Here's The Basics...

Step 1 - Find Out The Rules

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What is a Self Directed IRA?

A self-directed IRA is a type of traditional or Roth IRA that allows you to invest in a variety of different things, including real estate. Typically, to start your investment process, you find a custodian to help set up your self-directed IRA. We help you find a custodian that will work with you to get your money in one place, and then our team helps you find a real estate property that fits your future goals. Once we help you identify a real, tangible, cash-flowing investment property, we handle all the details, and put you in control of your retirement, so you can start replacing your income one property at at time. Real estate is a great investment option because it comes with cash-flow from rent, potential equity growth, and can even hedge inflation for you.

A Basic Guide To Self-Directed IRA's and Real Estate

What is a Self Directed IRA?

A self-directed IRA is an IRA (Roth, Traditional, SEP, Inherited IRA, SIMPLE) where the custodian of the account allows the IRA to invest into any investment allowed by law. These investments typically include; real estate, promissory notes, precious metals, and even private company stock.

Many Americans have not heard of self-directed IRAs before because large financial institutions, what we often refer to as the world of “traditional retirement,” want to maintain control, and keep the dollars in the “system.” Large financial institutions rely on your IRA dollars to charge large fees and make large profits, instead of allowing you to have control over your choices and your profits…

Despite the major financial institutions absence of interest in self-directed IRAs there are still plenty of companies our there that are looking to assist you in taking back control. You need to have a retirement plan custodian who specialize in this type of investment, and who will allow you to invest your retirement account into “alternative” investments, like real estate.

A self-directed IRA can invest in real estate or other alternative assets, and it will receive the same tax-deferred treatment, including the tax free treatment a Roth IRA receives. When you buy and sell stock or mutual funds in a retirement account, be it a Traditional IRA or a Roth IRA, you will not pay capital gains tax on the gains from the sale of the stock. Similarly, if you buy and sell, and cash flow real estate inside of your self-directed IRA (Traditional or Roth), your real estate will receive the same treatment by avoiding capital gains inside of your IRA.

 

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Can I Rollover Existing Retirement Funds To A Self-Directed IRA?

Most retirement account owners have their funds in company 401(k) accounts, government or private pension plans, or in brokerage account IRAs. These retirement plans typically allow for investment options into publicly-traded stocks, bonds or mutual funds. Account owners are usually not allowed to invest their funds into real estate, non-publicly traded businesses, precious metals or other “alternative” investments.

According to federal law governing retirement plans, a retirement account can invest into any investment allowed by law, so long as the plan or the administrator of the account does not in some way restrict the account’s investments. As a result, if you are unable to invest your retirement account into real estate or some other “alternative” investment, it is because your retirement plan administrator or the financial institution for your retirement account restricts your investments to specific types of investments. The is due to their business practices and not as a result of any legal restriction…

You ability to self direct your retirement account funds is typically dependent upon whether you are able to do a rollover or transfer of your current retirement account funds to a custodian who allows you to self direct your IRA. If you have an existing IRA with a brokerage or bank, that IRA can always be transferred or rolled over to a custodian who allows you to self direct your account and who won’t restrict your investments to “traditional” investments. Also if you have an old 401(k) account from a former employer, you are able to roll over those funds from your 401(k) account to a self-directed IRA custodian by doing a rollover.

If you have a 401(k) or other type of company sponsored retirement account with a current employer, then you are likely restricted from rolling over those funds to a self-directed IRA. The reason for this is that most employer retirement plans restrict their employees from moving funds outside of their plan. This is a restriction that is binding on the employee’s account as long as the employee is employed by that employer.

If you are in this situation, then in order to roll out your funds you either have to leave employment with that employer or you need to see if the employer’s plan allows for what is called an “in-service withdrawal.” An in-service withdrawal is a withdrawal whereby you can roll out a portion of your retirement plan funds for a specific use. Some of those uses are for things like disability or financial hardship but many plans also allow an employee to roll out a portion of the plan to an IRA of his or her choice as a rollover in-service withdrawal. Under law, the employee must be 59 1/2 and you can only withdraw employee deferrals/contributions as employer contributions cannot be rolled out while still employed.

According to the IRS, 62% of 401(k) plans allow for in-service withdrawals that are not based on hardship. (IRS 2010 401(k) Questionnaire Results, www.irs.gov/retirement-plans.) If you have an existing 401(k) or other employer-sponsored plan and if you are 59 1/2, it is likely that you will be able to do an in-service withdrawal from the employer plan, and that you will be able to roll/transfer funds over to a self-directed IRA. Be persistent to make sure that you get the right answer, as the typical easy answer is always “no.” When in doubt read your employer’s actual plan document to see if an in-service withdrawal would be allowed in your situation.

 

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Prohibited Transaction Rules

Real estate is the most common investment made by self-directed retirement plan investors. IRA’s may invest in all types of real estate, including: residential and commercial properties, apartment complexes, land, water or mineral rights, and new construction and development. Real estate owned by a retirement plan must always be held for investment, and the IRA owner and disqualified persons, such as specifically outlined family members, cannot live in or benefit from the property, as this would result in a prohibited transaction. Additionally, all income derived from the property should be paid directly to the IRA custodian for the benefit of the IRA, and all expenses for the property should be paid from the IRA (except when an IRA/LLC is used.)

