Part 1 of this article explained how the self-directed IRA works with real estate. As you know from that article, the self-directed IRA for real estate faces a wall of regulations. And from a practical standpoint, putting real estate in an IRA for the do-it-yourself individual does not work well.
Part 1 covered several drawbacks that arise when you place real estate in a self-directed IRA. Here we explain three more potential problem areas that you need to consider if you want to put real estate in a self-directed IRA:
Debt financing Unrelated business income tax Problems with RMDs
One of the great advantages of owning real estate is leverage: you ordinarily can borrow a substantial portion of the purchase price. Your self-directed IRAs also can borrow money to purchase real estate, but it is more difficult than a normal real estate transaction. Neither the self-directed IRA owner nor any other disqualified person may lend money to the self-directed IRA or
personally guarantee a real estate loan (or any other loan) taken out by a self-directed IRA. As a result, any loan used to purchase real estate in a self-directed IRA must be a non-recourse loan in the name of the self-directed
IRA (or self-directed IRA/LLC, if applicable). With a non-recourse loan, the lender’s sole recourse in the event of default is to foreclose on the property. The lender has no additional legal rights against the self-directed IRA or self-directed IRA owner. Such a non-recourse self-directed IRA loan is more difficult to obtain than a regular loan. Typically, lenders who furnish such loans will charge a higher interest rate and will require that the self-directed IRA furnish a 30 percent to 50 percent down payment. In addition, the self-directed IRA must use funds in the IRA to pay all the fees and expenses for the purchase. The self-directed IRA owner cannot pay the fees and expenses from his or her personal funds.
Ordinarily, the money or property in an IRA grows tax-free. But the non-traditional investments in a self-directed IRA may result in the IRA subjecting itself to the unrelated business income tax. This is a tax imposed on tax-exempt entities, including IRAs, that earn money from businesses unrelated to their tax-exempt purposes. If an IRA generates more than $1,000 in gross income from an unrelated business, it must file Form 990-T. Tax is paid on such income at the same rate as for trusts. The top rate is 37 percent, the same as for personal income tax. But there are only four brackets, and the self-directed IRA reaches the top bracket (37 percent) at taxable income over $13,050. If the self-directed IRA incurs the unrelated business income tax, it must pay the tax from its funds (the IRA owner may not pay).
If you’re at or near 72 years of age, you need to consider how holding real estate in a traditional IRA will impact the requirement that you take annual required minimum distributions (RMDs). (No RMDs are required for Roth IRAs.) Once you hit the RMD age (currently 72), you must distribute a percentage of your IRA’s value to yourself each year or face an enormous 50 percent penalty. The annual RMD amount is based on your life expectancy and goes up each year. If all or most of the assets in your traditional IRA consist of real estate, the property may not generate enough cash
to pay your RMD. This is not an unsolvable problem, but it is a problem. One possible solution that would result in sufficient cash to pay your RMD is to refinance the property to pull out enough cash to pay the required amount. It is also possible to pay your RMD in kind—that is, to distribute property
instead of cash. But this can get complicated with real estate. By the way, be aware that the fair market value of an IRA as a whole must be reported to the IRS each year on IRS Form 5498. In addition, IRS custodians must separately report the fair market value of hard-to-value assets such
as real estate. Many custodians permit estimates from the IRA owner or valuations based on online sources such as Zillow or Redfin. But once you reach RMD age, things get more serious because your RMD amount is based on these valuations. Thus, many custodians require a formal real property appraisal when the IRA owner has reached RMD age. This will cost at least $300 for a single-family home and can easily cost $1,000 or more for larger multi-family rental properties or commercial properties. The appraisal fee must be paid by the self-directed IRA, not by the IRA owner.