HOW TO BUY REAL ESTATE WITH IRA FUNDS
(UPDATED WITH 2023 RATE CHANGES)
Did you know that your traditional IRA could be rolled over or transferred to a self-directed IRA that is maintained by a specialized custodian to invest in real estate? Most Americans assume their traditional IRAs can only invest in bank CDs, the stock market, and/or mutual funds. The fact is that your IRA is really self-directed. You have the authority to make investment decisions on behalf of your IRA.
Self-directed IRAs account for less than 5 percent of the broader $12.5 trillion IRA market. According to data published by the Retirement Industry Trust Association (RITA), interest in self-directed IRAs is poised to rise further as individuals look to gain greater control over their investment planning and diversify their portfolios beyond stocks, bonds, and mutual funds. “As workers stay longer in jobs with 401 (k) plans, they are more likely to roll those assets over into a self-directed IRA at some point,” noted Mary L. Mohr, Executive Director of RITA.
Significant Retirement Savings Law Changes Beginning in 2023
The retirement savings bill, known as the SECURE 2.0 Act was signed into law on December 29, 2022. SECURE is an acronym for “Setting Every Community Up For Retirement Enhancement.” Significant changes are as follows:
- Effective January 1, 2023, the age at which minimum distributions must begin is now 73. In ten years, it will go up again to age 75. Also, the penalties for failing to take the Required Minimum Distributions (RMD) are cut in half in 2023 from 50% to 25% and drops to 10% if the mistake is corrected promptly.
- Catch-up contribution limitations for people age 50 and older have been increased from $6,500 per year to $7,500 per year as of 2023. In addition, in 2025, persons ages 60 to 63 will be able to make a $10,000 per year contribution.
- Emergency plan withdrawals of up to $1,000 annually are permitted with unforeseeable or immediate family expenses arise. The distribution are not subject to the 10% early withdrawal penalty.
Because Americans are living longer, the IRS announced in November 2020 an updated life expectancy and distribution period to calculate RMDs from IRAs, which is the first update since 2002. The finalized rules go into effect on January 1, 2022. Under the new RMD tables, your life expectancy factor will be longer, therefore, you will have a smaller annual RMD, which means less taxable income, while more retirement savings can be retained for tax-deferred growth.
Why Invest Your IRA in Real Estate?
Real estate is a logical addition to many retirement portfolios for the following 4 key reasons:
- It is totally transparent. Real estate is a tangible asset and is not subject to the same volatility of many traditional Wall Street products.
- It offers strong cash flow. Certain income properties generate between 8% and 10% annual cash returns.
- It can be acquired at a discount. Currently, there are landlords who need to liquidate properties. This provides an opportunity to acquire real estate at below-market prices, resulting in greater returns.
- It acts as a “safety net” against inflation. With the possibility of future inflation, real estate can act as a hedge against it. Historically, real estate has performed well in times of high inflation.
It is quite simple to convert your traditional IRA into a self-directed one.
Step One: Find a trustworthy, reliable, and competent independent custodian who specializes in self-directed IRA account management. Be aware that most banks and big brokerages do not allow owners of traditional IRAs to invest IRA funds in real estate. They generally limit your investment options to products they sell, like stocks, bonds, and mutual funds. They prefer not to take the administrative burden and complexities associated with maintaining IRAs invested in real estate.
When you have made your decision to purchase real estate with a self-directed IRA, you need to find an IRA custodian. By law, all IRAs must have a custodian who holds the assets for the IRA owner. Such custodians are licensed, bonded, and insured and handle all IRS recording and reporting requirements. Many have been formed in recent years, and their fees and services vary considerably. In choosing your custodian, it can be helpful to contact the Better Business Bureau. Check to see if the company has the highest rating and to determine if complaints have been lodged against the company and how they were resolved.
Step Two: Withdraw all or part of the assets of one traditional IRA and transfer those funds to a self-directed IRA. This transaction is sometimes referred to as a custodian-to-custodian transfer. IRA holders can perform as many of these transfers as they would like in any 12-month period. Typically, you would be liquidating publicly traded securities in your IRA prior to the transfer. Such transfers are not reportable events for the IRS.
You can also roll over a former employer’s 401 (k) plan into a self-directed IRA. Rollovers refer to the movement of funds from one IRA provider or qualified retirement plan to the account holder who then deposits those funds with another IRA provider. You have 60 days to complete this move tax-free. Or it’s often possible to arrange a direct rollover whereby the current provider sends a wire or check directly to your new custodian. Rollovers are reported to the IRS, but performed properly are not taxable events.
Technically, you can roll cash from your 401 (k) into a self-directed IRA once you reach the age of 59 ½. However, while the IRS permits such rollovers, your employer has the right to include or exclude a provision for in-service withdrawals from your 401 (k) plan.
Step Three: Decide how much money you want to roll over. You might like to invest in real estate through a self-directed IRA but don’t have enough money to buy an entire property. This can be resolved by “fractional ownership” whereby multiple investors pool their funds to make one large purchase.
Possible Tax Implications
Normally, earnings on investments held within a qualified account <IRA> are not taxable until the account owner takes a distribution.
However, there are tax implications if your IRA owns property that is “debt-financed.” This may generate Unrelated Debt Financed Income (UDFI). This tax would be based on the portion of the profit realized through the debt. If your property has debt of 25%, then 25% of your net rental income is subject to the tax that is based on current trust tax rates. However, keep in mind that most self-directed IRAs that hold leveraged real estate will not owe UDFI tax for the first few years due to depreciation.
If your IRA has UDFI, it will be reflected on a K-1 and the tax must be paid from cash held in the IRA. The IRA’s account owner’s tax advisor or CPA prepares the 990-T and the IRA signs the return as the Custodian. However, there is a $1,000 exemption. Consequently, the IRA would not have to pay the UBIT tax and file the 990-T tax return unless the IRA has over $1,000 of annual UBIT income. Additionally, if your IRA has a loss, the IRS allows it to carry forward to subsequent years. The 2023 trust tax rates cap out at a maximum rate of 37% at $14,450 of annual income subject to UBIT tax. Remember, the IRA account owner is responsible for determining if the filing of Form 990-T is necessary, which is why account owners are advised to work with an experienced tax professional. Also, keep in mind that if your self-directed IRA has invested in several real estate properties, the income and losses from each property will be consolidated on the Form 990-T.
Unrelated Business Income Tax (UBIT) Tax Rate (2023)
$0 - $2,900 UBIT Tax Rate of 10% of taxable income
$2,901 - $10,550 UBIT Tax Rate of $290 plus 24% of the amount over $2,900
$10,551 - $14,450 UBIT Tax Rate of $2,126 plus 35% of the amount over $10,550
Over $14,450 UBIT Tax Rate of $3,491 plus 37% of the amount over $14,450
At this point, one might ask, why make a real estate investment in an IRA if there are tax implications? Unlike personal investments, the IRA owes tax only on the portion of the net income related to the debt. Depending on how heavily leveraged the property is, the IRA may actually owe less tax than you would personally on the same investment. Secondly, the return you expect from this investment may, even after paying the tax, exceed the return you could achieve in the other non-taxable investments in your IRA.
If you are a successful real estate investor or just looking to diversify your retirement portfolios, the combination of real estate and your IRA can be a very powerful investment vehicle.
Asa L. Shield, Jr. CPA
CCP Commercial Real Estate