Using Self-Directed IRAs and 401(k)s to Make More Money Now and to Build Your Retirement Wealth for the Future

By H. Quincy Long

Self-directed IRAs and 401(k) plans have been around for more than 25 years, but many people are just now becoming aware of how powerful this idea can be.  There are currently trillions of dollars in retirement plans.  Do you know how to unlock your own retirement funds as well as the retirement funds of those within your circle of influence for real estate related and other non-traditional investments?  Your knowledge of self-directed retirement plans can help make you money now as well as ensuring that you retire in style.

Plans available for self-direction.  A lot of retirement wealth is in traditional IRAs and employer sponsored plans.  If you leave an employer, the funds in the employer plan can be moved into a self-directed traditional IRA.  This includes money rolled over from 401(k) plans, 403(b) plans, 457 deferred compensation plans, and the federal thrift savings plan.  Self-employed people may have their own Individual 401(k) plan, which may even include the new Roth 401(k), no matter what their income level.  Other employer sponsored plans which can be self-directed are SEP IRAs and SIMPLE IRAs.

The king of all IRAs when it comes to building tax free wealth is the Roth IRA.  Even if you do not qualify for a Roth IRA due to income limitations currently, in 2010 the income limitation for conversions from a traditional IRA to a Roth IRA will be eliminated.  At that point even the very wealthy will be entitled to have a Roth IRA.  This is a great planning opportunity!

How does paying for your child’s education or your health care expenses with tax free income sound?  You can even self-direct a Coverdell Education Savings Account (ESA) or a Health Savings Account (HSA), and as long as distributions are for qualified education or health care expenses they are TAX FREE FOREVER.  With an HSA you even get a tax deduction for putting the money in!

Perhaps the best news of all is that you may combine your IRAs and other self-directed plans to make non-traditional investments.  Even better, you can invest your IRAs with other people’s IRAs or even non-IRA money of people you know.  The key element is that you must have your plans administered at a self-directed IRA company like Quest Trust Company, Inc.

Make money now.  We have all heard that knowledge is power.  Your knowledge of self-directed retirement plans can translate into money in your pocket today.  How?  It’s easy!  While it is true that you may not derive a current benefit from your own IRA’s investments, this does not mean that you cannot benefit right now from Other People’s IRAs (OPI).  Simply become knowledgeable about self-directed plans by reading books and attending seminars or workshops, then spread the good news!

Quest has many FREE seminars and workshops to help you and those whose IRAs you want to use to make money for yourself.  There are also numerous books on the market explaining the power of self-directed retirement plans, such as Hubert Bromma’s “Investing in Real Estate With Your IRA and 401(k)” which are selling quickly.  For more information on seminars and workshops in your area, visit the Quest Trust Company website at www.QuestIRA.com.  Even if you don’t have a dime of retirement funds yourself, you can use your knowledge to:

*          Borrow other people’s IRA money to do your deals today

*          Sell real estate, notes or other non-traditional assets to people’s IRAs

*          Make others aware of an opportunity to invest in your business (always be aware of securities laws when raising money)

Anytime you go to a gathering of people, there are most likely millions of dollars available for non-traditional investments in their retirement plans.  It is up to you to let people know about this powerful tool, and how they can take some or all of that anemic money and put it to work in a way that benefits both you and them.  You will look highly intelligent and will inspire confidence with your advanced knowledge.  You owe it to yourself to learn more today.  Quest can help.

Invest your own IRA in what you know best.  With all your knowledge of self-directed IRAs, you will most likely want to invest your own retirement funds in non-traditional investments as well.  What investments do you know the most about?  Almost without exception, you can invest in what you know best with your own IRA.  The law contains very few investment restrictions for retirement plans, but most custodians refuse to allow IRAs to invest in non-traditional investments such as real estate simply because they are not set up to handle them.  Not true with Quest!

Quest self-directed retirement plans are under the same laws as plans at any other custodian or administrator.  We are simply more flexible when it comes to administering non-traditional investments in your IRA or other self-directed plan.  Quest clients have used their retirement plans to purchase all of the following and much more:  real estate, both foreign and domestic, including debt leveraged real estate, real estate options, loans secured by real estate, unsecured loans, limited partnership interests, limited liability company shares, stock in non-publicly traded corporations, land trusts, factored invoices (including factored real estate commissions), tax lien certificates, foreclosure property, joint ventures, oil and gas interests and even race horse colts!  You are limited only by your imagination.

Ignorance may be bliss, but it will not make you wealthy.  Use your knowledge of self-directed IRAs to make money now, to help others build their retirement wealth as well as your own, and to retire in the style and comfort in which you would like to become accustomed.  Contact Quest today!

Why Your IRA May Owe Taxes: To Pay or Not to Pay? – That is the Question

By: H. Quincy Long

A. Introduction

Many people are surprised to learn that, as discussed below, there are 2 ways in which an IRA or 401(k) investment in an entity may cause the retirement plan to owe tax on its income or profits from that investment. This does not necessarily mean that you should not make an investment which subjects your retirement plan to taxation. It does mean that you must evaluate the return on the investment in light of the tax implications.

B. Unrelated Business Income (UBI)

The first situation in which a retirement plan might owe tax on its investment is if the entity invested in is non-taxable, such as a limited partnership or an LLC treated as a partnership for tax purposes, and the entity operates a business. Although investment in an entity which is formed for the purpose of capital investment, such as the purchase and holding of real estate, should not generate taxable income for the retirement plan (unless there is debt financing, as discussed below), any income from business operations would be considered Unrelated Business Income (UBI) for the plan. UBI is the income from a trade or business that is regularly carried on by an exempt organization and that is not substantially related to the performance by the organization of its exempt purpose, with the exception that the organization uses the profits derived from this activity. Exclusions from UBI include dividends, interest, annuities and other investment income, royalties, rents from real property (but not personal property), income from certain types of research, and gains and losses from disposition of property (except property which is considered to be inventory).

Example. Ira N. Vestor has a large rollover IRA from a former employer and wants to help out his friend, Will B. Richer, who is starting a new restaurant business. Will offers Ira a 25% ownership interest in his new business, Eat Richer Restaurants, LLC. Ira believes Will is going to be a huge success, and wants to grow his IRA. The LLC will be taxed as a partnership. Ira will not be paid and will have no part in the management or operation of the business. Because the LLC is taxed as a partnership, the IRA must pay taxes on its share (whether or not distributed) of the gross income of the partnership from such unrelated trade or business less its share of the partnership deductions directly connected with such gross income.[1]

C. Unrelated Debt Financed Income (UDFI)[2]

A second situation in which a retirement plan may owe tax is when the plan or an entity invested in by the plan owns debt financed property. Anytime a retirement plan owns debt financed real estate (with a possible exception for 401(k) plans, discussed below), either directly or indirectly through a non-taxable entity, the income from that investment is taxable to the retirement plan as Unrelated Debt Financed Income (UDFI). The amount of income included is proportionate to the debt on the property. Your retirement plan is only taxed on the debt financed portion and not the entire amount of income.

Definition of “Debt Financed Property.” In general, the term “debt-financed property” means any property held to produce income (including gain from its disposition) for which there is an acquisition indebtedness at any time during the taxable year (or during the 12-month period before the date of the property’s disposal if it was disposed of during the tax year). If your retirement plan invests in a non-taxable entity and that entity owns debt financed property, the income from that property is attributed to the retirement plan, whether or not the income is distributed.

Calculation of UDFI. For each debt-financed property, the Unrelated Debt Financed Income is a percentage of the total gross income derived during a tax year from the property. The formula is as follows:

Average Acquisition Indebtedness x Gross Income from

Average Adjusted Basis Debt-Financed Property

Once the gross UDFI is calculated as above, your retirement plan is entitled to most normal income tax deductions including expenses, straight line depreciation and similar items that are directly connected with income from the debt financed property, plus an automatic deduction of $1,000.

