Source: This article was originally published on https://www.pensco.com/
Lately on the blog, we’ve been talking about the different ways that investors can use tax-advantaged IRA funds to invest in real estate. The method that often comes to mind when people picture a “real estate IRA” is directly investing in real estate using money in an IRA. For an investor who knows real estate well, prefers to choose the real estate investment themselves and doesn’t mind the extra legwork involved, self-directed IRA investing is a great way to diversify a portfolio and grow a real estate investment in a tax-advantaged account.
What exactly does direct investing in real estate using a self-directed IRA entail? Let’s walk through a few of the key elements:
1. The paperwork
The process usually begins with the IRA account owner finding a property, either on his own or through a broker/agent. When a purchase agreement is drawn up and earnest money deposit is agreed upon, the name of the buyer should always be the name of the IRA, and the funds for the deposit MUST come from the IRA’s cash balance (NOT from the client’s personal checking account). For example, at PENSCO the buyer name on all purchase agreements, escrow documents, and recorded documents would read “PENSCO Trust Co. Custodian FBO (client name) IRA.”
The account owner should then sign all purchase contract documents as “read and approved” and forward them on to the IRA custodian for countersignature (this is the general rule for all documents in this process). In the same vein, if there are addendums or amendments to the purchase contract or any other documents, the IRA must countersign for the account owner on those as well.
2. The deposit
The IRA account owner must then instruct the IRA custodian to send the earnest money deposit funds to the title/escrow company from the cash balance in their IRA. Prospective buyers cannot use personal funds for the down payment and then be reimbursed by the IRA, as that constitutes a prohibited transaction in the eyes of the IRS. However, if you don’t have all of the required cash available in a self-directed IRA, there are some other financing options available, such as a non-recourse bank loan. I’ll talk in detail about these options in my next post.
3. The review
At this point, the self-directed IRA custodian can usually work with the title/escrow company through the remaining steps in the process, as they will have contact with all parties involved (in some states, real estate investment transactions are handled by attorneys rather than title/escrow companies). The IRA custodian will need to review several other documents to make sure that the investment is feasible for administration and there are no visible prohibited transactions that would take place by virtue of the purchase. These documents include:
- A preliminary title report for the property (to verify that the seller is on title, that the seller is not a disqualified person with respect to the self-directed IRA, and to see if there are any liens/encumbrances on the property)
- A proposed grant deed (showing that the buyer/owner is “(custodian name) Custodian FBO (client name) IRA” and the owner’s address belongs to the IRA custodian)
- Escrow instructions from the title/escrow company (initialed/signed as “read and approved” by the client)
- A final settlement statement (initialed/signed as “read and approved” by the client)
- Custodial forms (every IRA custodian will require one or more forms to complete the purchase)
The title/escrow company usually handles the recording of the grant deed (or applicable instrument) and then returns the original to the IRA custodian for safekeeping.
4. The management
After the self-directed IRA funds are in escrow, documents have been signed, and the grant deed has been sent for recording, the IRA account owner is free to rent, lease, hold or sell the property as they choose.
If the IRA account owner chooses to rent or lease the property, most self-directed IRA custodians, including PENSCO Trust, require that there is a 3rd party property manager appointed to gather rental payments and forward them to the IRA. As with any income generated by a real estate investment owned within an IRA, all rental payments/income must be paid to the IRA and not to the underlying account owner personally. Rental income that is cashed by the account owner in their personal checking account will be construed as a distribution from the IRA and is subject to taxes and penalties.
Additionally, any improvements made to the property must be invoiced to and paid for by the IRA. This basically means that the IRA account owner cannot make any improvements/repairs by themselves, but instead must hire outside parties to perform the work. The IRS considers any improvements/repairs done by the owner to be “sweat equity”, and taking such actions is considered a prohibited transaction. Further, the IRA account owner and any other of their disqualified persons are not allowed to use the investment property for personal use. For example, you cannot use an investment property owned by your IRA as a vacation home for yourself or your family. Finally, any expenses such as utility bills and property taxes must also be paid from the IRA. The county where the property is located should have the IRA custodian’s address as the address of record and mail property tax bills to them when taxes are due.
At the end of the day, the process of purchasing a piece of property directly in one’s IRA account is similar to the process of purchasing it outside of an IRA. The main difference is that all documents (after being initialed/signed by the account owner) must be countersigned by the IRA custodian, and the money for the purchase must come directly from the IRA as well.Investing in real estate using a self-directed IRA does require more legwork and maintenance by the underlying client to avoid any prohibited transactions; however, it gives the client more freedom and control than other types of real estate investments.
PENSCO’s Blog is purely for educational purposes. PENSCO does not provide investment, tax, or legal advice nor does it evaluate, recommend or endorse any advisory firm or investment vehicle. Individuals are encouraged to seek professional advice before making any investment decision. Investments are not FDIC insured and are subject to risk, including the loss of principal.
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