A self-directed IRA is an individual retirement account that gives you complete control over your investment choices. Unlike other IRAs, you’re not limited to stocks, bonds, or mutual funds.
This means you can take advantage of investing in alternative assets – such as real estate with your self-directed retirement account.
What are the benefits of a self-directed IRA?
Increase the potential for growth
Opening a self-directed retirement account gives you the freedom to invest in almost any type of asset – meaning you have more flexibility in the amount of risk you take on and more potential for a higher rate of return.
Take control of your own financial future
Put your knowledge and expertise of a particular industry or niche to good use. Make investment decisions based on what you know and understand to grow your retirement savings.
Protect your wealth against economic fluctuations
The ability to diversify your portfolio by investing in alternative assets such as real estate can act as a hedge against market fluctuations and volatility.
Grow your savings in a tax-advantaged account
Investing over time in a self-directed IRA that allows for tax-deferred or tax-free growth can significantly affect future wealth positively.
Funding Your IRA for Real Estate Purchase
There are several ways to approach investing in real estate with your retirement funds. Here are a few examples:
A direct investment involves purchasing a physical property and collecting the income generated within your self-directed retirement account. It is the simplest and quickest way to use liquid assets in your retirement account. Your IRA pays cash for the investment property and holds title to the property. Rules about prohibited transactions apply to direct real estate investments. Please make sure you understand these rules to avoid potentially significant tax penalties.
You can partner your IRA with personal funds or other IRA funds. You can also partner with other people’s IRAs or their personal funds. You divide the investment according to each investor’s contribution. This will also split the profits and expenses for the investment, with each investor securing a percentage of the expense or return.
Your IRA borrows money to purchase a property with a non-recourse loan and the leveraged property is held in your IRA. This sort of credit cannot be obtained by going through traditional means.
A limited liability company, or LLC, is an entity often formed and used to purchase real estate in an individual’s IRA using IRA assets as a funding source. The IRA holds an interest in an LLC. The title of the property is held in the name of the LLC. For more information on LLCs.
Running Out of Funds
If there is insufficient cash to cover property expenses, you, as the IRA holder, have the option to rent the property, transfer funds from another IRA, make a contribution, or liquidate other IRA assets to pay the expenses.
Real Estate IRA Purchasing
How Investing in Real Estate with an IRA Works
In a Real Estate IRA, the property becomes an asset of your IRA. This means your IRA owns it. You do not own it, personally, nor can you use it for personal reasons. It’s important to stress that since the IRA directly owns the asset, the IRA holder cannot benefit from the asset. You, as the account holder, cannot live in the property or use it as a vacation home, for example. The property is held for the exclusive benefit of the IRA. Also, your IRA cannot purchase a property from you or any disqualified person.
Visit our Learning Center for information regarding disqualified persons and prohibited transactions in a Real Estate IRA. Title companies, financial professionals, and local Realtors and real estate agents and brokers who are familiar with self-directed IRAs are a good source for information.
The Real Estate Investment Process
You can purchase a number of real estate-related investments with an IRA. The process is fairly straightforward:
1. Open and fund a self-directed retirement account with The Entrust Group.
2. Identify a property and make an offer. Make sure the contract is titled in the name of your IRA as the buyer. For example, “The Entrust Group FBO Client Name Account X #555555.” Entrust signs the purchase contract and you sign as “read and approved.”
3. Complete an Entrust Buy Direction Letter and submit it with the purchase contract for Entrust’s signature. Allow up to one business day for review and processing.
4. Upon receipt of the fully executed Purchase Contract agreement, Entrust will fund the earnest money deposit the following business day.
5. Escrow is opened for your Entrust self-directed Real Estate IRA. When the title company is ready to close escrow, you will need these documents:
a. Warranty or Grant Deed
b. Preliminary Title Report
c. Estimated Closing Statement
d. Loan Documents (if applicable)
e. Seller’s Entity Formation Document (if applicable)
6. Entrust will review the paperwork and fund the remaining balance. Allow up to three business days for review. When the paperwork is completed, Entrust will fund the next business day.
