Self-directed IRAs provide a twofold opportunity for CRE pros.
Self-directed individual retirement accounts represent an estimated $171 billion of the overall IRA market, and one of the most popular assets for these accounts is real estate. Single-family residential property is the most frequent target of these real estate-focused IRA investors because there is widespread understanding of that market. But investors who are seeking value and potentially higher returns are increasingly interested in the commercial real estate market.
As a real estate professional, you can utilize your expertise and knowledge to grow your own IRA, SEP IRA, or Individual 401(k). However, an even more substantial opportunity to make money may be selling commercial real estate to your clients’ IRAs or helping developer clients coordinate IRA funding sources for purchases. IRA transactions are not complicated, but they are often unfamiliar to your clients. And the fact that real estate professionals derive a commission from sales involving an IRA just the same as they would from a non-IRA transactions means that working with this type of investor can be lucrative.
Potential clients who are interested in SDIRAs are likely to ask the following seven questions to help build their own knowledge and assess how prepared you are to help them with this type of real estate transaction.
How does IRA investing in commercial real estate differ from regular real estate investing?
The biggest difference between a “regular” real estate purchase and one done by an IRA is how taxes come into play. Because IRAs are tax-advantaged accounts, the Internal Revenue Service wants to track the money that is contributed, invested, and, ultimately, distributed. It does this by making IRAs custodial accounts, meaning that an authorized provider is the signer for the account and is keeping the books for that account.
Thus, an IRA is its own legal and financial entity, separate from an investor’s personal finances. The IRA has its own titling on legal documents associated with its investments, and all paperwork must be executed in conjunction with the IRA provider. As long as the account holder stays in concert with its provider, IRA purchases and sales can occur within the same time frame as transactions outside of IRAs.
How does an IRA make money in commercial real estate?
An IRA makes money the same way regular real estate investments make money. The following are the most common SDIRA approaches.
Rental returns. The IRA holder determines the terms of lease agreements and can vary them based on market conditions and investment goals. And the IRA holder decides what to do with the incoming cash: buy another asset, take a distribution, make improvements to the existing asset, or any combination.
Appreciation. Strategies such as land speculation and buying and selling options are allowed by the IRS. One of the advantages of investing within an IRA is that financial gains associated with the sale of real estate are still under the umbrella of the account, and as such, are tax deferred. Those proceeds can be used, in full, to turn around and buy another asset, real estate or not. Successful investments in land or commercial property can appreciate in value while concurrently generating rental revenue for the IRA. Of course, whatever return is generated by an asset goes back to the IRA and any expense that is incurred by the IRA’s asset must be paid by IRA funds.
Lender. IRA funds can be disbursed to an individual or entity and repaid according to the terms of that note. These loans may be secured by collateral or not, and the terms are negotiated by the IRA holder and the borrower. The IRS only mandates that the loan be a real economic transaction (no sweetheart deals), and that a nondisqualified person/entity cannot be the borrower. Bridge loans, construction loans, mortgage loans, and more are allowable.
What if an IRA doesn’t have the full purchase price of a commercial real estate property?
Many investors don’t have the funds in their IRAs to purchase a real estate property outright. However, through partnerships, joining an entity, debt financing, and more, IRA holders still have several options to own a portion of their desired asset.
Partnering an IRA with another source of funds — by being a tenant in common or owning a percentage of an entity such as an LLC — is a common way to structure an investment. IRAs may partner with anybody, including individual investors, LLC and C-corporation entities, and other IRAs or retirement plans — even disqualified persons/entities are eligible to partner with an IRA. An IRA may also take out a loan to increase its purchasing power.
Tenants-in-Common. A TIC agreement is typically set up as side-by-side, undivided percentage ownership: if IRA X owns 65 percent of a commercial property and IRA Y owns 35 percent, all revenue, payments, and distributions will be split according to that percentage.
Investors should think ahead about the logistics involved in this arrangement. For example, everything from replacing dripping pipes to building a new wing will be funded according to that percentage. TICs that include a disqualified person (account holder, spouse, direct ascendant, descendant or their spouse, certain fiduciaries, or entity owned by a disqualified person) as one of the investors are allowed but require planning and care in execution. Rules that apply to IRAs investing with disqualified persons include dividing revenue and payment of bills, maintenance arrangements, and more. A key rule that applies to this arrangement is that side-by-side ownership with the established percentage of ownership must remain unchanged throughout the life of the investment.
Purchase through an entity. Purchasing commercial real estate by pooling funds from multiple investors into an entity is another popular method for IRAs to invest in larger projects. In this strategy, the IRA’s asset is its ownership in the entity that, in turn, owns the property. In this scenario, all rules that would apply to an IRA buying the property would also apply to the entity’s ownership.
Debt-financed purchase. Individual IRAs (and in some cases partnerships and entities) can often arrange for a nonrecourse loan. Because the loan is not guaranteed by the IRA holder, the terms reflect the additional risk to the lender and usually require a larger down payment; details vary according to the lender. Other loan combinations are also possible.
Must I create an LLC or entity to own commercial real estate in an SDIRA?
