A Few Items To Avoid When Purchasing Real Property With An IRA

DEFINITIONS:

What is an IRA?

An IRA is an Individual Retirement Account. It is an account that holds your investments (ie:  stocks, bonds, mutual funds, real estate, precious metals, etc.).   An owner of IRA can take advantage of various tax breaks, each having their own set of rules.

How is Real Estate Purchased Using an IRA?

The most common way to purchase real estate with an IRA is by purchasing shares in a Real Estate Investment Trust (REIT). Another method, and the subject at hand, is to purchase via a Self Directed IRA (SDIRA).  This is an IRA where the owner makes the investment decisions for the account, not a brokerage firm. 

Traditional IRA vs. Self Directed IRA: 

 

In a traditional IRA, a brokerage firm advises the IRA owner and conducts transactions.   In a Self-Directed IRA, a custodian works on the investor's behalf preparing the necessary paperwork to set up the IRA, but the investor is responsible for directing the investments.

SELF DIRECTED IRA KEY TIPS:

Keep Your SDIRA Passive:  A key component to keeping the tax advantages of the SDIRA is to keep it passive. Arms length transactions are key and it is vitally important that investors only make purchases where they plan to use the property as an investment property that will be occupied by a tenant and not the investor themselves.

Taking Cash Flow Distribution From Your Account:  The income provided from an SDIRA is the investor's money, but that does not mean he or she can bypass the IRA and take the money directly from the investment. The custodian of the IRA is responsible for all distributions and all income. Deviating from that process can wipe out the tax protections and advantages and lead to taxes and penalties. The SDIRA is for protection and tax planning and just like a traditional IRA, there are time frames for taking withdrawals and distributions.

Self-Dealing & Non-Arms Length Transactions: Often times investors are interested in the SDIRA for its tax advantages and they are interested in protecting their wealth and assets with entity protections by setting up LLC’s or other legal entities to hold title and create barriers from lawsuits. Unfortunately, these two plans do not always line up. Property can be purchased and titled in the name of an entity and funded with an SDIRA so long as the investor does not own the property before hand. In other words, an investor cannot purchase property, place it in the name of an LLC and then set up an SDIRA to purchase that property from the LLC. The transactions must be arms length in nature meaning an investor cannot buy something from himself or herself or from his or her spouse or children or parents. There are some family member exceptions but they are not pertinent to this post and the custodian would be aware of these. 

Separating Expenses From The SDIRA:  Two problems can occur when purchasing an real estate with your SDIRA. First, from the very beginning, every cost associated with the purchase must come from the SDIRA. If an investor places earnest money on a property and writes a personal check, then the transaction could be voided and considered outside of the SDIRA.  Second, if an investor purchases a property and does not leave a proper amount of reserves in the SDIRA itself, it can lead to problems. With real estate, there are always going to be scenarios where additional costs are going to be incurred. There are rules in place limiting deposits into a SDIRA just as with a traditional IRA and paying for expenses outside of the SDIRA can have major consequences. So when purchasing real estate, make sure there are additional funds in the account to cover any future expenses.

A quality custodian will always should cover these areas thoroughly on the front end and take steps to make sure mistakes are avoided. That being said, knowing the rules and properly preparing to use an IRA can lead to a great investment experience. 

Source:  realtor.com