Self Directed IRA | Purchase Real Estate Arizona
Although not a new concept, purchasing real estate in Scottsdale Arizona can be accomplished utilizing a Self Directed IRA or Solo 401 K Pension plan.
Advantages of Using a Self Directed IRA LLC to Purchase Real Estate in Scottsdale
Income or gains generated by an IRA generate tax-deferred/tax-free profits. Using a Self Directed IRA LLC to purchase real estate allows the IRA to earn tax-free income/gains and pay taxes at a future date (in the case of a Roth IRA the income/gains are always tax-free), rather than in the year the investment produces income.
With a Self Directed IRA LLC, you can invest tax-free and not have to pay taxes right away – or in the case of a Roth IRA – ever! All the income or gains from your real estate deals flow through to your IRA tax-free!
Most people mistakenly believe that their IRA must be invested in bank CDs, the stock market, or mutual funds. Few Investors realize that the IRS has always permitted real estate to be held inside IRA retirement accounts. Investments in real estate with a Self Directed IRA LLC are fully permissible under the Employee Retirement Income Security Act of 1974 (ERISA). IRS rules permit you to engage in almost any type of real estate investment, aside generally from any investment involving a disqualified person.
In addition, the IRS states the following on their website : “…..IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option.”
The Law
The Self Directed IRA Structure has been in use for some 35 years, however, the concept of using an entity owned by an IRA to make an investment was first reviewed by the Tax Court in Swanson V. Commissioner 106 T.C. 76 (1996). In Swanson, the Tax Court, in ruling against the IRS, held that the funding of a new entity by an IRA for self directing assets was a permitted transaction and not prohibited pursuant to Code Section 4975. The Swanson Case was later affirmed by the IRS in Field Service Advice Memorandum (FSA) 200128011. In FSA 200128011, the IRS, in providing guidance to IRS agents for purposes of conducting audits, confirmed the Tax Court’s holding in Swanson and held that a newly established entity owned by an IRA and managed by the IRA owner may make investments using IRA funds without violating the prohibited transaction rules under Internal Revenue Code Section 4975.
Can I Buy Real Estate in Scottsdale with my Self Directed IRA?
The answer to the question “can I buy real estate with my IRA” is a definitive yes, but you need the right kind of IRA in order to do so. Before we find out how to practically invest an IRA in real estate, let’s first look at the different IRA platforms.
With a standard IRA, you will not be able to invest in real estate. The standard IRA usually comes through a bank, Wall Street brokerage, or similar institution, and only allows you to invest in Wall Street style products. Obvious examples of these products are stocks, bonds, and mutual funds. It does not provide a platform for investing in real estate. The reason for this is that the banks and brokerage houses make a nice profit on stocks and mutual funds, and they are content to keep clients in the existing infrastructure. Real estate would require a whole new labor-intensive accounting system without the same guaranteed fee structure. Why fix it if it’s not broken?
That brings us to the next platform: the self directed IRA. A self directed IRA does answer the question can I buy real estate with my IRA with a yes, but here the devil is in the details. There are actually two kinds of self directed IRAs: one that uses a Trust as its platform and one that uses a checking account. Let’s look at the Trust platform first. In simple terms the way it works is that the custodian who holds your self directed IRA will be acting as a middle man via whom you may access the self directed IRA. Whenever you want to make a transaction, you have to go through the custodian. If you want to buy a piece of real estate with your self directed IRA, you have to go through the custodian. If you want to do renovations, you have to go through the custodian. If you want to pay a real estate contractor, you have to go through the custodian. If you want to… well, you get the picture. Not only do you face the hassle of going through the custodian for every move you make, but your self directed IRA will also be charged a fee for the transaction. In effect, you are paying somebody to hassle you. So what’s the alternative?
A self directed IRA with checkbook control takes care of all of these problems. With checkbook control you can buy real estate with your IRA, and you can do so without the hassle or crushing fees. The way it works is with the power of a LLC. When you sign up with Broad, we will set up a LLC for your self directed IRA which will then allow you to open up a checking account at your local bank. This checking account is under the control of just one person: you. That means that there is no middle man that you have to go through in order to access your self directed IRA. If you want to buy real estate with your IRA, just write a check to the seller. If you want to buy supplies for renovations, just write a check at your local hardware store. If you want to pay a contractor for repairs, just write him/her a check. By having access to your self directed IRA via a checking account, you have effectively cut out the fees and the aggravation of third-party processing.
