Structuring a Self-Directed IRA Real Estate Investment in 2023

Looking to make a Self-Directed IRA Real Estate Investment? Many real estate experts believe real estate prices will become more moderate in 2023. With mortgage rates increasing, home prices should moderate, but low inventory will continue to keep pressure on the real estate marketplace.

2021 was a great year for selling a home but not such a great year if you were looking to buy a home.  Home prices rose significantly and at the same time, the number of homes for sale dropped.  This led to a very hot real estate marketplace in 2021. The market cooled off in 2022 as available homes began to dry up, but there’s been an upwards trend this year for real estate investors. What 2021 taught us is that cash is king and that is good news for Self-Directed IRA investors.

Before we examine the best ways to use retirement funds to buy real estate, it is important to understand what a Self-Directed IRA is and how it works.

What is a Self-Directed IRA?

The Self-Directed IRA is a retirement account vehicle that is best known for allowing investors to use retirement funds to buy alternative assets, such as real estate. It is not a legal term, and you will not find it anywhere in the Internal Revenue Code; it simply refers to an IRA account that is permitted to be invested in traditional assets, such as stocks, but also alternative assets, such as real estate.

One major advantage of purchasing real estate with a Self-Directed IRA is that all income and gains are tax-deferred until the time when the IRA holder (you) takes a distribution. In addition, for many Americans, it is their largest source of savings and capital, which can help get a real estate transaction done in a competitive market.

Self-Directed IRA Real Estate Rules

The Internal Revenue Code does not describe what a Self-Directed IRA can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits the IRA holder and his or her lineal descendants (“disqualified persons”) from engaging in certain types of transactions that would directly or indirectly personally benefit a “disqualified person.” In other words, a Self-Directed IRA can, generally, make any investment except for collectibles, insurance, or any transaction that does not exclusively benefit the IRA.

The IRS is essentially saying that when you use your IRA or 401(k) plan funds to make the investment, the investment should be made for the sole purpose of benefiting the retirement account and not the IRA holder personally or any of his or her lineal descendants or controlled entities. Therefore, in the case of a real estate investment using a Self-Directed IRA, you should not:

• Use the real estate for personal use
• Provide any active services personally, whether paid or not
• Hire any disqualified person to provide services to the real estate asset
• Use any personal funds in the real estate transaction that will be deemed self-dealing or a conflict of interest
• All income and gains from the real estate transaction should flow back to the IRA or respective partners pro rata

Best Ways to Structure a Self-Directed IRA Real Estate Investment

There are two ways to fund a Self-Directed IRA: (i) contribution, and a rollover from another IRA or 401(k) plan.  For 2023, the maximum IRA contribution is $6,500 or $7,500 if you are at least age 50. Alternatively, if you have access to a former employer 401(k) plan, you can roll those funds tax-free to a Self-Directed IRA. It’s important to note that you cannot move funds out of a current 401(k) plan; you generally can’t touch those funds until you separate from that job.

Now that you know how you can fund your Self-Directed IRA, let’s discuss the two options for buying real estate.

Self-Directed IRA

A Self-Directed IRA is a type of IRA that offers an IRA investor more investment options than an IRA with a traditional financial institution. With a Self-Directed IRA, IRA Financial Trust, a regulated trust company, will serve as the custodian of the IRA. The IRA funds are held with the custodian. At the IRA holder’s direction, the custodian will then invest the IRA funds into alternative asset investments, such as real estate.

Unlike a bank or brokerage firm, a Self-Directed IRA with IRA Financial will allow you to invest in alternative asset investments.  It is appropriate for Real Estate IRA investors with either one-off investments or investments that do not involve a high number of transactions.

Self-Directed IRA LLC

The Self-Directed IRA LLC with “checkbook control” is essentially the same as described above, but it involves a limited liability company (“LLC”) that is created which is funded and owned by the IRA and managed by the IRA holder.

In other words, the IRA would own the LLC, and the IRA owner or any third party would serve as the manager of the LLC. The Self-Directed IRA LLC offers the IRA investor limited liability protection on the real estate investments inside the LLC. In addition, the LLC offers the IRA owner more control over the assets so investments can be made quickly, and expenses can be paid easily without involving the IRA custodian.

The Self-Directed IRA LLC is best for Real Estate IRA owners that want more control and expect to have frequent transactions, such as rental properties or fix and flips. Because you have checkbook control of your IRA funds, transactions can be performed without consulting your custodian.

Why Does Using a Self-Directed IRA to Buy Real Estate Make Sense?

There are a number of reasons why using a Self-Directed IRA to buy real estate makes so much sense.

1. Tax Advantage: By using a Self-Directed IRA to invest in real estate, in general, all income and gains generated by the real estate investment would flow back into the plan without tax. For example, if a Self-Directed IRA invested in a home and paid $200,000, and later sold the home for $300,000, that $100,000 of gain would go back to the IRA tax-free.
   
2. Follow the Cash. For most Americans, their retirement funds are their greatest source of capital. With the cost of living increasing and inflation impacting our personal savings, using an IRA to invest in real estate is the only option for many Americans.  Accordingly, using a Self-Directed IRA is the primary way many Americans can gain the opportunity to invest in real estate.
   
3. Diversification Approximately 90% of retirement assets are invested in financial markets, such as stocks, mutual funds, and ETFs. Investing an IRA into real estate offers a form of investment diversification from the equity markets. In general, the more diversified your portfolio, the greater chance that your assets will offer lower correlation, meaning they are less likely to move in the same direction. Stocks may go down, while real estate, and other asset classes, may go up.
   
4. Hedge Against Inflation: Rising food and energy prices caused by an influx of trillions of dollars into the economy by the Federal Reserve over the last several years have caused core consumer prices to rise. As a result, many investors are looking for ways to protect their portfolios from the ravages of inflation. In general, having the ability to invest in certain hard assets, such as real estate, is viewed as a smart way to protect your retirement assets from inflation

A Hidden Real Estate Tax You Should Know About

If an IRA uses a non-recourse loan to purchase real estate, a tax called the unrelated business taxable income (UBTI) tax could apply to a portion of the net income associated with the leverage.  A non-recourse loan is a loan not personally guaranteed by the individual, which is not permitted under Internal Revenue Service Section 4975(c).

The maximum UBTI tax rate is 37%, so it is important to keep that tax in mind if you plan to use an IRA to buy real estate with leverage. For example, if you borrow 50% of the purchase price of a piece of property, then half the gains generated would be taxable.

Final Thoughts

2023 will likely shape up to be another great year for real estate investors.  However, having access to cash will be key to securing a real estate transaction.  Learning how to use your retirement funds, in a tax-advantageous manner to invest in real estate, can help many Americans better diversify their retirement portfolios, as well as hedge against inflation.

The Self-Directed IRA is the best way to invest in real estate. So long as the real estate property is held by your retirement account, you don’t pay taxes on the income it generates. Of course, if you do need to borrow to make an investment, make sure you are aware of the UBTI rules. That tax could turn a dream investment into a nightmare.