Investing in Real Estate, Notes and Trust Deeds with an IRA

IRA funds are typically invested in public stocks, bonds, mutual funds and money markets, but can also be invested in Real Estate, Trust Deeds, Mortgages, Promissory Notes and Private Stock/Bonds.  It can be very lucrative to purchase your best and safest investments with IRA funds to avoid income and capital gains taxes.  This works especially well if you have a large amount of money in your IRA account(s). 

The first step is to determine if your current IRA custodian allows real estate and/or trust deed investments with your account (most don’t).  If not, you can convert/rollover your IRA/401K into a “self-directed IRA” account. There are about a dozen custodians to choose from which specialize in self directed IRAs.  Management and transaction fees vary from custodian to custodian, and are usually more expensive than a normal IRA account.  Here is a list of “Self-Directed IRA Custodians”, its best to compare fee schedules based on the size of your account, types of investments you plan to purchase, and the number of trades you plan to do per year.

List of Self Directed IRA Custodians

The second step is to combine IRA accounts.  If you have several IRA accounts, combine them together to get a bigger bankroll. It is easier and more cost efficient to invest one self directed IRA account of $100k in real estate and notes, rather than three accounts of $33k each.  You cannot combine a ROTH IRA with a Non-ROTH IRA.

Once your account is transferred to a “self directed IRA”, a process which usually takes 1-4 weeks, your account can be invested directly into real estate, promissory notes, trust deeds and other non traditional investments.

Self Directed IRA Restrictions and Prohibited Transactions

It is possible to now buy real estate, notes and private stock with your IRA funds with restrictions.  Some of these restrictions (prohibited transactions) are:

• Arms length transaction – you cannot buy/sell assets to your IRA from/to yourself or certain family members (disqualified persons).
• You cannot use the asset personally (nor can your family members) Example: It is not allowed to buy a house with your IRA and live in it, or rent it to your children. You can buy a vacation rental, but you can’t vacation in it.
• You can buy real estate in an IRA and get a loan on it, however you cannot personally sign the loan documents, thus you need a special loan called a “non-recourse loan”.  There are lenders who specialize in this.
• You (and your disqualified persons) cannot borrow money from your IRA

Disqualified Person – The IRA holder and his or her spouse. The IRA holder's lineal descendants, ascendents (parents/children) and their spouses (brothers and sisters are ok). Any corporation, partnership, trust, or estate in which the IRA holder has a 50% or greater interest.  Anyone providing services to the IRA, such as the trustee or custodian (See IRS Section 4975) for a complete list of prohibited parties credentials)

Buying Real Estate in an IRA

Advantages of owning real estate with an IRA:

• Capital gains and income are tax deferred (tax exempt if it is a ROTH IRA)

Disadvantages of owning real estate with an IRA:

• Must keep cash reserves in the IRA account to cover unexpected expenses
• Since the IRA is tax exempt, you don’t get the benefit of depreciation on the property.
• All expenses must be paid from the IRA account
• You may be very limited in how active of a role you can play in property management.
• Leveraging / mortgaging a property is more difficult / expensive.
• Leveraging a property in an IRA may not be entirely tax free due to “UBT Tax” (Unrelated Business Tax), which may apply to the income generated from the leveraged portion of your asset.
• Real Estate may subject your IRA to liability exposure, IE a slip and fall suit could go after your other IRA assets.

A Few Good Ideas for buying Real Estate with an IRA:

• It makes more sense to purchase raw land with an IRA, than it does to buy improved property, because of the lack of depreciation.
• Buy raw land, subdivide & sell.
• Buy and flip properties (short term) avoiding capital gains tax.
• Buy triple net lease properties (low maintenance, no depreciation) – long term.
• Buy Real Estate Options and Sell them – the benefits of leveraging, without UBT.
• Buy Land Contracts and Sell them – the benefits of leveraging, without UBT.
• Create an LLC, which is owned by your IRA, and have the LLC purchase real estate.  This reduces liability exposure, and can also reduce custodian fees.  There are several companies out there that will setup an LLC like this. Setup fees vary from $2500-5000.

Investing IRA funds in Trust Deeds and Promissory Notes

Trust deed Investing with an IRA is an even better idea for investing IRA funds, due to the favorable tax treatment, the low maintenance requirements, and above average yields (12%+).  It is best to buy very safe, low LTV, 1^st position mortgages.  Junior position notes are not advisable unless you keep a large cash reserve in your IRA account to cover possibility of advancing funds to a senior lien.

Advantages

• Notes are almost always a positive cash-flow investment – even though an interruption to that cash-flow can occur if the borrower defaults.
• 1^st Position Notes rarely have expenses associated with the asset. Possible exceptions are if the borrower defaults on property taxes or fire insurance.
• Future yields can be predicted accurately based on the note rate.
• There is practically no liability exposure to owning notes.

Disadvantages:

• Trust Deeds and Notes owned by an IRA cannot easily be leveraged.

It is also possible to buy fractional notes in an IRA. As an example, if you would like to buy a 200k note but your IRA account has only 100k in it.  You can buy 50% of it yourself and 50% with the IRA.

When buying real estate notes, sometimes the borrower defaults, and the note holder must foreclose and take back the property.  In this scenario, the IRA would then own the property. Make sure that if you buy notes with a particular IRA custodian, that they also allow holding real estate (not all do).  Should you take back a property in your IRA, you can now sell it or rent it, but you can’t move into it or use it personally.

Another great idea might be to buy discounted notes or an option on a note.  This opportunity may be rare, but can have an astounding tax free rate of return.

Warning: Investing Self Directed IRA funds requires careful attention to IRS laws, violating IRS laws regarding self dealing, selling to disqualified buyers can be a serious taxable event and cause your IRA to be effectively distributed and penalized. The IRS has letter rulings on many of situations. Review these laws with your Self Directed IRA custodian.

About the author:

James MacArthur is broker/lender licensed by the California Dept of Real Estate.  We make “non-recourse IRA loans” in CA, as well as sell trust deeds to Qualified California investors. I am not an attorney, and this paper is not intended to provide legal advice. Consult your attorney and IRA custodian for the latest information.