With a self directed IRA with checkbook control, you can easily buy investment properties, such as foreclosures, multifamilies, and undeveloped land. So to answer the question can I buy real estate with my IRA, the answer is most definitely yes. Just make sure you do it with checkbook control.
What is a Solo 401(k) and Can I buy real estate in Scottsdale with it?
Before we answer the question “what is a Solo 401(k)”, let’s first discuss the structure of a standard 401(k). A 401(k) is a retirement plan (based on a section of the Internal Revenue Code) which allows an individual to dedicate income towards retirement. When the funds are designated as such, they receive special tax deferred benefits. In addition to the worker’s contribution, his/her employer may also contribute towards the retirement fund. These two contributions are known respectively as the Salary Deferral Contribution and the Profit Sharing Contribution. Most companies farm out their 401(k) plans to a third party who will typically offer the employees a choice of funds in which to invest.
So much for the standard 401(k); now to answer the question what is a Solo 401(k)? A Solo 401(k) is a 401(k) retirement plan that gives all the tax deferred benefits of a standard 401(k), but makes them available to self-employed individuals. It accomplishes this by removing a lot of the paperwork and bureaucratic procedures that accompany a standard corporate 401(k) plan. It also gives an added boost to the self-employed individual by allowing him/her to personally make both set of contributions: the Salary Deferral Contribution and the Profit Sharing Contribution. Depending upon the age of the investor, the Solo 401(k) contributions can reach between $51,000 and $56,500 per year.
Now that we’ve answered what is a Solo 401(k), let’s take it one step further and see how the Solo 401(k) platform can be taken to the next level. The best way to utilize the investment power of a Solo 401(k) is to enable its investment capability with Checkbook Control. In a standard Solo 401(k), (as mentioned before,) the bank or brokerage house offers the self-employed investor a choice of stocks or mutual funds. However, when the Solo 401(k) is empowered with Checkbook Control, the investor takes charge of all investment decisions. No longer is the choice limited to Wall Street products, but rather virtually any asset is available for investment purposes.
How does the Solo 401(k) achieve this investment power? When you call Broad to set up a self-directed Solo 401(k), Broad will provide you with an IRS-qualified retirement plan that will include a Trust as part of its structure. In setting up the plan, Broad designates you as the sole Trustee of the Trust, thereby enabling you to make all investment decisions. With this designation, you may then go the bank (whichever one you want!) and open a checking account in the name of the Trust. This checking account becomes your investment platform, and you may then invest in any asset by simply writing a check.
If you are self employed, or even have some minimal self employment income, then a Solo 401(k) is your best investment vehicle. And when you research the different Solo 401(k) platforms that are available, remember that Checkbook Control gives you the most investment power and freedom.
What are the Self Directed IRA rules and regulations?
When you first started driving you had to learn the rules. When you got your first real job, you quickly learned (and sometimes in very imaginative ways) the rules of your new office. When you get a self directed IRA, well… you just have to know the self directed IRA rules. Here’s a quick recap that can give you a picture of how it all works.
Self Directed IRA Rule #1 – Prohibited Transactions
This rule is the one which causes the most confusion, so let’s address it first. Prohibited Transactions are simply transactions that your self directed IRA is not allowed to make. There are two parts to each of these transactions: the who and the what. The who is the investor and any linear relative like a child or parent. The what is giving or getting benefit to the account. Here’s two easy examples:
Your father may not make a donation, cash or work related, to your self directed IRA.
You can not take a salary for managing your self directed IRA.
Self Directed IRA Rule #2 – Contributions and RMDs
In a self directed IRA, all contributions and Required Minimum Distributions must be made to the IRA itself, and not to the IRA’s checking account. Other than that, the rules for the self directed IRA are similar to those of a standard IRA. The investor may start taking distributions at 59 ½, must start taking distributions at 70 ½, and can contribute up to $5,000 a year. (If the investor is 55 or older, then the contribution limit is $6,000.)