Capital Gains Income. The good news is that if there has been no debt owed on the property for at least 12 months prior to the sale, there is no tax on the capital gains. However, if a retirement plan or a non-taxable entity owned by the retirement plan sells or otherwise disposes of debt-financed property and there has been acquisition indebtedness owed within 12 months prior to the date of sale, the retirement plan must include in its taxable income a percentage of any gain or loss. The percentage is that of the highest acquisition indebtedness with respect to the property during the 12-month period preceding the date of disposition in relation to the property’s average adjusted basis. The tax on this percentage of gain or loss is determined according to the usual rules for capital gains and losses. This means that long term capital gains are taxed at a lower rate than short term capital gains.

Example. Ira N. Vestor wants to use his IRA to invest in a limited partnership, Payor Go, L.P., which will purchase an apartment complex. The lender requires a 20% cash down payment, and will not permit subordinate financing. Because the property is 80% debt financed, Mr. Vestor’s IRA will owe a tax on approximately 80% of its net profits from the limited partnership (the percentage subject to tax changes as the debt is paid down and the basis is adjusted). When the property sells, Mr. Vestor’s IRA will have to pay capital gains tax on the debt financed portion of the profits. Only the profits from the rents or capital gains from the sale that are attributable to the debt financing are taxable to the IRA. For example, if the gain on the sale of the apartment complex is $100,000, and the highest acquisition indebtedness in the 12 months prior to the sale divided by the average adjusted basis is 75%, then $25,000 of the gain is tax deferred or tax free as is normal with IRA’s, while the IRA would owe tax (not Mr. Vestor personally) on $75,000.

D. Exemption From Taxes on UDFI for 401(k) Plans

One piece of great news for those with self-directed 401(k) plans is that plans under §401 of the Internal Revenue Code (IRC) enjoy an exemption from the tax on UDFI in certain circumstances. This exception to the tax is found in IRC §514(c)(9), and applies only to “qualified organizations.” Qualified organizations include certain educational organizations and their affiliated support organizations, a qualified pension plan (ie. a trust qualifying under IRC §401), and a title-holding company under IRC §501(c)(25), but only to the extent it is owned by other qualified organizations. IRAs are trusts created under IRC §408, not IRC §401, so the real estate exception to the UDFI tax does not apply to IRAs. The good news is that plans such as the Quest Individual (k) Plan do qualify for this exception under the right circumstances.

There are six basic restrictions which must be met for the exemption from the UDFI tax to apply. They are:

1) Fixed Price Restriction. The price for the acquisition or improvement must be a fixed amount determined as of the date of the acquisition or the completion of the improvement.

2) Participating Loan Restriction. The amount of any indebtedness or any other amount payable with respect to such indebtedness, or the time for making any

3) payment of any such amount, must not be dependent, in whole or in part, upon any revenue, income, or profits derived from such real property.

4) Sale and Leaseback Restriction. The real property must not at any time after the acquisition be leased by the qualified organization to the seller of the property or to certain related persons, with certain small leases disregarded.

5) Disqualified Person Restriction. For pension plans, the real property cannot be acquired from or leased to certain disqualified persons described in 4975(e)(2), with certain small leases disregarded.

6) Seller Financing Restriction. Neither the seller nor certain related disqualified persons may provide financing for the acquisition or improvement of the real property unless the financing is on commercially reasonable terms.

7) Partnership Restrictions. Partnerships must meet any one of three tests if the exemption from the tax on UDFI is to apply to the qualified organizations who are partners. First, all of the partners can be qualified organizations, provided none of the partners has any unrelated business income. Second, all allocations of tax items from the partnership to the qualified organizations can be “qualified allocations,” which means that each qualified organization must be allocated the same distributive share of each item of income, gain, loss, deduction, credit and basis. These allocations may not vary while the qualified organization is a partner in the partnership, and must meet the requirement of having a “substantial economic effect.” Third, and perhaps most commonly, the partnership must meet a complex test called the “Fractions Rule” (or the “Disproportionate Allocation Rule”).

Even with the restrictions, there are circumstances where this exemption can work. For example, one client rolled over her IRA into a 401(k) plan she created for her home based interior decorator business. The 401(k) plan then purchased 2 apartment buildings with non-recourse seller financing (which was on commercially reasonable terms). Not only is the 401(k)’s rental income exempt from the tax on UDFI, but so will the capital gains be exempt. If there is a concern about asset protection, a title holding §501(c)(2) or §501(c)(25) corporation can be formed, and the exemption will still apply.

But the best news of all is that we now have the Roth 401(k). Starting in 2006, if your plan allows it, you can defer part of your salary into a Roth 401(k). For 2007 and 2008, the maximum salary deferral into a Roth 401(k) plan is $15,500 ($20,500 if you are 50 or over). This doesn’t include the profit sharing contribution of the plan which can be up to 25% of the wages or net income from self-employment. Although the salary deferrals are post tax (meaning you still have to pay income, social security and Medicare taxes on the amount deferred into the plan), qualified distributions from the account are tax free forever. Unlike the Roth IRA, there is no maximum income restriction. Combining the power of an Quest self-directed Roth 401(k) and the real estate exception for 401(k) plans under IRC §514(c)(9) means you can use Other People’s Money to purchase real estate and NEVER PAY TAXES on the income and capital gains!

E. Frequently Asked Questions on Unrelated Business Income Tax (UBIT)

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 incur tax.

Q. But if an investment is taxable, why make it in the IRA?

A. That is a good question. To figure out if this makes sense, ask yourself the following key questions. First, 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! Second, what plans do you have 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. Third, what would you pay in taxes if you made the same investment outside of the IRA?[3] 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.

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 investment which will cause the IRA to pay taxes. Also, bear in mind that companies which are publicly traded also pay taxes before dividends are paid, 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.” In my view, the double taxation issue should not be your focus, but rather merely a factor in your analysis. Is the IRA glass 1/3 empty or 2/3 full? At least the IRS is a silent partner.

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. Remember, in the case of UDFI the IRA only pays tax on the income attributable to the debt and not 100% of the income.

Q. Where can I find out more information?

A. Visit our website at www.QuestIRA.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.

F. Solutions to the UBIT “Problem”

Is there any way to get around paying this tax? The short answer is yes. Investments can often be structured in such a way as to avoid taxation. Dividends, interest, investment income, royalties, rents from real property (but not personal property), and gains and losses from disposition of property (unless the property is debt financed or is considered “inventory”) are all excluded from the calculation of taxable income to the retirement plan. Some examples of how you might structure a transaction in ways that are not taxable to the retirement plan include:

Example. Suppose in the Eat Richer Restaurants, LLC example above the LLC elected to be treated as a corporation instead of a partnership, or a C corporation was formed instead (IRA’s may not own shares of an S corporation). Because the entity has already paid the tax, the dividend to the IRA would be tax free or tax deferred. This may not be acceptable to other shareholders, however.

Example. Instead of his IRA directly in Pay or Go, LP, Ira N. Vestor could have made a loan instead. The loan could have been secured by a second lien on the property (which may not be permitted by the first lienholder, however). The loan could even be secured by shares of the LP itself, possibly with a feature allowing the loan to be converted at a later point to an equity position in the LP (a “convertible debenture”). Caution: With lending there may be state or federal usury limits on how much interest may be charged, and if the debt is converted into equity the IRA may then owe taxes at that time.

Example. Another choice for investing without the IRA paying taxes is to purchase an option instead. When your IRA owns an option to purchase anything, it can 1) let it lapse, 2) exercise the option, 3) sell or assign the option (provided the option agreement allows this) or 4) release the owner from the option for a fee (in other words, getting paid not to buy!).

