Always speak with a CPA, a Registered Investment Advisor, a Certified Financial Advisor, a Certified Financial Planner or Administrator to see if real estate is a suitable investment for you inside your IRA trust or retirement plan.

Real Estate IRA Investing: A General Overview

Let's assume that YOU have $250,000 inside a 401k plan with your previous employer, (or a 457, 403b, SEP, etc) and that money is currently invested in stocks and mutual funds.   Let's also say that you were driving home day, and you saw a $700,000 multifamily investment property that was in a perfect location, and could be rented and managed by a local real estate management company. 

Without any withdrawal penalties, did you know you could purchase this investment property INSIDE your retirement account?  Well, you can and additionally, you could also do so despite the fact that you only have $250,000 inside your account. 

Here is a general explanation of how you would do it. 

First, An Example.
•  First, you would need to speak with a CPA, a Registered Investment Advisor, a Certified Financial Advisor, a Certified Financial Planner or Administrator to see if real estate is a suitable investment for you inside your retirement plan.  While real estate allows one to diversify their retirement savings away from Wall Street stocks and mutual funds. this is not an investment for everyone.

• Assuming you and your advisor agreed that this is a prudent investment for you inside your retirement plan, you would first need to do a "custodian to custodian transfer" from your 401k, to an IRA, which is a non-taxable occurrance if done correctly.  You would "roll" your $250,000 in funds from your previous employer's 401k plan, to a self-directed IRA custodian that allows real estate investments.  It is unlikely your current custodian would allow this type of transaction in your 401k. Most custodians usually limit your investment choices to stocks, mutual funds, bonds, etc...

• You would instruct your new self directed IRA custodian to allocate $175,000 of your IRA funds, to be applied as a down payment on the purchase of this $700,000 multifamily property;  You would then apply for a mortgage on your IRAs' behalf (through your local mortgage broker), and obtain a $525,000 loan for your IRA from First IRA Mortgage, Inc.

• With your $175,000 in downpayment, and a First IRA Mortgage of $525,000, you would instruct your custodian to purchase the property you identified, in the name of the Custodian "for the benefit of" (FBO) your IRA.   (i.e. "ABC TRUST COMPANY for the benefit of John Doe's IRA" would be the titled owner of the property)

• Your property manager would rent the property out, and all rents and income on the property would be paid directly to the self directed IRA account.  Additionally all mortgage payments and operational expenses would also be paid directly from your self directed IRA account.

• The balance your IRA funds ($75,000) would also remain inside your self directed IRA account.  These funds would be used for any ongoing property maintenance and for any deficiency reserves.

• Some of these IRA funds would also be impounded and put in an escrow acocunt, and would be applied towards the PITI escrows (Principal, Interest, Taxes and Insurance).

Here is the breakdown in this very general example:

That is the gist of the transaction, however there are many questions that you probably have.  Please visit our Frequently Asked Questions, our Tax Issues our Legal Issues, and also our In The News sections for the answers to your questions.

The following article is courtesy of Tom Anderson, Pensco Trust

The Basics
Real estate IRA investing opens up a huge range of alternative investments for individuals who are knowledgeable about real estate investing or who work with knowledgeable advisors, sponsors, or brokers. Investing in real estate for your retirement may serve as a means to diversify your retirement portfolio to hedge against the cyclical changes in the stock market, economy and bank and government-based investments.

For many who are experienced with real estate investing, real estate investments hold the potential to protect against the loss of principal while generating better than market rate returns through income production and capital gains. When real estate investments are not leveraged, both income and capital gains can flow back to IRAs tax-deferred (or tax-free if the IRA is a Roth IRA).

Easy
If you have your IRA purchase real estate from an unrelated party and pay cash for it, and you do not use the real estate for personal reasons while it is in your IRA (i.e., you treat it strictly as an investment), there are no special issues.

More difficult
If your IRA invests in real estate through a down payment and leveraging, there are some significant issues:
1. You cannot personally guarantee a loan for your IRA;
2. It may be difficult to get a bank to allow an IRA to be the debtor without a personal guarantee;
3. Your IRA will pay tax on UDFI (Unrelated Debt Financed Income), which is the income and/or capital gains attributable to the leveraged portion. (UDFI is taxed at the trust tax rate because an IRA is treated as a trust for this purpose.)

As a consequence, although it is perfectly legal, it may not be desirable to have an IRA carry debt in a real estate investment transaction.

What you can't do in an IRA with real estate
1. Your IRA cannot directly or indirectly buy real estate from a "disqualified person". Who is a disqualified person?

• The IRA owner; 
• the IRA owner's spouse, descendant (e.g., son), or ascendant (e.g., mother); 
   spouse of a descendant of the IRA holder; 
• a fiduciary of the IRA or person providing services to the IRA (e.g., the trustee or custodian); 
• an entity at least 50% of which is owned (or at least 50% of the beneficial interests are held) by a combination of the above (e.g., if you and your spouse own 50% of an LLC, that LLC is a disqualified person with respect to your IRA); or 
• a 10% owner, officer, or director or highly compensated employee of such an entity.

2. You cannot have your IRA enable an investment for yourself or another disqualified person. In other words, if the IRA's investment is deemed essential to accomplishing a transaction in which both you and your IRA invest, then the transaction would be considered a prohibited transaction.

