As far as “do it yourself” retirement planning goes, the IRA structure is one of the easiest and least expensive to set up, use to invest, and use to finance your retirement.
Self-directed IRAs are even more advantageous than IRAs with traditional custodians because they can be used to invest in less traditional assets like real estate. But there are some particularly tricky legal issues that you need to take into consideration when you use your self-directed IRA to invest in real estate.
The investment process is relatively straightforward when you have adequate resources in your account to purchase a piece of property outright. But if you choose to employ financing to complete a particular investment transaction, then you are likely exposing your account to “unrelated business taxable income” or “UBTI.”
The IRS rules for IRAs state that an IRA which borrows money is engaging in an activity that is unrelated to its fundamental purpose of retirement savings, and that that borrowing activity (or, more accurately, the portion of any income or gain attributable to such borrowing will be taxable.
Property Taxes, Maintenance Expenses and Carrying Costs
Virtually all types of investment properties will involve some type of carrying costs, such as property taxes, maintenance fees and repair expenses. This won’t raise any legal implications if you have sufficient liquid resources in your self-directed account in order to satisfy those financial obligations. But if you’re forced to pay those costs and fees with funds from outside your account, you could again be hit with negative UBTI tax implications.
One of the biggest mistakes that individuals inadvertently make with the real estate holdings in a self-directed IRA is violating the legal prohibition on “self-dealing.” In short, his prohibition states that an IRA account owner (as well as his or her family and other “related person”) cannot receive any benefit from their account without taking a distribution from the account.
In the context of real estate investments, this means that you and your family are prohibited from using any of the real estate your account holds prior to you taking a distribution of that property (and paying any taxes and early distribution penalties that may be due on such distribution) from the account. So if you hold a vacation property as an investment within your self-directed IRA, you can’t use that property before retirement.
If you or your family violates this prohibition, the consequences could be severe, including that the use constitutes a distribution of the property, which means that you’d own it outright (rather than in your retirement account), and that you’d have to pay early distribution penalties if you’re not of retirement age yet, and taxes on the entire amount of the distribution if your self-directed IRA is set up as a traditional account.