Frequently Asked Questions About Buying Debt Financed Real Estate in an IRA
Good news! You can buy real estate in your traditional, Roth, SEP, or SIMPLE IRA, your 401(k), your Coverdell Education Savings Account for the kids, and even in your Health Savings Account. Even better, your IRA can borrow the money for the purchase or even take over a property subject to existing financing. What could be better than building your retirement wealth using OPM (Other People’s Money)? However, there are some restrictions which you must be aware of when using your IRA to purchase debt financed real estate. Below I answer a series of frequently asked questions regarding the purchase of debt financed real estate in an IRA.
Q. Is it really legal to buy real estate in an IRA?
A. Yes. Even the IRS agrees that real estate is a permitted investment. In its answer to the question “Are there any restrictions on the things I can invest my IRA in?” the Internal Revenue Service states “IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option.”
Q. Can my IRA buy real estate with a loan or take over a property subject to an existing loan?
A. Yes. An IRA may borrow money to acquire real estate or take over a property subject to an existing loan, provided that the loan is non-recourse to the IRA and to any “disqualified person.” This means that typically the lender may only foreclose on the property in the event of a default. Even if there is a deficiency, the lender cannot come after the rest of the IRA’s assets, nor can the lender come after the IRA owner or any other disqualified person. Neither the IRA holder nor any other disqualified person is permitted to sign a personal guarantee of the debt.
Q. Where can I get a non-recourse loan for my IRA?
A. There are at least four sources for financing which do not violate the non-recourse requirements for IRAs. First, there is seller financing. Most sellers understand that if the loan goes into default they get the property back anyway, so asking for the loan to be non-recourse should not be too difficult to negotiate. Second, there is private financing from financial friends. If you cultivate a reputation as a professional real estate investor, there should be no reason that your financial friends would not loan your IRA money on a non-recourse basis, either from their own funds or from their own IRAs. I have seen IRAs borrow the money for both the purchase and the rehab on a non-recourse loan! Third, there are banks and hard money lenders. Non-recourse loans are not the norm, so many banks will turn you down. However, there is at least one bank that lends in all 50 states, and in Houston I have had at least 3 local banks and 2 hard money lenders make non-recourse loans to IRAs. Finally, as mentioned above, you could take over a property subject to an existing loan, provided the originator of the loan is not you or another disqualified person.
Q. Is there any tax effect of having an IRA own debt financed real estate?
A. Yes. Income and gains from investments in an IRA, including real estate, are normally not taxed until the income is distributed (unless the distribution is a qualifying distribution from a Roth IRA, a Coverdell Education Savings Account, or a Health Savings Account, in which case the distribution is tax free). However, if the IRA owns property subject to debt, either directly or indirectly through an LLC or a partnership, it may owe tax on the net income from the property or partnership.
Q. If the profits from an investment are taxable to an IRA, does that mean it is prohibited?
A. Absolutely not! There is nothing prohibited at all about making investments in your IRA which will cause the IRA to owe taxes.
Q. But if an investment is taxable, why do it in the IRA?
A. That is a good question. To figure out if this makes sense, ask yourself the following key questions. First, what would you pay in taxes if you made the same investment outside of the IRA? The “penalty” for making the investment inside your IRA, if any, is only the amount of tax your IRA would pay which exceeds what you would pay personally outside of your IRA. Unlike personal investments, the IRA owes tax only on the portion of the net income related to the debt, so depending on how heavily leveraged the property is the IRA may actually owe less tax than you would personally on the same investment. Second, does the return you expect from this investment even after paying the tax exceed the return you could achieve in other non-taxable investments within the IRA? For example, one client was able to grow her Roth IRA from $3,000 to over $33,000 using debt financed real estate in under 4 months even after the IRA paid taxes on the gain! Third, do you have plans for re-investing the profits from the investment? If you re-invest your profits from an investment made outside of your IRA you pay taxes again on the profits from the next investment, and the one after that, etc. At least within the IRA you have the choice of making future investments which will be tax free or tax deferred, depending on the type of account you have.
Q. If the IRA pays a tax, and then it is distributed to me and taxed again, isn’t that double taxation?
A. Yes, unless it is a qualified tax free distribution from a Roth IRA, a Health Savings Account (HSA) or a Coverdell Education Savings Account (ESA). The fact is that you still want your IRA to grow, and sometimes the best way to accomplish that goal is to make investments which will cause the IRA to pay taxes. Keep in mind that companies which are publicly traded already have paid taxes before dividends are distributed, and the value of the stock takes into consideration the profits after the payment of income taxes. In that sense, even stock and mutual funds are subject to “double taxation.”
Q. If the IRA makes an investment subject to tax, who pays the tax?
A. The IRA must pay the tax.
Q. What form does the IRA file if it owes taxes?
A. IRS Form 990-T, Exempt Organization Business Income Tax Return.
Q. What is the tax rate that IRAs must pay?
A. The IRA is taxed at the rate for trusts. Refer to the instructions for IRS Form 990-T for current rates. For 2005, the marginal tax rate for ordinary income above $9,750 was 35%. Capital gain income is taxed according to the usual rules for short term and long term capital gains.
Q. Is there any way to get around paying this tax?
A. Yes. In some ways it may be considered a “voluntary” tax, since investments can often be structured in such a way as to avoid taxation. Some ways to structure your IRA investment to avoid taxation include loaning money instead of acquiring the real estate directly or purchasing an option on the real estate, then assigning or canceling the option for a fee. These techniques have a disadvantage in that they may not result in as much profit to the IRA, but will generally be free of tax. There is also an exemption from this tax for 401(k)’s and other qualified plans in certain circumstances.
Q. Where can I find out more information?
A. Visit our website at www.TheEntrustGroup.com for more information. Also, Unrelated Business Taxable Income and Unrelated Debt Financed Income are covered in IRS Publication 598, which is freely available on the IRS website at www.irs.gov. The actual statutes may be found in Internal Revenue Code §511-514.
There is one general truth that applies both inside and outside of an IRA – you can do more with debt than you can without it. Despite the increased risk from debt and the taxes due on income from debt financed property, a careful analysis may lead to the conclusion that having your IRA pay taxes now may be the way to financial freedom in your retirement. Be sure to have your IRA pay the tax if it owes it, though. As I always say, “Don’t mess with the IRS, because they have what it takes to take what you have!”
H. Quincy Long is an attorney and is President of Entrust Retirement Services, Inc., with offices in Houston and San Antonio (www.TheEntrustGroup.com). Nothing in this article is intended as tax, legal or investment advice. He may be reached by email at [email protected].