No. An IRA can use an LLC or entity, but it is not required. An IRA can have direct ownership in a commercial real estate asset.
LLCs are commonly used for real estate investments outside of an IRA to achieve a level of liability protection. However, because an IRA is its own legal entity, separate from the IRA holder, it does provide separation from the IRA holder’s personal finances and may alleviate the need to have an LLC in the arrangement.
In addition, mass marketing by providers of IRA-owned entities has led to the myth that LLCs or entities are required for this kind of investing — or at the very least, provide an easier foundation for investing in real estate properties. Some promote this strategy because it ostensibly allows money to be available quicker through checkbook control. However, a few SDIRA providers such as New Direction IRA have developed technology that allows funds to be disbursed for real estate expenses quickly and for free, minimizing the costs and risks that checkbook control often includes. The decision on the structure of the investment is a matter of individual choice and risk tolerance.
Are there geographical limits on where an IRA can invest in commercial real estate?
An IRA can invest in commercial real estate anywhere in the world as long as the appropriate documentation of the asset can be acquired. Allowable structures may vary — IRA, partnership, entity, — depending on the country, and there may be foreign taxes and other expenses associated with real estate in a particular country.
Can an IRA buy and develop raw land?
SDIRAs can acquire raw land and participate in its development. The IRA holder can choose contractors, suppliers, tenants, and more according to their individual development and investment plans. However, the IRA holder (and any company that they own or control) will not be able to participate in the work itself.
If the IRA is one of many owners, and there are no disqualified persons/entities involved, the financing arrangements for development of a property are varied and relatively flexible. If disqualified persons/entities are involved in the land and development ownership structure, the possibilities may be more rigid. For instance, if IRA X owns 40 percent of the land and development and disqualified person Y owns 60 percent, all disbursements for purchase, improvements, maintenance, and all income generated by the project need to be split 40/60 throughout the life of the project. Of course, the IRA would always be able to sell its share to a non-disqualified person/entity at any point.
How do I distribute IRA funds?
Distribution of IRA assets can take place in two forms: cash or in-kind. In order to receive cash distributions, the IRA holder would either take distributions of the rental income or they would sell some, or all, of the asset. Once those proceeds are received by the IRA, the account holder can take distributions as he or she wishes.
With an in-kind distribution, the ownership changes from the IRA to the IRA holder’s personal finances. This is achieved by retitling the property. Similar to a cash distribution, the IRA holder can distribute their entire ownership interest or just part of it. The taxable amount for IRAs (other than Roth) is the value of the ownership distributed. Once a complete in-kind distribution has taken place, the rental returns of that investment become part of the IRA holder’s personal finances, and IRS prohibitions related to disqualified persons and the property cease.
Expertise in commercial real estate is a powerful tool that can be utilized in combination with the tax advantages of an IRA. One of the great benefits of a SDIRA is that the account holder can take their knowledge of how to make money outside their IRA and use it to make money inside their IRA.
What If…
“The IRS doesn’t really enforce the rules about buying properties from family members, right? I read that you can get around that by….”
Because the IRS can and does enforce its rules, it is important to adhere to the guidelines about prohibited transactions, which include the buying or selling of properties to/from disqualified persons and even to/from your own non-IRA real estate holdings. This is a particularly important rule since, outside of IRAs, real estate transactions between relatives and friends are common. The IRS considers an arrangement to circumvent a prohibited transaction a violation of the rules. This means that a disqualified person cannot sell a property to a non-disqualified person so that the IRA can buy it from that non-disqualified person. The consequences of a discovered prohibited transaction can be severe, including immediate distribution (and the tax consequence of that) at the time of the transgression, interest, and penalties.
“Can I get a commission if it is my personal IRA buying the real estate?”
Unfortunately, no. The IRS prohibits disqualified persons from receiving compensation from the IRA. However, even though you cannot be directly compensated with a commission, you are still the decision maker for the IRA and you can benefit from not having to pay the real estate commission that would ordinarily go to the real estate professional involved in a transaction. By negotiating a price reduction on the property to reflect the cost savings to both the buyer and the seller of not having to pay a traditional commission, you can instantly increase the equity in your newly acquired property. It may not be a commission in your pocket, but it’s the same amount of money in a tax-deferred vehicle with all the advantages that come with an asset in an IRA.
“Can I still take depreciation if my IRA is the real estate owner?”
You can’t do that through your personal taxes since the IRA is the owner of the property. But there are significant tax advantages for you in other ways because the real estate is being held in a tax-advantaged vehicle: Any profits derived from a real estate investment in an IRA are tax deferred, plus in most cases the IRA is set up in a way that exempts it from paying income taxes. That is a double tax savings that comes from doing this investing via an IRA. In fact, IRA profits do not even need to be reported your personal taxes.
“LLC or no LLC?”
This decision may be clarified by talking to your lawyer. Even if an IRA’s only asset is that real estate property, the IRA may or may not satisfy the IRA holder’s risk tolerance. And, of course, not all LLCs are created equally when it comes to liability protection. Strategies to mitigate risk certainly include liability insurance purchased by the IRA for its asset(s) as well as having the IRA own an LLC which owns the property. Consult with your legal adviser before proceeding.
