Before investing in real estate IRAs, it’s essential for investors to evaluate if it’s worth adding to their retirement portfolio. Along with this, learning about the different real estate IRA rules is also crucial. Here’s what investors need to know about investing in real estate inside their IRA.
In this article:
- Why Investors Consider Investing in Real Estate
- Rule #1: Self-Directed IRA Real Estate Rules Prohibit Owners or Disqualified Persons from Selling a Personally-Owned Property to Their Own IRAs
- Rule #2: IRA Owners Aren’t Allowed to Enjoy Indirect Benefits from Their IRA-Owned Properties
- Rule #3: Titles of Self-Directed IRA Real Estate Properties Aren’t Under the Names of IRA Owners
- Rule #4: Property Purchases by IRAs Can Be Done with Less Than 100% IRA Funding
- Rule #5: IRAs That Purchase Properties Through Financing Pay UBIT
- Rule #6: The IRA Pays for All Expenses
- Rule #7: Property Income Goes to the IRA
Real Estate IRA Rules Any Interested IRA Owner Should Know
Why Investors Consider Investing in Real Estate
One of the most enduring investments in history is real estate; people have always equated ownership of real estate with wealth.
Real estate investments can provide huge returns over the long-haul, and may even rival those of stocks. This is what attracts many IRA owners to invest a good portion of their IRA in a real estate IRA.
However, investing in real estate is neither simple nor easy, especially when compared to investing in financial securities like stocks and bonds. It has its own unique characteristics and sets of rules to abide by.
The following are seven of the most important real estate IRA rules that any IRA owner should consider.
Rule #1: Self-Directed IRA Real Estate Rules Prohibit Owners or Disqualified Persons from Selling a Personally-Owned Property to Their Own IRAs
One of the questions many IRA owners ask is whether they can sell their personally-owned properties to their own IRAs. And the answer is a resounding “no.”
When IRA owners sell properties they own to their IRAs, the IRS will consider it as a self-dealing transaction. And because the IRS prohibits self-dealing transactions, it also prohibits selling one’s property to one’s own IRA.
Disqualified Buyers and Sellers
The IRS also prohibits a disqualified person from buying or selling property from or to a self-directed IRA, respectively. Disqualified persons include the following:
- Fiduciaries, including the self-directed IRA’s owner;
- The IRA owner’s family including spouse, parents, children (including their spouses), grandparents/great-grandparents, and grandchildren/great-grandchildren (and spouses);
- The self-directed IRAs service providers like the financial planner, the accountant, and the custodian;
- A registered business, trust or estate, that’s at least 50% owned by a self-directed IRA’s service provider or fiduciary; and
- A partner that has a minimum share of 10% of a registered joint venture business.
Rule #2: IRA Owners Aren’t Allowed to Enjoy Indirect Benefits from Their IRA-Owned Properties
The main reason for opening an IRA is to prepare for eventual retirement, regardless of how far off retirement is. This means that, among other things, an IRA is not meant to provide benefits to owners or disqualified persons now.
When an IRA transaction provides any benefit, however small, to its owners or a disqualified person, it considers it as an indirect benefit. And unfortunately, the IRS prohibits IRA owners from benefiting from their IRAs assets before retirement, even if indirectly.
One example of how investors can benefit indirectly from their property IRA is by renting it out. An IRA owner who’s thinking of renting part or the entire property owned by their IRA should think twice because the IRS prohibits it.
Rule #3: Titles of Self-Directed IRA Real Estate Properties Aren’t Under the Names of IRA Owners
The IRS considers an IRA and its owners as distinct legal entities. Therefore, IRA-purchased properties will be named after the IRA and not the person who owns the IRA.
Titles to real estate IRAs usually look like this: [Fiduciary] FBO [IRA Owner’s Name] IRA. FBO means “for the benefit of.”
Rule #4: Property Purchases by IRAs Can Be Done with Less Than 100% IRA Funding
IRA owners have multiple options for purchasing properties under their IRAs. Aside from an outright purchase for the entire amount from an IRA, options include partnering with others and using undivided interest.
Financing is another option. However, this option must be properly structured to work.
IRAs that purchase properties for investment through financing can only use non-recourse loans to fund such purchases.
Non-Recourse Loans: Loans that limit creditors’ claims to only the assets used as collateral in the event borrowers can’t pay them back.
Rule #5: IRAs That Purchase Properties Through Financing Pay UBIT
When an IRA purchases property using debt, it means that the property was bought using other people’s or institutions’ money. This means that the IRA doesn’t own 100% of the purchased property.
Because the IRA only owns part of the financed property, the percentage of which depends on the loan balance, it can’t use the tax-exemption benefit for the entire 100% of the income generated by the property. The part of the property’s net income where the tax-exemption benefit can’t be applied is called the unrelated debt-financed income (UDFI).
UBIT applies only to an IRA property’s UDFI.
- An IRA property that was 40% financed by a non-recourse loan earned a net income of $15,000 during the year.
- The IRS will apply UBIT only to $6,000 of the $15,000 income, which is 40% of $15,000.
Rule #6: The IRA Pays for All Expenses
Whoever owns a property is responsible for all expenses related to its maintenance and repairs. These include:
- Property taxes
- Association dues
- Regular maintenance works
- Repair works
Because IRA properties are under the name of an IRA and not the IRA owner, the IRA pays for all property-related expenses.
While the beneficial owner is the IRA owner, the legal or registered owner is the IRA. That’s why all related expenses must be paid from the IRA account, not the IRA owner’s account.
Rule #7: Property Income Goes to the IRA
Because an IRA property is owned by an IRA, all income derived from it should go to the IRA. The IRA’s owner can’t claim it.
It’s no different than income generated by other financial investments made under an IRA, (e.g., stocks, bonds, or target date funds). Income generated by IRA assets isn’t taxed prior to distributions or withdrawals because it’s still inside the IRA accounts.
When an IRA owner wants to benefit from such assets, that owner needs to make a withdrawal, which the IRS may tax depending on whether such distributions are qualified. It may also depend on the type of IRA from which distributions will be made.
Real estate IRAs can provide good returns on investment and help ramp up retirement finances. It’s essential for account holders who are considering diversifying their IRA portfolio with properties to understand everything they can about it before making a decision.
Which of the seven real estate IRA rules do you think is the most important to consider before deciding to invest in real estate IRA? Let us know what you think in the comments section below.
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