IRA.