The topic of holding rental properties in a self-directed IRA is such a heated debate among real estate investors. One side says that it makes absolutely no sense and that you would have to be a complete idiot (they really say these things) to hold rental property in a self-directed IRA. The other side says if it is your absolute only available entry point into real estate investing, why not?
I can understand both sides of the argument under specific circumstances. I think people are misinformation on both sides of this argument.
Not Being Able to Leverage
First of all, I think most people don't realize that you can get a loan on a property held in a self-directed IRA. I have read most of the Rich Dad Series books on real estate investing and in one of the books, the author stated that you cannot get a loan on a property held in a self-directed IRA.
You CAN get a loan on a property held in a self-directed IRA. The loan is called a non-recourse loan. There are only a handful of banks in the US that will award a non-recourse loan. You have to present a proforma for the property that you are interested in and they tell you whether or not they will do the loan and the terms.
Their determination is based on property performance…i.e. cash flow…and available funds. The interest rate is a little higher than a traditional rental property loan and you usually need 40% down + emergency funds. They will only finance 60% of the property value. This is because if you default on the loan, they are limited in how they can collect.
The difference between a recourse and a non-recourse loan is that the bank can not come after any of your personal assets if the amount that you default on is higher than the value of the home at the time they foreclose on it.
The bottom line is that you CAN get a loan on a property held within a Self-Directed IRA. The interest rate is slightly higher and the amount that you can finance is lower, therefore the property will not perform as well as a property outside of a self-directed IRA.
Losing Your Tax Benefits
The second concern is losing all the amazing tax benefits which are also a real concern.
First, there are two basic types of Self-Directed IRAs: Traditional and ROTH. When you contribute to a Self-Directed Traditional IRA, you can deduct that contribution on your taxes. The investment grows tax-free and you have to pay taxes when you take distributions during retirement. When you contribute to a Self-Directed ROTH IRA, you cannot deduct the taxes. The investment grows tax-free and you DO NOT pay taxes when you take distributions during retirement.
If you do have a ROTH IRA, you can take out your contributions you had made to that ROTH IRA without penalty, but not any gains. If you've made enough contributions to a ROTH IRA over the years, this might be a good place to start when looking at coming up with a down payment for a rental property.
Taking Required Minimum Distributions
Self-directed IRAs are treated the same as traditional IRAs. You must start taking Required Minimum Distributions (RMDs) no later than April 1st of the year after you turn 70 ½. If you have a Roth IRA, there is no RMD requirement since you paid your taxes when contributing to the IRA.
The amount you are required to take as a Required Minimum Distribution is calculated based on the value of all your retirement accounts, not just the ones held at IRA Resources. If your self-directed IRA account holds real estate but you have another retirement account holding cash, you can take your RMD from the cash account without distributing your real estate. If you do not have enough cash to cover an RMD, you will need to distribute your real estate assets.
There are two options when distributing real estate from a self-directed IRA: a full distribution or partial distribution.
Full Distribution of Real Estate held in a self-directed IRA
You can transfer your property into your name as a distribution from your self-directed IRA, however, you will have to pay ordinary gains tax on the full value of the asset once you receive it. That is if the IRA is traditional. If your IRA is a ROTH, you can distribute the entire property to yourself without any penalties.
If you do not have a ROTH IRA and cannot pay the taxes all at once, you can slowly distribute it to yourself via a partial distribution.
Partial Distribution of Real Estate in a self-directed IRA
Partial distributions of your property over time would help ease the tax burden. The property will simply be deeded with the correct percentage ownership to both your self-directed IRA and yourself. As an example, let's say that you distributed 50% of the property to yourself. The deed would rad, “IRA FBO John Doe #12345 50% and 50% undivided interest John Doe”.
With a self-directed IRA, all expenses have to come from the IRA and all income has to be deposited into the IRA. As if the paperwork and bill paying wasn't cumbersome enough in a self-directed IRA, now you have to pay bills based on your percentage ownership.
What happens after You Pass?
Make sure you have designated beneficiaries on all your retirement accounts. You must have named beneficiaries. Otherwise, the retirement account will become part of the estate and automatically be subject to the 5-Year Rule.
Like any retirement account, if your Self-Directed IRA is left to a surviving spouse, he or she can choose to cash it out or to take the minimum required distributions. Cashing the account out typically creates a very large tax burden via taxes and penalties and is rarely advisable. It is better to be patient and take advantage of the tax-deferred required minimum distributions over time.
Non-spouse beneficiaries have to take the first required minimum distribution by Dec 31st of the calendar year following the year the original owner of the IRA passed away.
Lack of Step Up in Basis at death is a tough pill to swallow. According to Investopedia.com, a Step Up in Basis is the readjustment of the value of an appreciated asset for tax purposes upon inheritance. The higher market value of the asset at the time of inheritance is considered for tax purposes. When an asset is passed on to a beneficiary, its value is typically more than what it was when the original owner acquired it. The asset receives a step-up in basis so that the beneficiary's capital gains tax is minimized. If they want to sell the property right away, they will pay no capital gains tax.
As you saw what happens when you take a real estate distribution from a self-directed IRA, you pay taxes on the full value of that distribution. Instead of your children paying no taxes, they will be hit with an ordinary gain tax (their current tax rate) bill on the full value of the property, not a capital one (15%). Also in the off chance that the property was sold at a loss, the loss won't be allowed.