G. Conclusion

From a financial planning perspective, the question becomes “Should I avoid doing something in my IRA which may incur UBIT?” Many people just say “Forget it!” when they learn a certain investment may subject the IRA to UBIT. Or worse yet, they ignore the issue and hope they won’t get caught. However, being afraid of UBIT is short sighted and ignores the opportunity it presents for building massive wealth in your retirement plan. Remember, making an investment which may subject the IRA to UBIT is not a prohibited transaction, it just means the IRA has to pay a tax. The best financial advice on UBIT is simple: “Don’t mess with the IRS!” If the IRA owes UBIT, make sure it is paid. After analyzing a transaction, you may come to the conclusion that paying UBIT now in your IRA may be the way to financial freedom in your retirement. Like I often say, “UBIT? You bet!”

The Truth About Self-Directed IRAs and Other Accounts

There is a lot of confusion over self-directed IRAs and what is and is not possible.  In this article we will disprove some of the more common self-directed IRA myths.

 

Myth #1 – Purchasing anything other than CDs, stocks, mutual funds or annuities is illegal in an IRA.

Truth:  The only prohibitions contained in the Internal Revenue Code for IRAs are investments in life insurance contracts and in “collectibles”, which are defined to include any work of art, any rug or antique, any metal or gem (with certain exceptions for gold, silver, platinum or palladium bullion), any stamp or coin (with certain exceptions for gold, silver, or platinum coins issued by the United States or under the laws of any State), any alcoholic beverage, or any other tangible personal property specified by the Secretary of the Treasury (no other property has been specified as of this date).

Since there are so few restrictions contained in the law, almost anything else which can be documented can be purchased in your IRA.  A “self-directed” IRA allows any investment not expressly prohibited by law.  Common investment choices include real estate, both domestic and foreign, options, secured and unsecured notes, including first and second liens against real estate, C corporation stock, limited liability companies, limited partnerships, trusts and a whole lot more.

 

Myth #2 – Only Roth IRAs can be self-directed.

Truth: Because of the power of tax free wealth accumulation in a self-directed Roth IRA, many articles are written on how to use a Roth IRA to invest in non-traditional investments.  As a result, it is a surprisingly common misconception that a Roth IRA is the only account which can be self-directed.  In fact, there are seven different types of accounts which can be self-directed.  They are the 1) Roth IRA, 2) the Traditional IRA, 3) the SEP IRA, 4) the SIMPLE IRA, 5) the Individual 401(k), including the Roth 401(k), 6) the Coverdell Education Savings Account (ESA, formerly known as the Education IRA), and 7) the Health Savings Account (HSA).  Not only can all of these accounts invest in non-traditional investments as indicated in Myth #1, but they can be combined together to purchase a single investment.

 

Myth #3 – I don’t qualify for a self-directed Roth or Traditional IRA because I am covered by a retirement plan at work or because I make too much money.

Truth: Almost anyone can have a self-directed account of some type.  Although there are income limits for contributing to a Roth IRA (in 2008 the income limits are $169,000 for a married couple filing jointly and $116,000 for a single person or head of household), having a plan at work does not affect your ability to contribute to a Roth IRA, and there is no age limit either.  With a Traditional IRA, you or your spouse having a retirement plan at work does affect the deductibility of your contribution, but anyone with earned income who is under age 70 1/2 can contribute to a Traditional IRA.  There are no upper income limits for contributing to a Traditional IRA.  Also, a Traditional IRA can receive funds from a prior employer’s 401(k) or other qualified plan.  Additionally, you may be able to contribute to a Coverdell ESA for your children or grandchildren, nieces, nephews or even my children, if you are so inclined.  If you have the right type of health insurance, called a High Deductible Health Plan, you can contribute to an HSA regardless of your income level.  With an HSA, you may deduct your contributions to the account and qualified distributions are tax free forever!  It’s the best of both worlds.  All of this is in addition to any retirement plan you have at your job or for your self-employed business.

 

Myth #4 – I can’t have a self-directed 401(k) plan for my business because I am self-employed and file a Schedule C for my income.

Truth: You can have a self-directed SEP IRA, a SIMPLE IRA or a 401(k) plan even if you are self-employed and file your income on Schedule C of your personal tax return.  With a SEP IRA, you can contribute up to 20% of your net earnings from self-employment (calculated by deducting one-half of your self-employment tax from your net profits as shown on Schedule C) or 25% of your wages from an employer, up to a maximum of $46,000 for 2008.  With the SIMPLE IRA, you can defer up to the first $10,500 of your net earnings from self-employment (calculated by multiplying your net Schedule C income by 0.9235% for SIMPLE IRA purposes), plus an additional $2,500 of your net earnings if you are age 50 by the end of the year, plus you can contribute an additional 3% of your net earnings as an employer contribution.  Beginning in 2002 even self-employed persons are entitled to have their own 401(k) plan.  Better yet, in 2006 the Roth 401(k) was added, allowing even high income earners to contribute after tax dollars into an account where qualified distributions are tax free forever!  With an Individual 401(k) you can defer up to $15,500 (for 2007 and 2008) of your net earnings from self-employment (calculated by deducting one-half of your self-employment tax from your net profits as shown on Schedule C), plus an additional $5,000 of your net earnings if you reach age 50 by the end of the year, plus you can contribute as much as an additional $30,500 based on up to 20% of your net earnings for 2008 (or 25% of your wages from an employer).  This means that a 50 plus year old self-employed person can contribute up to $51,000 for 2008!

 

Myth #5 – Because I have a small IRA and can only contribute $5,000, it’s not worth having a self-directed IRA.

 Truth: Even small balance accounts can participate in non-traditional investing.  Small balance accounts can be co-invested with larger accounts owned by you or even other people.  For example, one recent hard money loan we funded had 10 different accounts participating.  The smallest account to participate was for only $1,827.00!  There are at least 4 ways you can participate in real estate investment even with a small IRA.  First, you can wholesale property.  You simply put the contract in the name of your IRA instead of your name.  The earnest money comes from the IRA.  When you assign the contract, the assignment fee goes back into your IRA.  If using a Roth IRA, this profit is tax-free forever!  Second, you can purchase an option on real estate, which then can be either exercised, assigned to a third party, or canceled for a fee.  Third, you can purchase property in your IRA subject to existing financing or with a non-recourse loan from a bank, a hard money lender, a financial friend or a motivated seller.  Profits from debt-financed property in your IRA may incur unrelated business income tax (UBIT), however.  Finally, as mentioned above, your IRA can be a partner with other IRA or non-IRA investors.

 

 Myth # 6 – If I want to purchase non-traditional investments in an IRA, I must first establish an LLC which will be owned by my IRA.

 Truth: A very popular idea in the marketplace right now is that you can invest your IRA in an LLC where you (the IRA owner) are the manager of the LLC.  Effectively you have “checkbook control” of your IRA funds.  Providers generally charge thousands of dollars to set up these LLCs and sometimes mislead people into thinking that this is necessary to invest in real estate or other non-traditional investments.  This is simply not true.  Not only can an IRA hold title to real estate and other non-traditional investments directly with companies such as Quest Trust Company, Inc., but having “checkbook control” of your IRA funds through an LLC can lead to many traps for the unwary.  Far from protecting your IRA from the prohibited transaction rules, these setups may in fact lead to an inadvertent prohibited transaction, which may cause your IRA to be distributed to you, sometimes with substantial penalties.  This is not to say that there are not times when having your IRA make an investment through an LLC is a good idea, especially for asset protection purposes.  Nonetheless, you must educate yourself completely as to the rules before deciding on this route.  Having a “checkbook control” IRA owned LLC is kind of like skydiving without a parachute – it may be fun on the way down, but eventually you are likely to go SPLAT!

 

Myth #7 – I can borrow money from my IRA to purchase a vacation home for myself.

 Truth: Although the Internal Revenue Code lists very few investment restrictions, certain transactions (as opposed to investments) are considered to be prohibited.  If your IRA enters into a prohibited transaction, there are severe consequences, so it is important to understand what constitutes a prohibited transaction.

