How to own a property or business in an IRA?

8 02 2011

Occasionally we get this question – how can I use my IRA assets to buy a rental property or a business of some sort?  Many people over the years have accumulated assets in their company 401(k) and rolled them to an IRA,  or saved money in their IRA throughout their working years, but may have not accumulated any assets in other accounts – accounts not directly considered retirement accounts, and as such, not subject to all the special rules that govern retirement accounts.  As a result, they find it difficult to to invest in rental property or to finance a business startup because of a lack of readily accessible funds. 

So, the question is – how can I use the money in my IRA to buy these types of assets?  Can I?  The answer is – sort of.

The laws governing an IRA are designed to limit IRA’s to saving for retirement – but in exchange for following these sometimes burdensome rules, IRA’s allow for investors to accrue funds while enjoying some significant tax advantages.  Since retirement is the primary purpose of IRA accounts, IRA rules intentionally make it difficult to use IRA funds for any other purpose without suffering a 10% early withdrawal penalty (for withdrawals prior to age 59 and 1/2) and income taxation on funds withdrawn from the IRA.

There are specific exemptions from the 10% early withdrawal penalty, such as the exemption that allows an investor to use up to $10,000 for a first-time home purchase or for education purposes.  However, these exemptions typically do not really allow an IRA owner to finance a business or to buy a real estate as an investment tool.

Fortunately – for savvy investors – there ARE ways to get the job done.  As long as the IRA does not engage in “prohibited transactions,” or own “disallowed” investments – then an invesor can use IRA funds to start a business or to buy investment real estate – if he or she does it correctly.

First – the following transactions are considered prohibited within an IRA:

  • Borrowing money from your IRA
  • Selling your own property to your IRA
  • Using your IRA as security for a loan
  • Buying property within the IRA for personal use

Any of these transactions could result in your IRA being disqualified by the IRS – resulting in a forced distribution of the IRA with all taxes and early withdrawal penalties becoming immediately payable! So, first and foremost, an investor needs to carefully play by the rules governing IRA’s to avoid running afoul of the IRS.

Secondly – certain types of investments cannot be held within an IRA:

  • Collectibles (such as art, antiques, most coins, stamps, etc)
  • Life insurance contracts
  • Derivatives (other than covered calls on stock owned within the IRA)
  • Real Estate from which YOU directly benefit (ie – receive rents directly)

So – back to the original question – How can I use my IRA assets to buy rental property or finance a business startup?  The key to success is to remember that anything purchased by the IRA – and any benefits (such as rental income or appreciation) derived by investments within the IRA –  must be owned by the IRA and remain inside the IRA, lest it be considered a distribution from the IRA.  

So – in order to buy rental property or a business with your IRA – here is what you must do:

  1. You must find a custodian that allows these types of transactions, and has expertise in getting these transactions done effectively and legally.  Most custodians (ie – brokerage firms) do NOT handle or allow these transactions.  You must choose a custodian that specializes in these types of transactions to hold your IRA.  Additionally, you should expect to pay top dollar for their services; you will not get a “free” IRA at one of these firms.  Expect each transaction to have a significant fee, and expect an annual fee on the account.
  2. Once you choose your investment, the custodian of your IRA will then direct your IRA to purchase the investment property or the business within the IRA.  Therefore, the investment property or the business effectively becomes an investment within the IRA itself, and is considered a part of the IRA portfolio.  As long as it is not a prohibited investment – then it is allowable.  Remember – as far as real estate being a prohibited investment – the prohibition is against YOU getting a direct benefit from the property (such as having rental checks made out to you directly).   The prohibition is NOT against your IRA owning a rental or investment property as an investment in an arms-length transaction.
  3. Any mortgages on the property, repair costs, or financing for your business, must be conducted within the IRA itself.  Therefore, the mortgagee on the property bought within the IRA is NOT you – but your IRA.  Any business loan to the business is made to your IRA – not to you.  Generally custodians that specialize in these type of IRA transactions can assist investors in finding lenders who have experience loaning funds to IRA-owned businesses, or for the purposes of repairs or rehab operations on properties owned by IRA’s.  Do not expect these loans to be particularly competitive. 
  4. Essentially – the IRA – under the supervision of a custodian who specializes in these types of transactions – becomes a legal entity conducting business for itself.  Your IRA can even loan money for investment purposes (ie – make “hard-money loans” to other real estate investors), finance the rehab of homes for later resale, and own the business within which you work. 

Many people ask about using their IRA for purposes such as these – but few people ever actually do so because of the complexity of the planning required.  From a financial planning standpoint – conducting these types of investments within an IRA can be profitable – but are also considered to be quite risky, as they introduce additional types of risk (such as liquidity risk, default risk, and business risk) that most investors do not wish to see within their IRA’s.  Additionally, owning a business within your IRA can subject your IRA to what is called “UBTI,” – Unrelated Business Taxable Income.   It is for these reasons that you should always consult with tax and financial planning professionals who are completely familiar with your particular situation, risk tolerance, investment experience, tax situation, and financial goals before actually trying this. 

Many custodians who specialize in these types of transactions advertise how “easy” it can be, and how profitable it can be – but in my experience, few investors whom I have seen actually try these types of strategies have been overly pleased with their results.  Most of them have not significantly improved their financial situation above and beyond what their situation would have been had they merely practiced good financial planning behaviors and invested their IRA funds in a fully diversified, properly constructed portfolio that was appropriate for their risk tolerance.

Information in this article does not constitute a recommendation or solicitation for any product mentioned.  Mutual funds may only be sold by prospectus.  Past performance is no guarantee of future performance.  All investing – including the investing discussed within this article – involves risks of loss.  Consult your financial advisor for specific recommendations.

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One response

29 04 2011
Traudi

I found your blog on the bizstart blog. I am looking to move to the Jacksonville area and this information has given me just what i was looking for. Thank you!

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