Using an IRA to buy Investment Properties
The Individual Retirement Account (IRA) was initially established to give the workingman (or woman) a true retirement savings account. An individual’s employer does not have control over their IRA, differentiating it from a 401k or pension plan.
Many individuals that funnel money into Traditional IRA’s know that until they reach 59½ years of age, penalties for withdrawing money from the account will be issued. What most individuals do not know is that the IRA funds can grow, using investments with untaxed income!
It is legal and common to take advantage of the tax-free income potential of an IRA to build wealth, and it is the practice of many of the world’s millionaires today. The process of using an IRA to invest in real estate is very similar to a traditional real estate sale, with differences revolving around how funds are moved, and who can utilize the real estate.
Understand the difference between real estate owned privately, vs owned through an IRA.
The process of an IRA-funded real estate purchase is very similar to that of a traditional transaction. Realizing that the IRA and the investor are considered two separate entities is important to basis of IRA-funded investments. The use of a Custodian is required to purchase real estate through IRA funds. A custodian is a financial institution that holds and distributes an IRA owner’s funds, and is regulated by the IRS.
Because IRA funds purchase the property, the title will go in the name of the IRA, rather than that of the investor. Additionally, the EMD offered to the seller of the property during initial purchase must be acquired from the custodian, who pulls funds from the IRA account. All closing costs, taxes, and insurance fees are also pulled from the IRA account. The general theme here is obvious; the IRA finances everything!
Step 1—Set up Self-Directed IRA
In order to use the funds of a Traditional IRA for investment purposes, the account must be converted to a “Self Directed IRA”. The huge advantage of using a Self-Directed IRA is that you have control over your own money, and can invest in the assets you understand and are interested in. Contributions to this IRA type are tax-free and can be used for investments, with certain rules/limitations. The limitations include restrictions against borrowing money from the IRA, using the funds for personal use, along with prohibitions of using the funds on certain investments such as artwork, coins and collectables.
Step 2—Find the Right Investment
When purchasing real estate as an investment property, due diligence will not only serve to ensure appreciation and profit, but avoidance of IRS violations and subsequent fees. Any type of real estate is essentially up for grabs. Certain individuals are restricted from utilizing the property for personal use, as outlined by federal guidelines. Prohibited persons include the IRA owner and spouse, lineal descendants or their spouses, individuals providing services to the investment process, and investment advisors. Additionally, the IRA cannot purchase an investment property that is currently owned by the IRA-owner.
The tax-free nature of IRA-holdings bolsters the potential for growth. Choosing an investment property that will not require additional funds than what’s already in the IRA will help in avoiding complications down the road. If IRA funds are not sufficient to cover the entirety of the investment, it is possible to establish an LLC with other individuals contributing towards the purchase of the property. All contributors will appear on the Grant Deed as percentage owners, with respective ownership reflecting each individual contribution. Investment properties with long-term appreciation values often prove to be best for IRA-investing, and can serve as long-term, appreciating tax shelters.
Step 3—Assign a Custodian to Purchase the Real Estate on your Behalf
In order to utilize IRA funds for investing, an IRS-regulated 3rd party (bank, credit union, trust) must have access to the IRA funds. The custodian is given the authority to set up and execute transactions using the funds. Finding a reputable company to work with is important, as they will help in understanding all the fees, restrictions and complexities of your investment plans. A good custodian should know the rules and regulations of IRA’s and investment properties, and will be able to keep you from IRS violations, inquiries and fees. A custodian or firm that is managing the purchase and oversight of the IRA transaction will often take very little off the top—1% annually or lower in some cases. As all things, you get what you pay for, and a higher cost custodial firm may provide connections in the industry, and offer an unprecedented bank of information and advice towards the profitability of your investment.
Always have an Exit Strategy in Mind
Just as is expected for traditional real estate investments, an exit strategy should always be in mind when purchasing property. Options are simple; purchase and flip, purchase and hold, or purchase and tenant. Using a reputable property developer will ensure no net loss on the transaction, and will greatly aid in choosing the most financially sensible exit strategy.
Managing a rental property purchased through an IRA
One of the most important points to remember when dealing with an IRA-funded investment property is that all maintenance items, renovation costs, and management fees are to be taken out of the IRA. Payments are most typically distributed as a check taken from the custodian, directly to the party owed. All taxes, insurance, and associated costs with the property are also taken from the IRA fund. The IRA-owner may do regular maintenance, as long as it does not increase the value of the property. Any type of self-funded service or work (not funded by the IRA) that increases the value of the property will raise red flags by the IRS, therefore should be avoided altogether.
Earn Passive, Tax-Sheltered Income!
Getting into an investment using IRA funds should always be meticulously planned to avoid breaking laws, as they are strict and specific. A qualified custodial firm to handle the legalities and specifics of the investment should be utilized to maximize returns and avoid unnecessary fees. Retirement investing is considered a long-term strategy to build wealth, and should be treated as such. It’s not a get rich quick scheme! Many investors who have taken advantage of the benefits of IRA-investing have made millions of dollars in perfectly legal, tax-free income. IRA-funded investments are a great way to protect and grow hard earned assets, and they become more and more popular among investors every day!