Self Directed IRA Rule #3 – Taxes
A self directed IRA is a tax deferred instrument, and thus no taxes are due until distributions are made. There are two exceptional cases, though, when taxes could become due in the present tax year. One is UBIT – Unrelated Business Income Tax – which is a tax that is applied if the IRA owns an active business. The second is UDFI – Unrelated Debt Financed Income – which is a tax levied on the portion of profits that can be attributed to leverage. (Obviously, if no leverage or borrowing occurred, then this doesn’t apply.)
Self Directed IRA Rule #4 – Reporting
There are three filings which may be required from your self directed IRA:
Form 5948 – This reports the value of the IRA and any of the past year’s contributions.
Form 1099R – This reports any distributions from the IRA.
Form 990T – This is used for filing any potential UBIT or UDFI.
Self Directed IRA Rule #5 – No Credit Cards
This is actually a Prohibited Transaction. Your self directed IRA may not apply for a credit card, as the process entails giving a personal guarantee to the card. However, if is important that you possess a bankable piece of plastic for your IRA LLC’s checking account, you may apply for a debit card.
So there you have it: the top 5 self directed IRA rules. When you actually put the rules into practice, you most probably will come up with some questions of your own.
What can I do for a property owned by my IRA?
Self directed investors are familiar with the concept of Prohibited Transactions – a set of restrictions which define how the investor may interact with his/her property. The obvious ones are easy: don’t live in it, don’t let linear relatives provide paid services, and don’t pay for upkeep out of your own pocket. On the flip side, self directed investors also know that they may function as the non-compensated manager of the property in order to insure its viability and financial health. The area between these two parameters, however, touches upon a grey area of the law, and is frequently debated amongst legal experts.
If you use a self directed retirement plan, it’s usually best to err to the side of caution and take a more conservative approach as to which interactions are permitted. Sweat equity, (i.e. non-compensated services that are physically provided to an asset,) is clearly not allowed. This would even include something like quickly cutting the grass. It is unclear, however, whether the IRS treats this as an impermissible non-cash contribution to an IRA, a Prohibited Transaction, or both. In either case, it is prohibited and could possibly incur legal ramifications for your account.
On the permitted side, legal experts consider management duties to be an acceptable responsibility for the account holder. Such duties include hiring workers and contractors, keeping the books, and writing checks from the LLC’s checking account. An easy way to think about this is that the investor may donate “desk” power but may not be involved in any physical upkeep.
Limited Liability Protection: The State of Arizona has enacted a statute that provides for the creation and governance of LLCs. In addition, The State of Arizona allows an IRA to be a member/owner of an LLC.
By using an Arizona Self-Directed IRA LLC with “Checkbook Control”, your IRA will benefit from the limited liability protection afforded by using an Arizona LLC. By using an Arizona LLC, all your IRA assets held outside the LLC will be shielded from attack. This is especially important in the case of IRA real estate investments where many state statutes, including Arizona impose an extended statute of limitation for claims arising from defects in the design or construction of improvements to real estate.
Types of Real Estate Investments in Scottsdale Arizona That Can be Made Using a Self-Directed IRA LLC
With a Self-Directed IRA LLC with “checkbook control,” you will have the ability to invest in almost any type of real estate investment.
Below is a partial list of allowable real estate investments:
- Residential or commercial real estate
- Raw land
- Foreclosure property
- Mortgages
- Mortgage pools
- Deeds
- Tax liens
- Domestic real estate
- Foreign real estate
- Vacation homes
- Rental units
- Condos or coops
- Farm land
Use your Self-Directed IRA LLC funds to make 100% of the investment
If you have enough funds in your Self-Directed IRA LLC to cover the entire real estate purchase, including closing costs, taxes, fees, insurance, you may make the purchase outright using your Self-Directed IRA LLC. All ongoing expenses relating to the real estate investment must be paid out of your Self-Directed IRA LLC bank account. In addition, all income or gains relating to your real estate investment must be returned to your Self-Directed IRA LLC bank account.
