Disclaimer: I am neither a lawyer nor an accountant. This discussion is for informational purposes only, and should in no way be considered “advice”. Hopefully your curiosity will be piqued and you will be inspired to educate yourself further on the subject with the help of a trusted advisor. Should that inspiration subsequently move you to wish to start looking at potential investment properties, why yes, as a matter of fact, I would love to help with that.
Now that we have that out of the way, the short answer, and good news, is yes, you can buy investment real estate using the money in your IRA. The general consensus, backed by decades of practical experience, is that anything not explicitly forbidden by IRS rules can be a legal IRA investment holding.
The less good news is that it is much more complicated to set up and manage your IRA so as to avail of these opportunities, with many potential pitfalls. One misstep could throw your IRA into noncompliance, possibly resulting in the entire balance being taxed. Yikes!
Scary, but then again possibly some of you, like me, are tired of feeling like a total pawn in the traditional investment arena. I feel ill every time the stock market does another one of its swoons, but with most non-junk bond payouts hovering in the low single digits, and the drumbeat of rising interest rates (which would promptly tank the value of fixed income investments), I’m sure I’m not the only one looking farther afield.
To make a long story short, about four years ago I decided it was time to take matters into my own hands, and I created a self-directed IRA. I’d like to share a few things I’ve learned along the way.
Let’s start by answering a few questions:
“I spoke to my financial advisor about this and he said I couldn’t do it. What gives?” Let me translate for you: what he meant to say was that you couldn’t do it with money residing in his institution. Most IRA custodians only allow traditional investments: stocks, bonds, CDs, money market, some insurance products (annuities). Only a handful of IRA custodians allow alternative investments, so if you want to partake of those, you need to seek out one of those custodians. And if you are a Nevada resident, that custodian must reside in Nevada.*
“What are the explicitly forbidden investments?” There are only a few… life insurance, antiques, collectibles (for example fine art and wine), and some derivatives (for example uncovered calls). Note that real estate does not appear on the list.
“This is wonderful! I think I’ll buy a condo in Cancun and then I’ll have a great investment plus a place to go on vacation.” Sorry, nope. You cannot use your investment property in any way that provides benefit to you; can’t stay in it, rent it to your immediate relatives, be paid for managing it, sell it from yourself to your IRA, and so on. Any hint of “self dealing” will promptly disqualify your investment.
“I’ve opened an account with a custodian, and would like to purchase my first rental property, but I notice that everything the custodian does on my behalf comes with a fee; anything I can do about that?” Yes. As you might imagine, purchasing a property requires many documents to be signed, and running a rental property, even with professional management, requires a multitude of bills to be paid. If you must have the custodian pay each bill, of course they require a fee. Every document that they sign on your behalf…you guessed it, another fee. Not that I blame them, in fact it is refreshing to see upfront what your investments are costing you, rather than have it buried in some bid-ask spread or load fee.
Which brings us to the juiciest tidbit I have to share: the IRA LLC. Here’s how it works: a single member LLC is created in which your IRA is the sole member, and you are designated as the non-member manager. So for instance, the LLC might be called My Big Buck Retirement Fund LLC, and the sole member would be Bob’s Pretty Good IRA Custodian Account #12345 FBO John Q Doe. The LLC would elect to be managed by a manager rather than by managing members, and John Q Doe would be designated the manager.
Although it is extremely simple to create an LLC in Nevada, completely online in minutes with a credit card, I took the approach of hiring an outside firm to do it for me in this instance in order to maintain arm’s length in a documentable way. The firm also provided an Operating Agreement for the LLC which had been created by attorneys versed in the IRS requirements for such an entity. It cost me a few hundred extra dollars, but I sleep better at night.
Once your LLC is up and running, simply have your alternative IRA custodian fund it. With the LLC Articles of Organization in hand, it is possible to open a bank account and obtain checks and a debit card with you, the manager, as signatory. Voila! Now the custodian charges are based on either the value of your LLC or the number of entities you hold with them (i.e. one), a very reasonable few hundred dollars per year approximately.
Henceforth, all the real estate you purchase, expenses you pay, and money you receive, are managed by you, the manager of the LLC. All holdings are in the name of the LLC. Keep in mind that self-dealing is still prohibited. You cannot rent your rental to your children, be paid for managing it, or perform any work on it yourself. Obviously, neither can you move into it, although it is perfectly legal to take it as a distribution from your IRA at a later date, with taxes due of course, at which time it transfers into your own name and is yours to do with as you please. But in the meantime, you now have a new source of cash flow growing pretax in your IRA that is not subject to stock market gyrations.
One other caveat: while it is not illegal to obtain a loan to purchase property for your IRA, it complicates things significantly in ways that are beyond the scope of this article. The biggest difference involves a tax called UBIT (unrelated business income tax) that is paid on the percentage of income attributable to the debt on the property. Talk to your accountant before you go there.
Paperback by Hubert Bromma, one of the original promoters of self-directed IRAs:
How to Invest in Real Estate With Your IRA and 401K & Pay Little or No Taxes
Good article from the Journal of Accountancy about the pitfalls of self-directed IRAs:
Self-Directed IRAs: A Tax Compliance Black Hole
General article from the New York Times:
Tackling Real Estate in a Do-It-Yourself Approach to IRAs
Insight into the ways high-frequency traders have changed the stock market, and, you’ll be shocked to learn, not in ways that benefit you, the investor. By one of my favorite authors:
Flash Boys by Michael Lewis (author of The Big Short and Liar’s Poker, among others)
*I learned this the hard way. At the time I opened my alternative account, there were few, if any, alternative IRA custodians in Nevada, so I chose a well-known California company to hold it. After a number of years, and with those sorts of custodians now existing in Nevada, a Nevada statute was passed (or perhaps it already existed?) stating that any IRA custodian holding accounts for Nevada residents had to be based in the State of Nevada. The State took my account holder to court, demanding that all accounts belonging to Nevada residents be transferred to a Nevada custodian, and ultimately prevailed. I received notice (well after the fact) that I had about a month to transfer my account to the chosen new custodian. While I have no complaint with my new custodian, my cynical self can’t help but wonder what prompted this sudden State enthusiasm for creating (enforcing?) this statute and the resulting money grab.