Essentially, the prohibited transaction rules were made to discourage disqualified persons from dealing with the assets of the plan in a self-dealing manner, either directly or indirectly. The assets of a plan are to be invested in a manner which benefits the plan itself and not the IRA owner (other than as a beneficiary of the IRA) or any other disqualified person.  Investment transactions are supposed to be on an arms length basis.

As a result of these legal restrictions, a loan from your IRA or staying at a vacation home owned by your IRA, even if fair market rates are paid for interest or rent, would be prohibited.

 

Myth #8 – With a self-directed IRA, I can borrow my IRA funds to purchase real estate and then put all the profits back into the IRA.

 Truth: When real estate or any other asset is purchased within a self-directed IRA, the money never leaves the IRA at all.  Instead, the IRA exchanges cash for the asset, in the same way that an IRA at a brokerage house exchanges cash for shares of stock or a mutual fund.  Therefore, the asset must be held in the name of the IRA.  For example, if Max N. Vestor were to purchase an investment house in his self-directed IRA, the title would be held as “Quest Trust Company, Inc. FBO Max N. Vestor IRA #12345-11.”  Since the IRA owns the asset, all expenses associated with the asset must be paid by the IRA and all profit resulting from that investment belongs to the IRA, including rents received and gains from the sale of the asset.

 

 Myth #9 – If my IRA buys real estate, it must pay all cash for the property.  An IRA cannot buy real estate with debt.

 Truth: An IRA can own debt-financed property, either directly or indirectly through a non-taxed entity such as an LLC or partnership.  Any debt must be non-recourse to the IRA and to any disqualified person.  An IRA may have to pay Unrelated Debt Financed Income Tax (UDFIT) on its profits from debt-financed property.  In general, taxes must be paid on profits from an IRA-owned property that is debt-financed, including profits from the sale or disposition of the property, in the same proportion that it had debt.  For a simplified example, if the IRA puts 50% down, then 50% of its profits above $1,000 will be taxable.  Although at first this sounds terrible, in fact leverage can be an extremely powerful tool in building your retirement wealth.  The same leverage principle applies inside or outside of your IRA – you can do more with debt-financing than you can without it.  One client was able to build her Roth IRA from $3,000 to over $33,000 in less than 4 months even after paying the taxes due by taking over a property subject to a debt and selling the property to another investor!

 

 Myth #10 – An IRA cannot own a business.

 Truth: A self-directed IRA is an amazingly flexible wealth building tool and can own almost anything, including a business.  However, due to the conflict of interest rules you cannot work for a business owned by your IRA and get paid.  Some companies have a plan to start a C corporation, adopt a 401(k) plan, roll an IRA into the 401(k) plan and purchase employer securities to effectively start a new business, but this is not a direct investment by the IRA in the business and is fairly expensive to set up.  Also, if your IRA owns an interest in a business, either directly or indirectly through a non-taxed entity such as an LLC or partnership, the IRA may owe Unrelated Business Income Tax (UBIT) on its profits from the business.  A solution to this problem may be to have the business owned by a C corporation or another taxable entity.

What’s in a Name? – Why It’s Important to Name a Beneficiary for Your IRA

Many people probably don’t think too much about how important it is to name a beneficiary for their IRAs.  However, as my family recently found out, ignoring this important detail when setting up your IRA can be costly from a tax perspective.

I recently received a distribution check from an IRA of my father, who passed away last year.  My father was a very careful planner, so I was quite shocked at his lack of tax planning with his IRA.  When setting up his IRA he named his estate as the beneficiary of the IRA (this is equivalent to not naming a beneficiary at all).  This meant that when he passed away the estate had to be probated, even though the IRAs were the only assets requiring probate in his estate.  IRAs that have named beneficiaries are generally non-probate assets, meaning that they pass directly to the beneficiaries instead of passing through a will.  That was the first problem.

The larger problem came because of the lack of choices he left us by naming his estate as beneficiary.  In a Traditional IRA, required minimum distributions must begin no later than April 1 of the year after the IRA owner turns age 70 ½.  This is known as the required beginning date.  My father died before his required beginning date.  Since his estate is a non-individual beneficiary, the IRA had to be distributed within 5 years, or by December 31, 2011.  If my father had died after his required beginning date without having a named individual beneficiary, the yearly required minimum distributions would have been based on his remaining life expectancy in the year of his death reduced by one for each year following the year of his death.

In contrast, the choices available to our family had my father simply named beneficiaries would have been much more favorable.  Assuming my father wanted his wife and 3 sons to split the IRA in the same percentages he listed in the will, he could have named us specifically instead of requiring the distribution to be made through his estate.  If the IRA was not split into separate IRAs by September 30 of the year following the year of his death, then required minimum distributions would have been based on the remaining life expectancy of the oldest beneficiary, which was of course his wife.  As his wife is a few years younger than he was, this certainly would have been a large improvement over taking the entire IRA over the next 5 years.

Had my father named the 4 of us as beneficiaries specifically, an even better plan would have been to separate the IRAs into 4 beneficiary IRAs with each of us as the sole beneficiary prior to September 30 of 2007 (the year following his death).  In his wife’s case this would mean that she could choose to take all the money out within 5 tax years, leave the IRA as a beneficiary IRA, thereby allowing her to take distributions without penalty even if she was under age 59 1/2, or she could have elected to treat the IRA as her own.  In the case of his sons, we could have taken the IRA over 5 years or we could have stretched the distributions over our life expectancy.  For example, in my case I could have elected to take the distributions over the next 39 years instead of all at once!

Since I expected nothing from my father’s estate and have no critical need for the funds, I would have taken the longer distribution period.  Instead I must add the distribution check to my taxable income for this year, which in my tax bracket means a substantial bite out of the money for taxes.  Since I am reasonably good at investing in my self-directed IRAs, having the ability to stretch the distributions out over 39 years would have meant an inheritance of many times what I will end up with after taxes because I had to take it all within 5 years.

The problem is even worse for my father’s wife, who will have an extraordinarily large tax burden this year, since she chose to take her share of the IRA out all at once instead of over a 5 year period.  While I am certainly grateful that my father thought of me in his will, simply naming specific beneficiaries would have made his legacy worth so much more to his family.

Don’t let it happen to your family!  Review your IRA beneficiary designations, and if you haven’t already done so, name your beneficiaries.  Your family will be glad you did.

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.
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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.”

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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.

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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 IRA’s.  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 IRA’s.  I have seen

IRA’s 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 IRA’s.  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.

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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.

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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.

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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.

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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.”

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Q.        If the IRA makes an investment subject to tax, who pays the tax?

A.        The IRA must pay the tax.

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Q.        What form does the IRA file if it owes taxes?

A.        IRS Form 990-T, Exempt Organization Business Income Tax Return.

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Q.        What is the tax rate that IRA’s 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.

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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.

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Q.        Where can I find out more information?

A.        Visit our website at www.QuestIRA.com for more information.  Also, Unrelated Business Taxable Income and Unrelated Debt Financed Income are covered inIRS

Publication 598, which is freely available on the IRSwebsite 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!”

