Self directed IRA’s for real estate investing are a popular choice for individuals looking to augment their returns in a tax deferred account. (For those of you unfamiliar with this term, a self directed IRA is an IRA (ROTH or Traditional) that allows the IRA owner to invest in non traditional investments such as real estate, tax liens, private lending, etc..) The issue for many investors is obtaining accurate information from their IRA custodian. Most custodians take a hands off approach in so far as you, the IRA owner, are expected to know the rules of the road and if a mistake is made it is your responsibility. They will not offer advice about your investing (some will and it is typically coming from a salesman who knows very little about prohibited transactions but understands how to motivate people utilize his services) and will tell you to seek the advice of your CPA or attorney i.e., we are covering our own as_. The problem is when you do not seek the advice or the person from whom you obtain the advice is inexperienced in the use of IRAs. The penalties for the improper use of your IRA can be punitive resulting in taxes and penalties of over 60%.
It is vitally important for every investor to know the limitations of his IRA, which unfortunately requires your becoming partially, if not fully versed, in the IRA prohibited transaction rules. A violation of any of these rules can result in a loss of your IRA’s tax deferred status. Section 408 and 4975 of the Internal Revenue Code explain everything the IRA investor must be aware of when dealing with his own IRA. To save you the time of looking up these code sections I will lay out the gist of the rules in English. Here we go ….
- Certain transactions with an IRA account are prohibited if a “disqualified person” is involved in the transaction.
- Disqualified persons include the IRA owner, certain family members, any other fiduciary and certain service providers (among others).
- Prohibited transactions include the following:
- a transfer of plan income or assets to, or use of them by or for the benefit of, a disqualified person;
- any act of a fiduciary by which plan income or assets are used for his or her own interest;
- the receipt of consideration by a fiduciary for his or her own account from any party dealing with the plan in a transaction that involves plan income or assets;
- the sale, exchange, or lease of property between a plan and a disqualified person;
- lending money or extending credit between a plan and a disqualified person; and
- furnishing goods, services, or facilities between a plan and a disqualified person.
- If a prohibited transaction occurs, the IRA ceases to be an IRA as of the first day of the tax year in which the transaction took place.
Do people make these mistakes? Absolutely, especially when it comes to real estate investing. I receive several inquiries each month from investors seeking to put their IRA monies to use in real estate. To be sure, this is not one area that you want to jump into with the hope that you will find your wings as you fall. A violation of these rules can result in losing the tax-deferred benefit of your IRA. Here is a list of common mistakes made by IRA owners:
- Borrowing from their IRA
- Partnering with their IRA to purchase real estate (many times a LLC is used however it does not change the nature of the transaction unless structured properly)
- Rehabbing the property owned by the IRA
- Serving as a property manager for IRA property
- Receiving a property management fee for managing IRA property
- Receiving a commission for selling IRA property
- Not taking title in the IRA or LLC owned by the IRA
The best way to invest with your IRA is to adopt a hands off approach. Go out and find the investment but then sit back and turn over all aspects of the purchase, management, rehab, etc., to other UNRELATED individuals. I also find it beneficial to create separate IRA’s for each deal. This will limit your exposure to prohibited transactions because the rules apply on a per IRA basis. If one IRA is found to have violated 4975 only that one IRA will be affected.
Your mother probably taught you your ABC’s which, when applied in the legal context, is “Always Be Careful.” Next week I will discuss a vastly superior strategy to the self directed IRA that involves the use of your own self directed pension plan. Stay tuned…