7. Once your IRA owns the asset, income and expenses for the property must flow through your Entrust account.
All legal documents related to an IRA-owned asset, such as property manager contracts, the lease or rental contract with tenants, and property insurance, must be held in the name of the IRA.
Earnest Money Deposit (EMD)
The earnest money deposit (EMD) is a payment made in major real estate transactions to demonstrate that the buyer has good faith and is serious about completing the transaction. It also implies that both parties intend to deal with each other fairly and honestly.
The amount of the EMD varies. When the deal closes, the EMD is applied to the buyer’s downpayment or closing costs. However, you and the seller should have an agreement in place to determine how the EMD would be handled if the deal fails to go through.
Before Entrust can fund the EMD on a real estate purchase, all documents involved in the transaction must be reviewed and titled in the name of the IRA.
Real Estate IRA Prohibited Transactions and Rules
The decision to purchase real estate with your retirement funds is a great way to take advantage of the benefits of a self-directed IRA. However, property investments are also governed by rules that investors must familiarize themselves with and follow.
In order to avoid penalties and excess tax payments on the real estate investment properties in your self-directed IRA, you must adhere to certain regulations regarding prohibited transactions and disqualified persons.A prohibited transaction is defined as any improper use of your IRA by you or any disqualified person.
Many prohibited transactions stem from the involvement of a disqualified person. The following people are considered disqualified persons for the purposes of your self-directed IRA:
You, the account owner
A beneficiary of the IRA
Your lineal ascendants/descendants and their spouses
Plan fiduciaries (including advisers, custodians, and administrators)
An entity (corporation, estate, partnership, etc.) in which you own at least 50% of the voting stock, directly or indirectly.
An officer, director or a 10% or more share holder or partner of
Anyone providing services to the IRA, such as the trustee or custodian (See IRS Section 4975 for a complete list of prohibited parties credentials)
Examples of prohibited transactions in a real estate IRA may include:
Buying the property of a disqualified person in your IRA
Borrowing money from your IRA to pay off a personal mortgage
Taking personal payment directly from an income producing property
Hiring a disqualified person to provide services for a property held in your IRA (i.e., using your spouse as the property manager)
Using real estate owned by your IRA as collateral for a personal loan
Any use of a property owned by your IRA that brings personal benefit to you, rather than the account
Using property owned by your IRA as your vacation home
Allowing a disqualified person to live in IRA-owned property
How to Title an Investment Property
The title of the property is vested in the name of the IRA. The word “vesting” refers to the title and/or registration of the asset held in the self-directed retirement account. If your IRA is not partnering with personal funds, make sure the investment documents are titled in the name of your Real Estate IRA as the owner – not in your own name. Consult with your attorney or tax adviser to be aware of your state’s legal requirements and regulations on how to take title to the property, as there may be legal or tax obligations.
Entrust will review the investment documents to ensure that the contract has the correct title prior to processing the Buy Direction Letter and funding the transaction. The property must be titled with an “FBO” before your name, which means “for the benefit of.” The FBO designation helps maintain the administration chain for the IRA along with the asset ownership: The person for whose benefit the IRA custodian holds the money. An IRA-vested note will reference the custodian and account number as well as the IRA holder.
Proper vesting of the title:
For IRAs, ESAs, HSAs: “The Entrust Group, Inc. FBO [Client Name] Account # [Entrust Acct. Number]
Example: The Entrust Group, Inc. FBO John Smith Account #12345.
If there is more than one owner: The Entrust Group, Inc. FBO John Smith Account #12345, [Percentage of ownership] % undivided interest.
For Qualified Plans: [Trustee’s Name], Trustee of [Plan Name] FBO [Client’s Name, Entrust Acct. Number]
Example: David Smith, Trustee of Little Angels Profit Sharing 401K Plan FBO John Smith Account #12345.
If there is more than one owner: David Smith, Trustee of Little Angels Profit Sharing 401K Plan FBO John Smith Account #12345, [Percentage of ownership] % undivided interest
All documents must be noted “read and approved,” then signed and dated by you as the IRA holder before sending them to Entrust for signature. Do not sign the documents where a signature is required, as Entrust must sign all documentation for the purchase on behalf of your IRA.