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IRA Prohibited Transactions

I. Investment Restrictions – What Your IRA Cannot Invest In

The Internal Revenue Code does not say anywhere what investments are acceptable for an IRA. The only guidance in the Code is what investments are not acceptable – life insurance contracts[1] and “collectibles.”[2] “Collectibles” are defined as any work of art, any rug or antique, any metal or gem, any stamp or coin, any alcoholic beverage, and any other tangible personal property specified by the Secretary.[3] An exception to these restrictions exists for certain U.S. minted gold, silver and platinum coins, coins issued under the laws of any state, and gold, silver, platinum or palladium bullion.[4] If you direct your IRA to invest in any prohibited collectible, your IRA will be deemed to be distributed to you to the extent of the investment.[5] Everything else can be purchased in an IRA, provided that the custodian is willing to hold the asset. According to the Internal Revenue Service, “IRA trustees are permitted to impose additional restrictions on investments. For example, because of administrative burdens, many IRA trustees do not permit IRA owners to invest IRA funds in real estate. IRA law does not prohibit investing in real estate but trustees are not required to offer real estate as an option.”[6] II. Transaction Restrictions – What Your IRA Cannot Do Legally Although the Internal Revenue Code lists very few investment restrictions, certain transactions (as opposed to investments) are considered to be prohibited.[7] If your IRA enters into a prohibited transaction, there are severe consequences (see below), both for you as the IRA owner and for disqualified persons who participate, so it is important to understand what constitutes a prohibited transaction. The general rule is that a “prohibited transaction” means any direct or indirect

  • Sale or exchange, or leasing, of any property between a plan and a disqualified person;[8]
  • Lending of money or other extension of credit between a plan and a disqualified person;[9]
  • Furnishing of goods, services, or facilities between a plan and a disqualified person;[10]
  • Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of the plan;[11]
  • Act by a disqualified person who is a fiduciary whereby he deals with the income or assets of a plan in his own interest or for his own account;[12] or
  • Receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan.[13]

Note that all of these transactions involve a “plan” (including an IRA) and a “disqualified person.” Therefore, in order to see whether or not a transaction is prohibited, you have to understand both what is prohibited and who is a disqualified person. In the next section disqualified persons will be discussed in more detail. Essentially, the prohibited transaction rules were made to discourage disqualified persons from dealing with the assets of the plan in a self-dealing manner, either directly or indirectly. The assets of a plan are to be invested in a manner which benefits the plan itself and not the IRA owner (other than as a beneficiary of the IRA) or any other disqualified person. Investment transactions are supposed to be on an arms length basis. Fiduciaries of retirement plans owe a duty of undivided loyalty to the plans for which they act. The prohibitions are therefore imposed on fiduciaries to deter them from exercising the authority, control, or responsibility which makes them fiduciaries when they have interests which may conflict with the interests of the plans for which they act.[14] Any action taken where there is a conflict of interest which may affect the best judgment of the fiduciary is likely to be a prohibited transaction. There are various exemptions and exceptions to the definition of a prohibited transaction,[15] but unless you know of a specific exception, the wisest course is to stay away from a transaction involving one of the above situations. You may seek a one time individual prohibited transaction exemption (PTE) from the Department of Labor (DOL) if you want to do something which is prohibited. For example, you may be able to get a PTE to sell real estate owned by your IRA to you or another disqualified person for market value, even though this would normally be a prohibited transaction, by going through the formal process.[16] Also, if you are unsure about whether a transaction is prohibited you may ask the DOL for an Advisory Opinion Letter or the Internal Revenue Service for a Private Letter Ruling. Advisory Opinion Letters and Private Letter Rulings are only applicable to the person requesting them, but reviewing Advisory Opinion Letters and Private Letter Rulings often give hints about how the DOL or the IRS might interpret certain transactions. III. Person Restrictions – Who Your IRA Cannot Do Transactions With As noted above, all prohibited transactions involve both a plan and a disqualified person. The definition of a disqualified person is designed to make sure that transactions done in an IRA are on an arms length basis and for investment purposes only. Disqualified persons are deemed to be too close for a transaction to be arms length. There are four major classes of disqualified persons and five additional classes of disqualified persons who have relationships with the first four. The four major ones are: 1) A fiduciary,[17] which is defined to include any person who exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets; renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so; or has any discretionary authority or discretionary responsibility in the administration of such plan.[18] Note that this definition of a fiduciary is much broader than in traditional trust law, and at least with a self-directed IRA includes the IRA owner who exercises control over the management or disposition of its assets. 2) A person providing services to the plan.[19] This can include attorneys, CPA’s and your third party administrator. 3) An employer any of whose employees are covered by the plan.[20] 4) An employee organization any of whose members are covered by the plan.[21] The five additional classes of disqualified persons include: 5) An owner, direct or indirect, of 50 percent or more of the voting power of stock in a corporation, the profits or capital interest in a partnership, or the beneficial interest in a trust or other unincorporated enterprise which is an employer or employee organization described above in paragraphs 3 and 4.[22] 6) A member of the family[23] of any individual described above in paragraphs 1, 2, 3, and 5, which is defined to include only a spouse, ancestor, lineal descendant and any spouse of a lineal descendant. Caution: Although other members of the family are not disqualified persons (for example, brothers, sisters, aunts, uncles, step-children), dealing with close family members may still be a prohibited transaction because of the indirect rule. For example, in the IRS Audit Manual it states: “Included within the concept of indirect benefit to a fiduciary is a benefit to someone in whom the fiduciary has an interest that would affect his/her fiduciary judgement (sic).”[24] The focus in this case is not on the family member, who may not be a disqualified person or may fit within an exemption such as 4975(d)(2) (the “reasonable compensation” exemption), but rather on the benefit to the fiduciary, who is a disqualified person. 7) A corporation, partnership, trust, or estate owned 50% or more, directly or indirectly, by the first 5 types of disqualified persons described above.[25] Caution: Note that the ownership can be “directly or indirectly.”[26] This means that ownership by certain family members of a disqualified person counts as ownership by the disqualified person for purposes of this rule. For example, the ownership by an IRA owner of 25% and the ownership by the IRA owner’s spouse of 25% is aggregated together to disqualify the corporation, partnership, trust or estate.[27] 8) An officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10 percent or more shareholder, or a highly compensated employee (earning 10 percent or more of the yearly wages of an employer) of a person who is an employer or employee organization, the owner of 50% or more of an employer or employee organization, or a corporation, partnership, trust or estate which is itself a disqualified person.[28] Caution: This can catch some people by surprise. For example, suppose Ira N. Vestor and Will B. Richer are unrelated friends. They decide to purchase, rehab and sell real estate. To do this they form a limited liability company. Will B. Richer now is a disqualified person as to Ira N. Vestor’s IRA, even though they have no other relationship. Similarly, if Ira owns a business that is incorporated and his secretary earns at least 10% of the yearly wages paid by that corporation, she is a disqualified person and cannot enter into any transaction with Ira N. Vestor’s IRA. 9) A 10 percent or more (in capital or profits) partner or joint venturer of a person who is an employer or employee organization, the owner of 50% or more of an employer or employee organization, or a corporation, partnership, trust, or estate which is itself a disqualified person.[29] Caution: Note how far removed from the IRA this disqualified person is. In the above example where Ira N. Vestor and Will B. Richer formed an LLC, under this rule any 10 percent or more partner or joint venturer of their LLC is also a disqualified person. IV. Crime and Punishment – What Happens to Your IRA if You Make a Mistake For the IRA Owner. If the IRA owner enters into a prohibited transaction during the year, the IRA ceases to be an IRA as of the first day of that taxable year.[30] The value of the entire IRA is treated as a distribution for that year, and if the IRA owner is not yet 59 1/2, there could be premature distribution penalties also. Since the IRS often does not catch the prohibited transaction for several years, additional penalties can accrue for underreporting income from transactions in years after the prohibited transaction took place. For Other Disqualified Persons. Initially, an excise tax of 15% of the amount involved for each year (or part of a year) is paid by any disqualified person who participated in the prohibited transaction.[31] An additional tax equal to 100% of the amount involved is also imposed on a disqualified person who participates in the prohibited transaction if the transaction is not corrected within the taxable period.[32]
[1] See 26 USC 408(a)(3)

