Every year I get this question from clients wanting to invest in real estate through their IRA or SEP IRA. While it is not as straight forward as buying stocks, mutual funds or bonds it is doable if the proper steps are followed and adhered to. First you would transfer the existing IRA to a self-directed IRA, your banks and brokerage firms will not handle these type accounts. Then form a dedicated LLC to own the properties, it will have no other business except that of the investments by the IRA.
The taxpayer should not co-mingle his funds with those of the dedicated LLC. This includes mortgages, guarantees, insurance and other indirect enhancements to the LLC or loans or advances by the LLC to the taxpayer or one of his other entities. Therefore, one of the key considerations is does the LLC have sufficient funds to carry the properties without debt? With the current credit environment borrowing from traditional sources without credit backup is difficult.
Consider the costs. This structure would require annual tax returns be filed for the LLC and the Self-directed IRA Trustee would also have an annual fee.
The next question is what type of real estate should I buy. There are basically 3 types to consider,
- rental properties either residential or commercial,
- property for construction and then either hold or sell, and
- rehabs, the fixer uppers to flip when done.
Each of these can have pitfalls but the rental units in a stable market can be the least headaches. In the construction and rehabs the trap is that the taxpayer or one of his entities should not be doing the construction or contract work. The LLC should hire its contractor and subs independent of the taxpayer. This would not preclude the taxpayer individually doing some incidental work on the property without compensation.
For tax purposes the IRS Code requires depreciation on the rental properties and thereby, at least in theory, increasing the long-term capital gain on the sale of the property. Since the funds are those of an IRA there is no benefit from the capital gain and the net proceeds from the sale would be returned to the IRA Trustee. The LLC cannot sell the property to the taxpayer, that would be a prohibited transaction.
If you think this process is too much work or to complicated your regular IRA or SEP could by REIT stock, invest in master limited real estate partnerships or private REIT’s.
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