You must submit documents to your county’s records office for recording before returning it to Entrust. Be sure to keep a copy for your records. Entrust also signs all documents on behalf of your self-directed IRA.
Real Estate IRA Property Income and Expenses
How Property Income and Expenses Work
While it is not required, some investors choose to hire a property manager for the purpose of consolidating expenses. Though the IRS prohibits the IRA holder from being the property manager, Entrust permits IRA holders to receive the rental income and forward it to The Entrust Group for record keeping. Please note, the check from tenants must be made payable to your IRA, not in your name.
If you hold a self-directed Real Estate IRA with Entrust, all income and expenses are sent to the Entrust cash management team (CMT) for processing. Rental checks must be made payable to The Entrust Group Inc. FBO [client legal name or plan name], account # [account number]. For expenses to be paid by Entrust for your IRA-owned property, complete a Payment Authorization Letter and send it, along with a copy of the invoice or bill, to the CMT.
If the property is being managed by a property manager, the property manager collects the rent and sends it to Entrust for deposit, along with the profit and loss statement. It is preferred if the profit and loss statement is sent monthly. If no property management company is managing the property, the rental income should be deposited directly to the IRA. The income goes into the IRA tax-deferred until a distribution is taken. If the property is owned by a Roth IRA, you do not pay taxes on the rental or any income associated to the Roth at the time of a qualified distribution because you will already have paid taxes on the contributions made to the Roth.
Having a property manager is advantageous if you are partnering with others. Your tenants do not have to write multiple rental checks to the various investors. They just write one to the property manager, who then distributes the percentages accordingly.
Any expenses related to the investment, including escrow or deposit funds, maintenance fees, insurance, and repairs must be paid directly from the self-directed Real Estate IRA. This means the IRA must have sufficient cash to pay these amounts.
Partnering Your IRA
One way investors acquire funds to make larger investments is to combine their IRA funds with another person’s IRA funds. Here is an example of how the income and expenses would be divided in the case that you partnered with another IRA:
Real Estate IRA Property Management
Once your IRA has purchased real estate, you can start making management decisions, such as choosing tenants, contractors, or individuals to maintain the property. As the IRA holder, you cannot be the property manager, nor can you perform the labor. Property management companies can be very useful to help real estate investors navigate day-to-day operations and avoid the risk of prohibited transactions. See IRS Code 4975.
Property management encompasses duties such as:
Accounting and record keeping
Property maintenance and repairs
Finding a Property Manager
While the IRS doesn’t require it, it is advisable to find a property manager that specializes in your area of investments (residential or commercial). A personal referral is a good way to ensure that you are contracting with a reputable firm. You may ask a real estate professional, title company, or other investors in your area who they use to manage their properties. Joining and attending local real estate investor groups can provide a wealth of information from seasoned investors. Trade groups such as the Institute of Real Estate Management (IREM) and National Apartment Association (NAA) can also provide referrals.
Research property managers before calling them for an interview. Check their licenses and certifications. Drive by properties they manage to see how they are maintained. Find out how they handle vacancies. Check to see if any complaints have been filed against them. You should also consider how many units they manage and what type of insurance they carry. Before hiring a property manager, determine exactly what services the firm will provide, and of course, knowing a company’s fee structure is imperative.
It is important to have a properly prepared agreement that fits the needs of your investment property. Review the contract carefully. You may even want to involve your attorney. The property management agreement will be made in the name of the IRA and is signed by Entrust for the benefit of the IRA at your direction.
For example: The Entrust Group, Inc. FBO John Smith Account #12345.
Be sure to review the liability that the property manager holds. A “hold harmless clause” typically protects the property manager, except in cases of negligence. To protect the property from negligence on the part of contractors or third parties who the property manager hires, make sure to include a reasonable care clause in the agreement.
Income and Expenses
Any income (rent) coming from the property cannot be deposited into any non-IRA account. This would be counted as a distribution. It is a prohibited transaction to pay yourself profits generated from the IRA’s rental property. An investor may hire a third party who is not a disqualified person to be the property manager and handle the cash flow or daily operations.