[2] 408(m)
[3] 408(m)(2). No other personal property has been specified by the Secretary at this time.
[4] 408(m)(3)
[5] 408(m)(1)
[6] See IRS website at www.irs.gov in the Frequently Asked Questions on IRAs section.
[7] See 26 USC 4975(c)(1)
[8] 4975(c)(1)(A)
[9] 4975(c)(1)(B)
[10] 4975(c)(1)(C) [11] 4975(c)(1)(D) This is far easier to violate than you might imagine. See the Joseph R. Rollins v. Commissioner of Internal Revenue case.
[12] 4975(c)(1)(E) This provision and 4975(c)(1)(F) are known as the conflict of interest provisions. Note that in these two sections the disqualified person involved is a fiduciary of the IRA.
[13] 4975(c)(1)(F) [14] See 26 CFR 54.4975-6(a)(5)(i)
[15] See 4975(d), for example. Also, there are various class prohibited transaction exemptions (PTE’s) which are issued by the Department of Labor (DOL). These can be viewed on DOL’s website – www.dol.gov/ebsa/compliance_assistance.html.
[16] You may get more information on obtaining a PTE from the DOL website – www.dol.gov/ebsa/compliance_assistance.html.
[17] 4975(e)(2)(A)
[18] The definition of a fiduciary is in 4975(e)(3).
[19] 4975(e)(2)(B)
[20] 4975(e)(2)(C)
[21] 4975(e)(2)(D)
[22] 4975(e)(2)(E)
[23] 4975(e)(2)(F). The definition of who is included as a member of the family is in 4975(e)(6).
[24] IRM 4.72.11. This is available on the IRS website at www.irs.gov.
[25] 4975(e)(2)(G)
[26] The constructive ownership rules of Internal Revenue Code §267(c) are incorporated into this rule by 4975(e)(4) and 4975(e)(5), except that the members of the family are considered to be those described in 4975(e)(6).
[27] For an example of how the indirect ownership rule applies, see Advisory Opinion 2006-09A (Appelt), in which the Department of Labor ruled that ownership of shares of a corporation (or other entity) by certain family members of a fiduciary is imputed to that fiduciary. The relevant family members are the ones referenced in 4975(e)(6), which includes the fiduciary’s spouse, ancestor, lineal descendant, and any spouse of a lineal descendant. In the Appelt opinion letter, the ownership of a corporation 87.5% by Mr. Appelt’s daughter and son-in-law was imputed to him, so that the proposed transaction between Mr. Appelt’s IRA and the corporation was deemed to be a prohibited transaction under 4975(c)(1)(A) & (B).
[28] 4975(e)(2)(H)
[29] 4975(e)(2)(I)
[30] 408(e)(2)
[31] 4975(a)
[32] 4975(b)

Buying Real Estate in Your IRA

1.  Who is H. Quincy Long and why do I care?

H. Quincy Long, who holds the designation of CISP (Certified IRA Services Professional), is CEO/President of Quest Trust Company, Inc., a self-directed IRA third party administrator with offices in Houston, Dallas, and Austin, Texas as well as Mason, Michigan.  Mr. Long has been a licensed Texas attorney since 1991 who specializes in real estate, and has been a fee attorney for American Title Company.  He has sat on the board of directors of the Realty Investment Club of Houston (RICH), the second largest real estate club in the country.  Mr. Long received his Doctor of Jurisprudence law degree in 1990 from the University of Houston.  He received his Master of Laws, also from the University of Houston, in 1997.

Mr. Long is also the author of numerous articles on self-directed IRAs and other real estate related topics, and is editor and co-author of the book Real Estate Investment Using Self-Directed IRAs and Other Retirement Plans by Dyches Boddiford and George Yeiter, CPA.

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Mr. Long knows real estate and real estate investing. This can be critical to you when choosing a self-directed IRA custodian or administrator, especially if you want to buy real estate or real estate related products in your IRA.

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2.         What does Quest Trust Company, Inc. do?

Quest Trust Company, Inc. (www.QuestIRA.com) is a third party administrator of self-directed IRAs in Houston, Dallas, and Austin,Texas, as well as Mason, Michigan. Quest Trust Company, Inc. is the leading provider of self-directed retirement account administration services.  Quest Trust Company has been in business since 2003 with over $400MM in assets under management.  As a neutral party, Quest Trust Company does not offer any investments and therefore has no conflicts of interest with what our clients want to do with their IRAs.  Quest allows you to be in total control of your retirement wealth.

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3.         As a real estate professional, how can knowledge about self-directed IRAs put money in my pocket now?

For those of you who are investors, you can make other people aware that they actually have more money to invest in real estate than they thought since they can use their IRAs to buy real estate.  In other words, your knowledge of self-directed IRAs can increase your pool of eligible buyers for your properties.  Also, you can help others transfer their retirement funds into a self-directed IRA, then you can borrow those funds to make your own investments – in other words, you can create your own private bank!  Finally, you can make your own retirement wealth grow with your knowledge and experience in real estate by buying and selling through your own self-directed IRA.

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4.         What is the difference between a “self-directed IRA” and a regular IRA?

There is no legal distinction between a “self-directed IRA” and any other IRA.  The difference is simply this:  Quest lets you take control of your retirement by letting you invest your IRA in what you know best.  There are 2 different sets of rules that govern what you can do with your IRA.  First, there is the Internal Revenue Code, which has surprisingly few restrictions.  Second, there is your account agreement with the custodian.  With most custodians you are restricted in the type of investments you can buy in your IRA.  Quest allows you the maximum amount of control and flexibility.  Almost anything that can be documented can be held in your Quest self-directed IRA.

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5.         Which types of IRAs does Quest Trust Company offer?

  • Quest offers almost all types of retirement plans, including:
  • Traditional IRAs
  • Roth IRAs
  • SEP IRAs
  • SIMPLE IRAs
  • Individual 401(k)s, including the NEW Roth 401(k)
  • Coverdell Education Savings Accounts (formerly Education IRAs)
  • Health Savings Accounts (HSAs)

All of our plans are self-directed, and all of them can hold the same type of non-traditional assets, such as real estate.

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6.         How much can I contribute to my IRA?

Roth and Traditional IRAs –   $4,000 for 2007 (increased to $5,000 for 2008) plus $1,000 catch-up if you are age 50 or over by the end of the year.

SEP IRAs – 25% of your wages (or up to 20% of your net earnings from self-employment) up to a maximum of $45,000 for 2007 and $46,000 for 2008.  Contributions can be made up to the employer’s tax filing deadline, including extensions (if you are self-employed, you are the employer).

SIMPLE IRAs – $10,500 salary deferral plus $2,500 catch-up if you are 50 or over for 2008 plus up to 3% of your salary matched by your employer.

Profit Sharing/401(k)s – $15,500 in salary deferral for 2007 and 2008, plus catch-up deferral of $5,000 if you are age 50 or older by the end of the year plus 25% of your wages (or 20% of your net earnings from self-employment) up to a maximum of $45,000 for 2007 and $46,000 for 2008 (excluding the catch up contribution of $5,000).

Coverdell ESAs (formerly Education IRAs) – $2,000 per year until the child is age 18.

Health Savings Accounts (HSAs) – $2,850 for individual coverage in 2007 ($2,900 for 2008) and $5,650 for family coverage in 2007 ($5,800 for 2008) plus $800 catch-up for 2007 ($900 for 2008) if you are over age 55.

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7.         What kinds of investments can be made in an Quest Trust Company self-directed IRA?

  • You have the broadest possible choice of investments, including:
  • Real Estate, including debt-financed and foreign real estate
  • Deeds of Trust
  • Real Estate Options
  • Lease Options
  • Unsecured Notes
  • Oil and Gas Interests
  • Small, non-publicly traded corporate stock
  • Limited Liability Companies
  • Limited Partnerships
  • Factored Invoices
  • Discounted Commissions
  • Security Agreements and Notes
  • Tax Lien Certificates
  • Foreclosure Property
  • Joint Ventures
  • Race Horses
  • Publicly traded stocks and mutual funds
  • and a whole lot more…

It should be made clear that you are not taking a distribution to purchase these assets.  All assets are purchased within the IRA, and all profits stay in the IRA!

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8.         Is it really legal to buy real estate in your IRA?

Yes, absolutely!  The Internal Revenue Code does not tell you what you can do with your IRA, only what you cannot do.  Besides restrictions on purchasing life insurance and most collectibles in your IRA, nearly everything else is fair game.  Unless your IRA is self-directed, however, your custodian may not allow investments in real estate.