There are some important keys to remember when it comes to making sure you are avoiding prohibited transactions when utilizing a self-directed IRA…

  • All contracts, deeds, and legal documents must be in the name of the IRA and not the IRA owner’s name. When applicable, documents may be in the name of an IRA/LLC.
  • The IRA owner and other disqualified persons may not receive a commission or other personal financial compensation for the IRA’s purchase, management, or sale of real estate.
  • Any loan in connection with the IRA’s purchase must be non-recourse and may result in UDFI tax.
  • The IRA owner and certain family members (disqualified persons) may not reside at or personally benefit from the real estate. The real estate must be held for investment.
  • The IRA owner and disqualified persons may oversee and direct repairs or management of the property through their IRA (or IRA/LLC as applicable) but the IRA owner and disqualified persons are prohibited from physically working on the property

 

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Avoid Prohibited Transactions

There are a set of rules known as the Prohibited Transaction Rules that dictate who your IRA may transact with. You should always avoid prohibited transactions with your IRA as the consequence of a prohibited transaction between an IRA and the IRA owner is that the entire IRA becomes disqualified and is no longer an IRA. This disqualification results in a distribution of the total amount in the IRA to the IRA owner personally. The distribution is subject to applicable taxes and penalties.

The prohibited transaction rules restrict your self-directed IRA in the three ways…

First, your IRA may not “transact” with anyone who is a “disqualified person.” This type of prohibited transaction is a per se prohibited transaction. A “transaction,” under the rule would include a purchase, sale, or lease. A “disqualified person,” includes the IRA owner, spouse, parents (ancestors), and children and their spouses (lineal descendants). So, for example, your IRA could not purchase real estate from your father as your IRA’s purchase would be a “transaction” and your father is a “disqualified person.” However, you IRA could purchase real estate from your sister as your sister is not a disqualified person.

Your IRA may engage in many transactions and those transactions will not be prohibited unless they are with a “disqualified person.” Similarly, your IRA may have dealings with a disqualified person but those are not prohibited transactions unless the dealings with the disqualified person constitutes a “transaction.” As a result, a per se prohibited transaction only occurs when an IRA engages in a transaction with a disqualified person.

Second, a disqualified person may not benefit from you IRA’s transactions or investments. This is called a self-dealing prohibited transaction. For example, if your IRA owns real estate, then a disqualified person may not use the property. Use of a property or compensation from an investment will result in a self-dealing prohibited transaction as a disqualified person ends up personally benefiting from the IRA’s investments or assets.

Third, the prohibited transaction rules restrict all extensions of credit between an IRA and a disqualified person. This type of prohibited transaction is known as an extension of credit prohibited transaction. In practice, this means that the IRA owner (and other disqualified persons) may not personally guarantee or otherwise offer their personal credit of the IRA owner and are merely loans secured by the IRA’s asset. Additionally, the extension of credit prohibited transaction rule prohibits the IRA from lending its funds to a disqualified person.

While an IRA may make loan investments, those loans may not be made to disqualified persons.

 

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Real Estate IRA Basics

When purchasing real estate with an IRA, the IRA must be listed on the contract as the buyer, and it is the custodian of the IRA and not the IRA owner who signs the contract to bind the IRA. Once the contract is ready to be signed, the IRA owner will send it to his or her self-directed IRA custodian with a direction of investment form, instructing the custodian to sign the contract for the IRA. In most instances, the custodian of the IRA will require the IRA owner to sign the contract as “read and approved” so that the custodian is certain that the IRA owner has read the terms and approved them for his or her IRA. Remember that the IRA is buying the property and not the IRA owner, so all contracts must be signed by the IRA custodian, who is the only party that can legally bind the IRA.

All funds due by the buyer and relating to the purchase of the property must be paid by the IRA, including: earnest money, deposit or down payment, closing costs, inspection and due diligence costs, and the final funds necessary to close the property. Since the IRA owner is a disqualified person to his or her own IRA, the IRA owner (and any other disqualified person) cannot make the earnest money deposit and cannot cover other expenses to the property with personal funds outside of the IRA…

The purchase contract for a property cannot be assigned from a disqualified person to an IRA. Similarly, the IRA cannot assign a property to the IRA owner or other disqualified persons. Assignment of a contract between an IRA and a disqualified person is a per se prohibited transaction.

A real estate contract could be assigned to the IRA from someone else who is not a disqualified person; conversely, any assignment from a disqualified person will likely constitute a prohibited transaction. In the event that an IRA owner mistakenly enters into a contract in their personal name, then the IRA owner should seek to unwind the contract in his or her personal name with the seller and should obtain a new contract, properly listing the IRA as the buyer. Any earnest money or deposits made by the IRA owner personally should be returned to the IRA owner personally and the IRA should then bear those expenses and contract requirements in the new contract.

If the contract cannot be undone in the IRA owner’s personal name, then an addendum to the contract can be added, clarifying that the buyer is the IRA. The addendum should no transfer or assign the contract but shall instead clarify who the buyer is.

