By It is getting increasingly popular for individuals to use self-directed IRAs to invest in alternative investments—that is, investments in things other than stocks, bonds, CDs and the like.
The single most popular alternative investment for self-directed IRAs is real estate.
With real estate values continuing to climb, you may be thinking about establishing your own self-directed IRA to purchase residential rental property, commercial property, or other real estate investments.
But before you do so, you should be aware of some potential downsides of using self-directed IRAs for real estate. These aren’t necessarily dealbreakers, but they can be big obstacles.
Debt Financing
First, it is more difficult to get debt financing for real estate held in a self-directed IRA.
You, the self-directed IRA owner, are not allowed to lend any money to your self-directed IRA. Your close relatives are also barred from making loans. Nor can you personally guarantee a loan taken out by your self-directed IRA.
Instead, your self-directed IRA must obtain a non-recourse loan. With a non-recourse loan, the lender’s sole recourse in the event of default is to foreclose on the property. Such loans are more difficult to obtain than regular loans. Typically, the lenders that make these loans require your self-directed IRA to furnish a 30 percent to 50 percent down payment.
Unrelated Business Income Tax
If you obtain such debt financing, your self-directed IRA could become subject 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.
The unrelated business income tax is based on the percentage of the property that is debt-financed. For example, if your self-directed IRA buys a rental property worth $500,000 with $250,000 of non-recourse financing, 50 percent of the rental income from the property is subject to the unrelated business income tax.
The unrelated business income tax most often poses a problem when your self-directed IRA sells debt-financed real property. It pays the unrelated business income tax on any profit at capital gains rates. If the property has substantially increased in value, the tax could be large.
Key point. Your self-directed IRA can avoid paying the tax if the debt on the property is paid off more than 12 months before the sale.
RMDs
Finally, 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, you must distribute a percentage of your IRA’s value to yourself each year, based on your life expectancy, or face an enormous 50 percent penalty.
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.
If you have questions about self-directed IRAs or RMDs, please call me on my direct line at 408-778-9651.