With many saying the stock market is overheated, prudent investors are constantly looking for long-term investment strategies to diversify their holdings and keep their nest eggs safe. The taxable income in a retirement account, whether it’s an IRA/401K or Simplified Employee Pension plan, or SEP-IRA grow tax deferred until withdrawals are taken out. If the account is a Roth IRA, the gains accumulate tax-free and withdrawals are tax-free. Why not diversify into real estate?
Section 408 of the Internal Revenue Code (IRC) provides for real estate investing in a qualified retirement account. Real estate allowed includes land, commercial property, residential property, condominiums, mortgages, trust deeds, real estate contracts or private placements. The IRC maintains many rules regarding the creation, management, and oversight of the real estate retirement investment vehicle. Improperly structured or mismanaged can invalidate the investment, jeopardising its “tax exempt” status. As always, with all investments, it is important to obtain and maintain the best tax, financial and investment advisers to keep your hard-earned retirement funds safe. The purpose of this article is to reveal some of the challenges in structuring an IRA-401k real estate investment.
Rules of the Game
Real estate investments must be “arms length.” The property cannot be used by you, your business or your family. This means renting a home to a family member or owning an office building rented to your business is not permissible. The same holds true for your plan administrator, and any work done on the property cannot be done by you, your business or a family member. A disinterested third party must be used for all facets of the investment. Converting existing property owned by you or your business is not allowed.
When transferring assets from an existing retirement account, a self-directed IRA (regular or ROTH) must be established either as a Limited Liability Company (LLC), Equity Trust Company, or other qualified entity with which to hold the assets. Two of the most common methods to purchase the real estate are either as:
1. Directly in the custodial account, where the custodian holds the title to the property, manages the income and expenses, which is subject to continual transaction fees; or
2. Creation of an Equity Trust Company or Self Directed IRA LLC. The LLC holds the title, the beneficiary can function as the manager of the LLC and manage the income and expenditures.
A qualified plan administrator must be hired to manage the investment. A plan administrator is separate from a property manager. A good administrator will help to oversee and maintain the investment to ensure the applicable rules are being followed so that the investment will not be disqualified as a retirement account. Commission-based financial planners and certain administrators tend to have a vested interest in placing your assets in their “pet” investments. Choosing an administrator that solely manages the account and does not steer investments is ideal. Expect to pay anywhere from $2,000 to $10,000 to set up with an administrator which depends on the investment size or complexity. A single-family residence will obviously cost less than a four-plex or multi-tenant commercial building. Administrators typically charge $600 to $2,500 in annual fees.
Mortgage Property
The real estate retirement account is tax-deferred and tax-exempt as long as its own funds are used for the investments. When a mortgage is utilized, the earnings no longer are tax-exempt.
For example, assume you have $300,000 in your IRA, you reserve $100,000 to cover operations and contingencies (vacancies, unplanned expenditures, etc.). $200,000 is used for a 50% down payment and $200,000 is mortgaged. After deductions of interest and operating expenses, suppose that the mortgaged half shows a profit of $10,000. There is a taxable liability on those profits each year as long as the mortgage exists. This is called Unrelated Business Income Tax (UBIT).
Real Estate Tax Breaks
Property held in an IRA/401k does not enjoy the tax benefits for operating losses, nor can depreciation be claimed. Deductions for repairs or asset expenditures such as installation of a new HVAC cannot be deducted either.
Property Selection Considerations
Seek realty in an area where long-term appreciation is expected. Avoid declining market areas or where population or job growth is also in decline or has limited growth potential. Focus on quality property that does not have deferred maintenance or could potentially be a “money pit.” Seek property that generates enough cash flow to cover all costs where annual or periodic cash infusions would not be required.
SEP-IRA or Solo 401(k) Accounts
Simplified Employee Pension (SEP) IRA or Solo 401(k) can allow contributions for up to about $51,000 per year, depending on your profits. These accounts also provide for the Roth component and should be considered.
Real Estate Agent, Property Management
Budget for a reputable property management company to collect rents, screen tenants, manage repairs and negotiate leases. Expect to pay around 10% of the annual rents plus any applicable commissions for tenant change-overs.
Hire a competent real estate agent that is familiar with investing in IRA/401k real estate. Your real estate adviser should be professional, with tenacious negotiation skills, experienced with property and rent evaluations and is responsive to your needs. QCBN
By Peter Medal
Peter Medal and Leslie Nelson are the founders of the Prescott Elite Team at My Home Group Real Estate. Their offices are in downtown Prescott at 240 S. Montezuma Street, Suite 101. Reach them at 928-597-5151 PrescottEliteTeam.com or PrescottEliteTeam@gmail.com
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