If the IRA is going to be on title to real property with other owners, then the multiple-party form of ownership must be tenants in common. Other forms of multiple-party title ownership, such as joint tenancy and tenants by the entirety, should not be used because those ownership interests have characteristics whereby ownership passes to the other party on title following the death of the owner. Because the IRA cannot die and because the IRA’s ownership following the death of the IRA owner is determined based on the IRA beneficiary designations, the IRA’s ownership cannot be transferred via joint tenancy or survivorship methods. Tenants in common, on the other hand, is a form of holding title whereby upon the death of an owner, the title to their ownership passes to his or her heirs. In the case of the death of the IRA owner, the heirs to the IRA pursuant to the IRA beneficiary designation forms will receive the ownership to the property. This change of ownership upon death of the IRA owner may occur by an inherited IRA to the beneficiary or via distribution to the beneficiary.

When IRA-owned property is held for rent, it must be structured such that rental income is received by the IRA, and expenses are paid by the IRA. The IRA owner and other disqualified persons cannot personally be the “middle man” by paying expenses personally or by collecting the rent in their personal account and then forwarding the funds to the IRA. This is the primary reason Done For You Real Estate advocates utilizing a property manager to collect the rents from the property.

The IRA hires a property manager, which is already selected and a relationship forged through the DFY investment system, and that property manager manages the property and receives the income and pays property expenses. Cash flow is returned to the IRA. The property management company cannot be a disqualified person to the IRA owner, and the property management company will typically take a percent of the rental income collected as payment for their services. DFY Property Management companies typically collect between 8% and 10% of the gross monthly rent. Under this method, the IRA enters into an agreement with the property management company, and the property management company then enters into leases with respective tenants. The IRA receives rental income minus property expenses and fees charged by the property management company.

When managing IRA investment assets, the IRA owner should limit his or her activities to administrative and investment oversight tasks. While it is permissible to administer the investment, it is generally viewed impermissible to physically work on investment assets like real estate since such actions can constitute a per se prohibited transaction or a self-dealing prohibited transaction.

While it is permissible to make decisions as to the property manager or tenants and making decisions like when to buy and sell and at what price, etc., it is not permissible to take title or enter into contracts in the IRA owner’s personal name as opposed to the IRA.

While it is permissible to set terms for the lease or other legal agreements (assuming the property is owned directly by the IRA and any contract must be signed by the IRA custodian), it is not allowed to receive rental income in the IRA owner’s personal account or paying IRA expenses from a personal account of the IRA owner.

While it is permissible to visit the property and oversee repairs and maintenance, it is not okay to physically work on the property, or have any work done by the IRA owner or any other disqualified person.

 

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Real Estate IRA Best Practices

The IRA owner should avoid overextending the IRA into an investment where the IRA may end up being unable to cover unexpected property expenses. For example, if the IRA owner has $250,000 in his or her IRA to purchase a DFY investment property, he or she should avoid buying a $250,000 property as there may be unexpected repairs or costs, which the IRA may need to pay and that it would be unable to afford should those costs arise. The IRA could use rental income from the property, or the IRA owner may be able to make an annual contribution to the IRA to cover the shortfall. However, if those funds are inadequate, the IRA is left in a difficult position and may be unable to cover its own expenses…

The IRA owner (and other disqualified persons) cannot just pay the expenses owed by the IRA personally to cover the shortfall as that would constitute a transaction from a disqualified person and would be a prohibited transaction. Self directed IRA expert and attorney Mat Sorensen (from the video above), recommends the IRA maintains 10% of the purchase price of the property on hand in a liquid investment to cover unexpected expenses. In other words, if the IRA buys a $200,000 property through DFY, if should have an additional $20,000 available in the self directed IRA to cover unexpected costs or expenses.

 

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Directed IRA...

Step 2 - Meet The Experts

Why Work With Directed IRA?

Founded by two leading tax attorneys in the self-directed retirement industry

Mat Sorensen

Mat Sorenson

Founder/CEO

Founder and CEO of Directed IRA & Directed Trust Company, he is an attorney, best-selling author, a national speaker, and expert on self-directed retirement accounts. Mat has been at the forefront of the self-directed IRA industry since 2006. He wrote The Self-Directed IRA Handbook, which is the most widely used book in the self-directed IRA industry that has sold over 30,000 copies. Mat is also a VIP Contributor at Entrepreneur and has been cited, referenced, or quoted by the Wall Street Journal, Forbes, and The Guardian on self-directed topics.

Mark Kohler

Mark Kohler

Founder/CFO

Founder and CFO, he is an attorney, CPA, and best-selling author of 4 books (3 of which have chapters on self-directed IRAs). Mark is a regular commentator on network television on tax, retirement, and legal topics. He is a top-rated podcast host, national speaker, and personal and small business tax and legal expert. He helps clients build and protect wealth through wealth management strategies, and business and tax remedies often overlooked in this challenging, ever-changing economic climate. His seminars have helped tens of thousands of individuals and small business owners navigate the maze of legal, regulatory, and financial laws to greater success and wealth.

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