A few months ago, I wrote an article about buying real estate within an individual retirement account (IRA). In that article, I discussed the rules and regulations related to that type of transaction. This article is intended to broaden your understanding of the different methods that can be used to purchase real estate inside of individual retirement arrangements. There are four main methods to make this kind of purchase.
The most common method by far is simply purchasing the property with cash.
For example, John Smith has built his retirement for many years and has accumulated $200,000 in his account. John finds an investment property for $175,000 and uses a self-directed IRA custodian to purchase it within his IRA. It is important to remember that John's IRA, not John himself, owns the property. So any income (i.e., rent/sale proceeds) needs to be delivered directly to his custodian. Furthermore, his IRA is responsible for any expenses related to the property, so as one example, John will need to direct his custodian to pay the property taxes from the remaining cash in his account.
The beauty of a cash transaction is twofold. First, without a mortgage, income-producing properties generally generate cash flow well. Second, John's IRA is growing tax-deferred (or tax-free if it is a Roth IRA). There are no capital gains taxes on the rent or sale proceeds since they flow to the IRA.
Another quite common method of purchase when IRA money is involved is a tenants-in-common partnership. Because of annual contribution limits, many people, especially if they are younger, may not have enough cash built up in their IRA to purchase the property they want. There also are rules that prohibit the purchase of an asset that you or your family already own (see Prohibited Transactions).
However, there is nothing to suggest you can't partner with your IRA. Keep in mind that once the ownership percentages are decided on, all income and expenses must be split accordingly. Because of the disqualified party rules, you would never be able to "buy out" your IRA or vice versa.
This type of transaction is also appealing when a spouse has an IRA. Even though IRAs are "individual" retirement accounts, that doesn't keep a married couple from purchasing an asset together. In that scenario, each IRA has its own share of ownership, splitting expenses and profits accordingly.
Limited Liability Company (LLC)
One strategy that has gained traction in the IRA industry over the past decade is the use of a newly established LLC, or more commonly referred to as a "checkbook control" LLC. For many years, there was much debate over the validity of an LLC that was owned by an IRA but operated and managed by the IRA account holder. Several court cases have examined the validity of this kind of setup (see Swanson v. Commissioner, 106 T.C. 76  and Ellis v. Commissioner, T.C. Memo 2013-245). In these cases, the court ruled that self-managing an LLC wholly owned by an IRA has not been deemed prohibited, and is therefore allowed.
What this specifically offers an IRA holder is control. While they still need a self-directed IRA custodian to administer the asset and do proper IRS reporting, this method allows the IRA account holder to use the LLC to buy assets, deposit income and pay bills derived from the LLC-owned asset.
For example, Jane Smith opens a self-directed IRA and transfers money from a traditional brokerage custodian. Then, Jane forms an LLC that is owned by the IRA (the self-directed custodian's title is listed on the operating agreement as the owner of record). Jane is set up as the LLC managing member. She then directs her custodian to send funds to the LLC and makes her investment purchases without involving the custodian (other than annual valuation requirements). There is a formation cost and annual state filing fee with this method, so whether this is right for you really depends on how much you want more control.
Did you know an IRA can borrow money to buy real estate? There are some important concepts you need to consider before jumping into a transaction like this.
First off, the IRS mandates that the loan be "nonrecourse." That means you can't personally guarantee the loan. The loan is given to your IRA, and the purchased asset is the only collateral. Because of the added risks, there are limited lenders, and the down payment typically needs to approach at least 40%-50% to be considered by the bank.
Also, the property usually needs to provide cash flow. This is because the IRA is required to pay back the debt, and the bank is going to want to know how the IRA will have the cash to do so.
Lastly, the IRS doesn't like the idea that borrowed "non-IRA" funds help the IRA grow faster than it can on its own. Therefore, a tax (UBIT/UDFI) is imposed on the share of the income that is attributable to the loan. The account holder is required to file Form 990-T to report this tax and will need the IRA custodian to cut a check from the IRA if any amount is due.
Due to all of these considerations, this kind of transaction is rare but allowable. If interested in this method, you will need to do your due diligence and possibly involve your accountant or tax adviser.