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9.         Can I partner with my IRA or with other peoples IRAs?

Your IRA can always partner with other people individually or with other people’s IRAs.  Under certain circumstances you personally may be able to partner with your IRA.  However, the burden of proving that you received no impermissible benefit from your IRA’s participation in the investment will be on you if the IRS ever questions the transaction.  The transaction still must be an arms-length transaction, and the investment remains subject to the same restrictions as if the entire investment were in your IRA.  In general it is better to separate your IRA’s investments from your own investments.

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10.       I only have a small IRA.  How can I buy real estate?

There are at least 4 ways you can participate in real estate investment even with a small IRA.  First, you can wholesale property.  You simply put the contract in the name of your IRA instead of your name.  The earnest money comes from the IRA.  When you assign the contract, the assignment fee goes back into your IRA.  If using a Roth IRA, this profit is tax-free forever!  Second, you can purchase an option on real estate, which then can be either exercised, assigned to a third party, or canceled for a fee.  Third, you can purchase property in your IRA subject to existing financing or with a non-recourse loan from a bank, a hard money lender, a financial friend or a motivated seller.  Profits from debt-financed property in your IRA may incur unrelated business income tax (UBIT), however.  Finally, as mentioned above, your IRA can be a partner with other IRA or non-IRA investors.

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11.       Can an IRA buy debt-financed property?

Yes.  Any debt must be non-recourse to the IRA and to any disqualified person.  An IRA may have to pay UBIT on its profits from debt-financed property.  In general, taxes must be paid on profits from an IRA-owned property that is debt-financed, including profits from the sale or disposition of the property, in the same proportion that it had debt.  For a simplified example, if the IRA puts 50% down, then 50% of its profits above $1,000 will be taxable.  Although at first this sounds terrible, in fact leverage can be an extremely powerful tool in building your retirement wealth.  The same leverage principle applies inside or outside of your IRA.  You can do more with debt-financing than you can without it.

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12.       Could my IRA be classified as a “dealer?”

It is possible that an IRA could be classified as a dealer.  The same principles for determining whether you are a dealer personally also apply to your IRA.  If the IRA is classified as a dealer, it would be considered to be running an unrelated trade or business, and the IRA would have to pay UBIT.  Remember, it is not illegal to do things in your IRA that incur UBIT.  Your IRA just has to pay taxes.

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13.       Can I sell a property I now own to my IRA?

No.  Although the IRS has very few restrictions on the types of investments which are permissible in an IRA, there is a list of “disqualified persons” who are prohibited from dealing with your IRA or benefiting from its investments.  The list of disqualified persons includes you, your spouse, your parents, your children, their spouses, certain business partners and key employees and persons providing services to your plan, among others.  Interestingly enough, the definition of disqualified persons does NOT INCLUDE non-lineal descendants or ascendants, so if the transaction is an arms length transaction your IRA may be able to transact business with your brother or sister, aunt or uncle, cousins, etc.  However, you should be aware that there is an element of danger in transacting business with any person in whom you may have an interest which affects your best judgment as a fiduciary of your IRA, as this could be considered to be a prohibited transaction.

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14.       Can I receive a fee for managing property owned by my IRA?

No.  The prohibited transaction rules are intended to make sure that you receive no current benefit from your IRA other than as the beneficiary of the IRA.  Investments must be arms-length and exclusively for the benefit of your IRA.

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15.       If I am a Realtor, can I receive a commission for property bought or sold by my IRA?

No, for the same reasons stated in the prior answer.  Anything that creates a possible conflict of interest with your IRA is likely to be a prohibited transaction.  Why take money that is tax-free or tax-deferred and pay taxes on it now anyway?

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16.       Can I collect rents and do other management without compensation?

Most likely the answer is yes, although this has never been tested in court to our knowledge.  An interesting question is how much can you do before your service to your IRA constitutes an excess contribution?  In any event all checks must be made out directly to your IRA.

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17.       I like the sound of this, but can you give me specific, real life examples of what has been done in an Quest self-directed IRA?

Example 1 – Wise Roth Conversion.  Dapper Don has two Quest Trust Company self-directed IRAs a traditional IRA with money from his former employer’s retirement plan and a Roth IRA.  Don found a small piece of property in the country with a mobile home on it, which he could acquire for about $12,000. Don realizes the high profit potential of this transaction, but has insufficient funds in his Roth IRA to do the deal. Because Don will have modified adjusted gross income of less than $100,000 this year, he decided to convert $12,000 from his traditional IRA into his Roth IRA. Only seven weeks after his Roth IRA purchased the property, it was sold to the neighbor for $30,000. Although Don must pay income taxes on the $12,000 he converted from his traditional IRA to his Roth IRA, the $18,000 in profit from the transaction is TAX-FREE FOREVER!

Example 2 – Note Secured by Real Estate.  Savvy Sam borrows money from Rich Rodney’s IRA at Quest Trust Company.  Sam agrees to pay Rodney’s IRA 15% interest with no points and a 3 month minimum term on the loan.  Before Sam can even finish the repairs, he gets an offer on the house.  Sam accepts the offer, and they close within 6 weeks.  Sam is ecstatic because he made $20,000 with no money from his pocket.  Rich Rodney is very happy too because Sam paid his IRA 90 days of interest at 15% and only kept the money outstanding for 6 weeks!

Example 3 – Rehabbing a House.  Rehabber Rhonda buys a house needing substantial repairs for $101,000 cash in her Quest Trust Company.  Rhonda spends approximately $30,000 from her IRA on the rehab.  The property is sold in 6 months for $239,000.  After the cost of the purchase, rehab, closing costs, holding costs and selling costs, Rhonda’s IRA nets approximately $94,000 on the deal.

Example 4 – Co-Investing With an IRA.  Wise Wally invests $5,000 from his SEP IRA at Quest Trust Company and Wally’s father invests an additional $5,000 on a house purchased for $10,000 cash.  Although the house could be called a junker, the rental income is $400 per month, which of course is split equally between Wally’s IRA and Wally’s father (the tenants send separate checks).  Wally believes that eventually this neighborhood will be bought up by developers because of its location right on the lake.  In the meantime, Wally expects to recover his acquisition expenses from the rental income in less than 3 years, even after payment of property taxes.

Example 5 – Purchase and Simultaneous Resale of Real Estate.  QuickQuincy finds a commercial piece of land and puts it under contract in his Roth IRA for $500,000. Quincy’s IRA pays the earnest money. Quincy then contacts a major home improvement chain about buying the land.  After some negotiation, the store chain and Quincy’s IRA agree to a sales price of $650,000.  At closing,Quincy’s IRA buys the property from the seller and simultaneously sells the property to Barry’s retail store chain. Quincy’s Roth IRA nets approximately $146,000 after payment of closing costs.

Example 6 – Assignment of a Contract.  Awesome Annie gets a contract on a burned out house in the Coverdell ESA of her daughter, Smart Sally, for $5,500 cash with a $100 earnest money deposit.  Annie locates Investor Ingrid, who is willing to pay $14,000 for the house.  Sally’s Coverdell ESA assigns the contract to Ingrid, and at closing Sally’s Coverdell ESA gets a check for $8,500.

Example 7 – Buying Real Estate With a Loan.  Realtor Rose is a full-time real estate agent who at times purchases rental real estate for her own investment portfolio.  Rose locates 2 properties that she wants to buy in her SEP IRA at Quest Trust Company.  The houses Rose wants to buy cost about $210,000.  Rose has a good relationship with a local bank, and they are willing to loan Rose’s IRA the money she needs with only 10% down on a 5 year, 6.5% interest, non-recourse note.