Partner with Family, Friends, Colleagues
If you don’t have sufficient funds in your Self-Directed IRA LLC to make a real estate purchase outright, your Self-Directed IRA LLC can purchase an interest in the property along with a family, friend, or colleague. The investment would not be made into an entity owned by the IRA owner, but instead would be invested directly into the property.
For example, your Self-Directed IRA LLC could partner with a family member, friend, or colleague to purchase a piece of property for $150,000. Your Self-Directed IRA LLC could purchase an interest in the property (i.e. 50% for $75,000) and your family member, friend, or colleague could purchase the remaining interest (i.e. 50% for $75,000).
All income or gain from the property would be allocated to the parties in relation to their percentage of ownership in the property. Likewise, all property expenses must be paid in relation to the parties’ percentage of ownership in the property. Based on the above example, for a $2,000 property tax bill, the Self-Directed IRA LLC would be responsible for 50% of the bill ($1000) and the family member, friend, or colleague would be responsible for the remaining $1000 (50%).
Can I Borrow Money for your Self-Directed IRA LLC to buy real estate in Scottsdale Arizona?
You may obtain financing through a loan or mortgage to finance a real estate purchase using a Self-Directed IRA LLC. However, two important points must be considered when selecting this option:
- Loan must be non-recourse – A “prohibited transaction” is a transaction that, directly or indirectly involves the loan of money or other extension of credit between a plan and a disqualified person. Normally, when an individual purchases real estate with a mortgage, the traditional loan provides for recourse against the borrower (i.e., personal liability for the mortgage). However, if the IRA purchases real estate and secures a mortgage for the purchase, the loan must be non-recourse; otherwise there will be a prohibited transaction. A non-recourse loan only uses the property for collateral. In the event of default, the lender can collect only the property and cannot go after the IRA itself.
- Tax is due on profits from leveraged real estate – Pursuant to Code Section 514, if your Self-Directed IRA LLC uses non-recourse debt financing (i.e., a loan) on a real estate investment, some portion of each item of gross income from the property are subject to Unrelated Business Income Tax (UBTI). “Debt-financed property” refers to borrowing money to purchase the real estate (i.e., a leveraged asset that is held to produce income). In such cases, only the income attributable to the financed portion of the property is taxed; gain on the profit from the sale of the leveraged assets is also UDFI (unless the debt is paid off more than 12 months before the property is sold). There are some important exceptions from UBTI: those exclusions relate to the central importance of investment in real estate – dividends, interest, annuities, royalties, most rentals from real estate, and gains/losses from the sale of real estate. However, rental income generated from real estate that is “debt financed” loses the exclusion, and that portion of the income becomes subject to UBTI. Thus, if the IRA borrows money to finance the purchase of real estate, the portion of the rental income attributable to that debt will be taxable as UBTI.
For example, if the average acquisition indebtedness is $50 and the average adjusted basis is $100, 50 percent of each item of gross income from the property is included in UBTI.
A Self-Directed IRA LLC subject to UBTI is taxed at the trust tax rate because an IRA is considered a trust. For 2011, a Self-Directed IRA LLC subject to UBTI is taxed at the following rates:
- $0 – $2,300 = 15%
- $2,300 – $5,350 = $345 + 25%
- $5,350 – $8,200 = $1,107.50 + 28%
- $8200 – $11,200 = $1,905.50 + 33%
- Over $11,200 = $2,895.50 + 35%
Can I have multiple IRA Accounts in my Self Directed IRA LLC?
Yes – you may have multiple IRA accounts in your Self Directed IRA LLC. Each account would be a member of the LLC and have an interest in the LLC based on the amount contributed. Profits and losses would be allocated to the IRA accounts based on the accounts percentage interest.
Yes – you may have a Traditional IRA and Roth IRA account as members of your Self Directed IRA LLC. Note: you should keep separate records for each account as the distribution and tax rules are somewhat different.
For more information contact me to take advantage of real estate opportunities in Scottsdale Arizona.
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As a 35 year + full time veteran of the REAL ESTATE Industry, I understand what it takes to not only find the Home, Lot, Land, of your dreams, but also how to negotiate the minefield of real estate transactions. Not only am I a veteran of the real estate industry, I also live in the area I service.
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- Jeff McDowell, North Scottsdale Realtor 623.262.0811 EMAIL ME
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