The ability to use a retirement plan to acquire an apartment or apartment building has become a popular option for investors looking to invest in a hard asset that also shelters the income and gains from taxation. This article will explore the advantages of buying an apartment with a Self-Directed IRA and how to actually use it to make the real estate investment. It will also cover the rules that must be navigated in order to fully capitalize on the tax advantages inherent in using a self-directed to buy real estate.
What is a Self-Directed IRA?
A Self-Directed IRA is a retirement account that offers investors greater flexibility and control over their investment choices compared to traditional IRAs. With a Self-Directed IRA, you can invest in a broader range of assets, such as real estate, precious metals, private equity, and other non-traditional investments, in addition to conventional options like stocks and bonds. This type of retirement plan allows you to customize your investment strategy according to your financial goals and risk tolerance, potentially leading to more diverse and personalized portfolio growth. However, it also requires a higher level of involvement and knowledge to manage and comply with IRS regulations.
What is the Primary Advantage of using a Self-Directed IRA?
The main benefit of using a Self-Directed IRA to buy an apartment or apartment building is that, in general, all income and gains from the investment will flow back to the IRA without tax. This is known as tax-deferral or tax-free investing in the case of a Roth IRA. The concept of tax deferral is predicated on the mathematical theory of compounding returns. Under the Rule of 72, assuming an 8% annual rate of return, your IRA assets should double every 8 years since they are not subject to tax. The U.S. retirement system is one of the greatest theaters for taking advantage of the power of compounding returns.
It is important to remember that before deciding to use your retirement funds to buy an apartment, it is crucial that one performs the necessary financial due diligence to make sure the investment makes economic sense and can provide the requisite rate of return on cash invested to make financial sense.
Can I Buy an Apartment with my Self-Directed IRA?
When it comes to making an investment, such as buying an apartment with an IRA, the IRS generally does not tell you what you can invest in, only what you cannot invest in. The IRS has always permitted real estate to be held inside IRA retirement accounts. Investments with a Real Estate IRA are fully permissible under the Employee Retirement Income Security Act of 1974 (ERISA).
The types of investments that are not permitted to be made using retirement funds is outlined in Internal Revenue Code (IRC) Section 408 and 4975. These rules are generally known as the prohibited transaction rules. Other than life insurance, collectibles, and transactions that benefit the IRA holder or a “disqualified person,” one can use his or her IRA to make the investments.
An extension of these rules is that the tenant of the apartment should not also be disqualified. For example, you cannot sublet the apartment to your daughter or hire your father to manage the property.
When it comes to using a Self-Directed IRA to buy an apartment, in general, so long as the seller of the apartment is not a disqualified person, the investment would likely not violate the IRS prohibited transaction rules.
How to Structure a Self-Directed IRA Investment to Buy an Apartment
Now that you are aware of the IRS prohibited transaction rules, the next thing to consider when electing to use IRA funds to acquire an apartment or apartment building, is what type of IRA should be established. In general, there are two different types of Self-Directed IRA solutions
Full Service Self-Directed IRA
A full-service Self-Directed IRA, also known as a custodian-controlled IRA, is the most common way to use retirement funds to make alternative investments. It offers an investor more options than a basic IRA. A special IRA custodian, such as IRA Financial Trust, will serve as the custodian of the IRA. Unlike a typical financial institution, most IRA custodians generate fees simply by opening and maintaining IRA accounts and do not offer any financial investment products or platforms.
With a full-service Self-Directed IRA, the IRA funds are generally held with the IRA custodian and at the IRA holder’s sole direction, the custodian will then invest them. Title to the apartment would be in the name of the IRA. In general, all rental income and gains from the apartment investment would flow back to the IRA without tax.
The Self-Directed IRA LLC
For real estate investors, the Self-Directed IRA LLC has become the most popular option. The core difference between the two is that with a Self-Directed IRA LLC, also known as a “Checkbook IRA,” a special purpose limited liability company is established that is owned by the IRA and managed by the IRA owner. Whereas, in the case of a Self-Directed IRA, the IRA would invest directly into the underlying investment and title to the investment would be in the name of the IRA and not the LLC.
An IRA is set up with a custodian, such as IRA Financial. It is then invested into a special purpose LLC, which IRA Financial can help you establish. The IRA LLC is then managed by the investor providing him or her with checkbook control over the IRA funds. The manager of the Self-Directed IRA LLC will have the authority to make the investment decisions without the involvement of the custodian. Plus, it will offer the IRA owner with limited liability protection over the IRA investments, and, since the LLC owns the asset, you will be afforded more privacy. Buying and maintaining an apartment can be used by simply writing a check.
All types of IRAs can be transferred tax-free to a Self-Directed IRA LLC!
Using Leverage to Buy an Apartment with a Self-Directed IRA
In general, most passive investments that your IRA might invest in are exempt from the unrelated business taxable income tax or UBTI. Some examples of exempt type of income include interest from loans, dividends, annuities, royalties, most rentals from real estate, and gains/losses from the sale of real estate.
However, IRC Section 514 requires debt-financed income to be included in unrelated business taxable income. If an exempt organization, such as an IRA, owns “debt-financed property,” some portion of each item of gross income from the property, and a like portion of all related deductions, are included in unrelated business taxable income, whether the income is in the form of rent, interest, gain on disposition of the property, or some other character. The term “acquisition indebtedness” generally includes any liability incurred before, contemporaneously with, or after the acquisition or improvement of the property if it arose because of the acquisition or improvement or if the need for the indebtedness was foreseeable at the time of the acquisition or improvement.
In other words, if one uses a Self-Directed IRA to buy an apartment and also use a loan from a non-disqualified person, such as a bank or friend, the use of the loan could trigger UBIT. For example, if one uses $100,000 from an IRA and also borrows $100,000 from a bank on a non-recourse basis (the IRS does not allow an IRA owner to personally guarantee an obligation of their IRA which is why the loan must be non-recourse), 50% of the net income or gains generated by the asset would be subject to the tax. In 2024, the highest UBTI tax rate is 37%, which gets triggered at around $15,000. It is important to fully understand that implications of triggering the tax. That being said, there are a number of ways to minimize and even eliminate the application of UBTI when acquiring an apartment using retirement funds.
Conclusion
Buying an Apartment with a Self-Directed IRA can offer several benefits:
- Tax Advantages: Profits from rental income and capital gains from selling the property can be tax-deferred or tax-free, depending on whether you use a traditional or Roth IRA.
- Diversification: Investing in real estate through an IRA allows you to diversify your retirement portfolio beyond traditional assets like stocks and bonds, which can help mitigate risk.
- Long-Term Growth: Real estate has the potential for long-term appreciation, and rental properties can provide steady income. This can contribute to your retirement savings growing over time.
- Control and Flexibility: A Self-Directed IRA gives you control over the investment decisions and allows you to invest in a property that aligns with your personal financial goals and risk tolerance.
However, it’s important to be aware of the rules and regulations governing IRA investments in real estate, as there are specific requirements and restrictions that must be followed. Fill out the form below to get started with an IRA Financial Self-Directed IRA!