Example 8 – Buying Property Subject to a Lien.  FantasticFlorence finds a property which is subject to nearly $100,000 in delinquent property taxes and is about to be foreclosed on by the taxing authorities.  She contacts the owner and buys the property in her Roth IRA at Quest Trust Company for around $3,000 (including closing costs).  The owner just wants to be rid of the headache. Florence’s IRA sells the property to an investor 3 1/2 months later and her IRA nets approximately $46,500 from the sale. Florence’s IRA will have to pay Unrelated Business Income Tax (UBIT) of about $13,500, but even after payment of taxes her IRA will be worth around $33,000 in only 3 1/2 months!

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18.       How can I find out more?

a)      Visit our website at www.QuestIRA.com.  The website has a real estate tour showing you step by step how to buy and sell real estate in your IRA.

b)      Call us at 281-492-3434 or toll-free 800-320-5950.

c)      Email Quincy Long at Quincy@QuestTrust.com.

d)     Sign up for our IRA and 401(k) Insights quarterly email newsletter.

e)      Plan on attending our next 8-hour or 3-hour MCE seminar and learn all about self-directed IRAs.

Either a Lender or a Borrower Be: Private Money Lending Out of Your IRA

Create Your Own Bank 5 stepsCreate Your Own Bank 5 steps back

Personally, I think Shakespeare had it wrong when he penned this advice in Hamlet: “Neither a borrower nor a lender be; For loan oft loses both itself and friend, And borrowing dulls the edge of husbandry.” Perhaps he may be forgiven for his error, however, since Shakespeare suffered from a lack of the tremendous benefits of a truly self-directed IRA.

Money in self-directed IRAs can be loaned out to any person who is not a “disqualified person.” While this means that you cannot loan yourself or other related disqualified persons money from your self-directed IRA, you can loan the money to anyone else. Loans can be secured by real estate, mobile homes, equipment or anything you like. If you are really a trusting soul, you can even make a loan from your IRA unsecured (although in that case I personally would tend to support Shakespeare’s advice).

First, let’s look at it from the borrower’s perspective. At our office we offer a seminar entitled “Make Money Now With Self-Directed IRAs.” One of the ways you can make money for yourself right now with your knowledge of self-directed IRAs is by creating your own “private bank.” To do this, simply share the news that an IRA can be a private lender, refer people with IRA money to Quest to open a self-directed IRA, and then borrow their IRA money for your own financing needs.

With private financing the loan terms can be whatever the borrower and the lender agree to within the legal limits. If you know a person who is getting 5% in a “safe” IRA at a bank, and you can offer them 9% secured by a first lien on real estate with only a 70% loan to value, would they be happy with that? Even with a higher interest rate, private financing can work for you. IRA loans can be done quickly and without a lot of fees or fuss, which may mean you can get a deal which might be lost if you had to wait on the bank. This is especially true in distressed sale situations, such as a pre-foreclosure purchase.

From a lending perspective, your IRA can grow at a nice rate while someone else does all the work. In a typical hard money loan, the borrower even pays all of Quest’s modest fees as well as any legal fees for preparation of the loan documents. True, you won’t hit a home run with lending, unless you are fortunate enough to foreclose on the collateral. But the returns can be quite solid. For example, by making very conservative hard money loans my Mom’s IRA has grown by about 10.5% in one year. This is much better than the amount she was earning in her money market fund before she moved her IRA to an Quest self-directed IRA.

Even small IRAs can combine with other self-directed accounts to make a hard money loan. My brother recently combined his Roth IRA, his traditional IRA, his wife’s Roth IRA, his son’s Roth IRA, his Health Savings Account (HSA), and 5 other IRAs to make a hard money loan. The smallest IRA participating in this loan was for $1,827.00! Each IRA made 2% up front and 12% interest on an 18 month loan, secured by a first lien on real estate with no more than 70% loan to value.

One thing to avoid in hard money lending is usury. Usury is defined as contracting for or receiving interest above the legal limit. The usury limit varies from state to state, with a few lucky states having no usury limit at all on commercial loans. Some people have the theory of “What’s a little usury among friends?” However, if the investment goes bad and your IRA has made a usurious loan, the consequences of the borrower making a claim of usury could include the loss of all the principal of the loan plus damages equal to 3 times the interest. Some states even have criminal usury statutes. It is best to consult with a competent attorney prior to making a hard money loan to make sure your IRA does not violate any usury laws.

To see how well hard money lending can work, let me give you an actual example. One of our clients made a hard money loan from his IRA to an investor who purchased a property needing rehab. The terms of the loan were 15% interest with no points or other fees except for the attorney who drew up the loan documents. The loan included not only the purchase price but also the estimated rehab costs. The minimum interest due on the loan was 3 months, or 3.75%. The investor began the rehab by having the slab repaired, and before he could take the next step in the rehab process, a person offered him a fair price for the property as is. The investor accepted the offer, and they closed about 6 weeks after the loan was initiated.

From the investor’s perspective, was this a good deal? Yes, it certainly was! True, he was paying a relatively high interest rate for the time he borrowed the money. However, he was able to purchase a property with substantial equity which a bank most likely would not have loaned him money to buy due to the condition of the property. Also, while the interest rate was high, the cost of financing was actually comparatively low. With a normal bank or mortgage company there are fees and expenses incurred in obtaining the loan. Common fees include origination fees, discount points, processing fees, underwriting fees, appraisal fees and various other expenses relating to the loan. On the surface an interest rate may be 8%, but the cost of the financing is actually higher than 8% since a borrower has to pay the lender’s fees in addition to the interest on the loan. Spread out over a lengthy loan term these additional fees do not add much to the cost of the financing. However, if an investor has to pay all of these fees up front and then pays the loan off in only 6 weeks, the cost of the financing goes way up.

In this case the investor’s total loan costs were limited to 3 months minimum interest at 3.75% plus $300 in attorney’s fees for preparing the loan documents. Best of all, the investor walked away from closing with $20,000 profit and no money out of his pocket! Far from “dulling the edge of husbandry” this loan actually made the “husbandry” (ie. the purchase and resale of the property) possible. Incidentally, the purchaser of the property was absolutely thrilled to get the property at less than full market value so that they could fix it up the way that they wanted it.

What about the lender in this case? The lender was also quite happy with this loan. His IRA received 3 months of interest at 15% while only having his money loaned out for 6 weeks. For the 6 week period of the investment, his IRA grew at a rate of approximately 30% per annum! Although his yield was above the legal limit for interest inTexason loans secured by real estate, prepayment penalties are generally not included in the calculation of usury here, so there was no problem. The investor was happy, the new homeowner was happy, and the lender was happy. Anytime you can create an investment opportunity with a win-win-win scenario, you should.

When I lecture about hard money lending, I ask the audience what they think is the worst thing that happens if you are a hard money lender. Invariably, most people in the audience answer that you have to foreclose on the property. Nonsense! If you are doing hard money lending correctly, the worst thing that can happen is that the borrower pays you back! Unfortunately, this is a common risk of hard money lending. Most hard money loans are made at 70% or less of the fair market value of the property. If you are fortunate enough to foreclose on a hard money loan, your IRA will have acquired a property with substantial equity while the investor did all the work of finding and rehabbing the property!

While it is true that foreclosing on a property owned by a friend may cause an end to that friendship, a properly secured hard money loan will at least not “lose itself” as Shakespeare asserts. In fact, it may lead to substantial profit for your IRA! To avoid losing a friend, simply don’t loan money from your IRA to someone you would feel bad foreclosing on. In order to be a successful hard money lender, you do have to be prepared to foreclose on the property if necessary.

In modern times, especially with the invention of Cryptocurrency IRA,  I believe the proper advice, at least in the right circumstances, is “Either a lender or a borrower be!” You can make more money for yourself right now by borrowing OPI (Other People’s IRAs). Borrowing from someone else’s IRA can even lower the total cost of your financing compared to a conventional loan from a bank or mortgage company, especially on short term financing. From a lending perspective, your IRA can make great returns by being a hard money lender, either through higher than average interest rates or, better yet, through foreclosing on property with equity. You may find that hard money lending from your self-directed IRA is a great way to boost your retirement savings without a lot of time and energy invested on your part.