3. Your IRA cannot purchase a real estate asset and then have a disqualified person use it while it is in the IRA. For example, you cannot buy a vacation home and use it partly for personal use, even though you might rent it to unrelated persons the rest of the year.

What you can do in an IRA with real estate
Buying real estate from an unrelated party (i.e., one who is not a disqualified person) with cash is the simplest way of investing in real estate with your IRA. Your IRA can buy raw land, commercial property, residential (e.g., rental) property, real estate options, as well as extend loans (e.g., first and second mortgages), secured by real estate with your IRA, to unrelated parties.

As discussed above, your IRA can also buy property through leveraging, provided the loan is not guaranteed by the IRA owner (or any other disqualified person) and that the IRA has enough liquidity to support the mortgage and expenses. Generally, most custodians will have limits on the amount of leverage they will permit. Also, as previously mentioned, leveraging can result in income taxes on UDFI that must be paid by the IRA. Generally, these taxes are higher than would be paid on income generated from a property that you buy and finance personally. In addition, the UDFI taxes must be paid from funds from the IRA and, therefore, there has to be enough liquidity in the IRA to cover these taxes. See IRS Form 990T and its accompanying instructions for details.

There are a variety of ways, however, that an IRA can participate in a real estate investment without a full cash capital investment. For example, your IRA can co-invest with other parties. You could also have your IRA, and other parties participate in real estate investing by becoming members of an LLC that buys and sells property.

Examples of Real Estate Investments that can be made Using IRA Funds

Example I
John's IRA has purchased a single family home from an unrelated seller. John now wishes to have the IRA sell it to his sister with a first mortgage that his IRA will hold.
The purchase of a single family home from an unrelated party is not a problem. John pays $300,000 cash and his IRA holds the grant deed from the sale to his IRA by the third party. John's IRA later sells his sister the property and takes back a first mortgage and a down payment in exchange. His IRA gives her a market rate loan for 15 years and receives a 10% down payment. Since this is a $280,000 debt owed to the IRA and not by the IRA, there is no concern about the potential liability of the IRA. John's IRA has a fixed income investment and is protected because it holds the trust deed in the event his sister defaults on the loan. The transaction may also have the incidental benefit of allowing John's sister to purchase the home more easily than she could have on the open market.

Example II
Allison wants to form an LLC that will buy property that will be developed. She wants to make her IRA the primary investor. She expects to have other investors in the LLC.
Allison's IRA can participate in the formation of the LLC provided Allison and related persons and parties do not already own 50% or more of the LLC in aggregate. If she is just starting the LLC, then the IRA can own something less than 100% (e.g., 90%). The LLC is considered a real estate operating company and, therefore, the assets are not considered plan assets unless there is 100% ownership by the IRA. If the company's assets are deemed plan assets, then a transaction between the company and the IRA owner is considered a transaction between the IRA and a disqualified person (such as the IRA owner) and is therefore possibly a prohibited transaction. Because of some recent legal rulings involving self-dealing, we recommend that you consult with a competent attorney if you intend to have a personal role in any entity in which your IRA is an investor.

If the LLC was not a real estate operating company or other type of operating company (for example, if it was a hedge fund), then the aggregate ownership of all IRAs and employee benefit plans would have to be less than 25% in order for the LLC's assets not to be considered IRA assets. (The interest owned by the IRA owner is disregarded for purposes of calculating the relevant percentage.)

Example III
Howard wants to have his IRA purchase a $400,000 rental property with a 50% down payment. Is this possible and are there any special considerations?

Yes, it is possible, but there are special considerations such as:

• Disqualified persons (such as the IRA owner and his or her spouse) cannot personally guarantee the loan for the IRA. The loan must be supported by the property itself or some other property that the IRA owns;
• The IRA will be subject to tax (UDFI or UBIT) on any income and/or capital gains attributable to the leveraged portion of the investment;
  It should be noted, as an alternative to borrowing, that the IRA can purchase the property with other parties, all of whom pay cash. When this is done, there is no UDFI and there are no issues associated with the financing.

Conclusion
In summary, the tax laws (1) require that the investments in an IRA not benefit the IRA owner or other "disqualified persons" and (2) prevent "self-dealing" between the IRA and the IRA owner or other disqualified persons. However, by properly structuring an IRA investment in real estate, an IRA can obtain the benefits of real estate investment in a manner that complies with applicable tax laws.
(The foregoing is a general discussion. It is not intended, and should not be relied upon, as an opinion or advice on any legal, tax or investment aspects of IRAs. An IRA owner considering an IRA investment in real property should consult with his or her own advisor.)

Credit
This article courtesy of Tom Anderson, Pensco Trust

With respect to documents available from this server, neither First IRA Mortgage, Inc. nor any of their employees, makes any warranty, express or implied, including the warranties of merchantability and fitness for a particular purpose, or assumes any legal liability or responsibility for the accuracy, completeness, or usefulness of any information, product, or process disclosed, or represents that its use would not infringe privately owned rights. Always speak with a CPA, a Registered Investment Advisor, a Certified Financial Advisor, a Certified Financial Planner or Administrator to see if real estate is a suitable investment for you inside your IRA trust or retirement plan.