So… you’re an investor with some real estate experience (maybe through a crowdfunding site like www.ifunding.co), and are looking for ways to shield your profits from immediate taxes through an IRA. You may be familiar with self-directed IRAs (SDIRAs) as an approach to using IRAs to invest in real estate, because traditional, institutional IRAs don’t allow direct real estate holdings. Our question for today is:
Exactly how do SDIRAs work and what types of real estate investments are they best for?
iFunding spoke with attorney Mat Sorenson , to give you more insights into SDIRAs. Mat is author of “The Self-Directed IRA Handbook”, the most widely-read book on the subject of SDIRAs, with a 5-star rating on Amazon. We ask him first about the growing use of SDIRAs, then turn to their application within real estate and crowdfunding.
Mat, when did you start building a legal practice around SDIRAs?
Starting 2006, my law firm encountered many clients involved with real estate and 1031 exchanges (‘swaps’ that defer taxation on real estate investments profits when a new investment is identified). We researched other means of sheltering gains from taxes, and found self-directed IRAs to be very viable. That’s true not just for real estate, but for holding precious metals or investing in startups as well. The practice at our firm, KKOS Lawyers, has grown, and I’ve spent the majority of my time advising clients on SDIRAs since 2008. My SDIRA Handbook was published in 2013.
How do SDIRAs work?
Self-directed IRAs give the individual more flexibility as to where they invest retirement funds. Traditional IRAs permit investments in stocks, bonds, mutual funds and CDs, for example. Only SDIRAs allow funds to be invested in specific real estate projects, direct loans to other parties, equity investments in startups, etc., while still providing tax deferral benefits, just with a broader range of investment opportunities.
Funds from existing IRAs or 401Ks (when you leave a job) can be rolled over into an SDIRA, or you can contribute new funds to an SDIRA, subject to maximum annual IRA contributions that the IRS allows someone in your particular situation. Your SDIRA needs to be administered by a service provider known as a custodian. For a fee, they hold the account, confirm the applicability of investments and wire funds on your behalf, and report form 5498 annually to the IRS regarding distributions, contributions, and your account value.
Is the use of SDIRAs to self-direct IRA investments growing?
Absolutely. They were created via government regulations in 1974, but didn’t receive attention for many years because individuals relied more on fixed pensions from their employer. Also, financial advisors are less inclined to recommend SDIRAs, because it empowers the individual to make independent investment decisions and place money outside of the traditional money management companies.
The environment today, where individuals are responsible for their nest egg, and feel qualified to make independent investment decisions, has changed things dramatically. There was a 2013 article in the Wall Street Journal that documents how the custodian companies for SDIRAs have grown from handling hundreds of millions of dollars around 2005, to tens of billions now.
With which kinds of real estate investments do SDIRAs work best?
iFunding recognizes that there is much more a potential IRA holder will want to know about SDIRAs’ benefits and set-up logistics. We recommend Mat’s book as a source, as well as a variety of articles on the Web. Here, we ask Mat about key real estate investing considerations that many other sources neglect to highlight.
You could invest in nearly any type of real estate investment property through an SDIRA, however only some of them will qualify for all the tax benefits of the self-directed IRA. Basically, real estate rental & income properties paid for in cash, as well as loans to real estate operators that strictly repay via interest, qualify for all the tax benefits. To restate, with loans or promissory notes on real estate projects, you would receive the interest payments fully tax-deferred in the SDIRA or tax-free if you have a self-directed Roth IRA.
When will taxes need to be paid with an SDIRA involving real estate?
There are several situations where taxes will apply to income made in a SDIRA. If the real estate project involves in new construction, or in property improvements (“flips”) for short-term turnaround and sale on a regular basis, then it is considered to have generated profits from a business, which are subject to UBIT, or Unrelated Business Income Tax. The SDIRA will need to pay taxes on these profits. You can see the taxation rates on the IRS’s form 990-W. They range from 15% tax on profits in a year under $2,500, to 39.6% marginal tax on profits over $12,150.
Second, if the investor has contributed equity to a rental project, and the real estate operator on that project has also taken out a loan from a bank, then the equity returns – that is, the profits – that the investor receives are subject to taxes in proportion to the amount of debt on the overall deal. This is called UDFI, or Unrelated Debt Finance Income Tax. The UDFI Tax rate on the sale of the property is the capital gains tax rate. UDFI rates on other income (e.g. net rental income) range from 15% to 39.6% on the margin; you can look them up via the IRS’s “Trust Tax Rate” for the current year.
There are other prohibited transactions to learn. You, or a direct family member, can’t be personally involved in the real estate project’s operations, for example. A qualified lawyer or CPA can ensure you set up and use your SDIRA property.
How well do SDIRAs work with crowdfunded real estate investments?
They work very well together, given the considerations mentioned above. Many crowdfund investments are structured as pass-through LLCs, so the tax deferral and other treatments are very similar to deals where an individual directly invests in a property. In some respects, investing through crowdfunding is more efficient for a SDIRA than direct real estate deal participation. That’s because the investor, and therefore the custodian, doesn’t incur costs of lots of income and expense handling; the crowfunding platform takes cares of that. For example, if you owned the property yourself, you would need to record monthly rent income or individual maintenance expenses through the SDIRA; with crowdfunding you’re only recording net income as it is distributed to you, at moderate intervals or end of project. You can read my blog post introducing the principles of SDIRAs with crowdfunding.
Does the custodian chosen by the investor matter for crowdfunding investments?
Yes, it can. Custodians charge servicing fees using a different calculation approaches. If you are making a higher number of smaller investments via crowdfunding – meaning relatively modest profits per investment – then try to avoid a custodian that charges fees based on the number of investments transacted. That will eat into your profits, potentially more than the tax deferral benefits of the SDIRAs will offset. In contrast, other custodians will charge based on total funds within the account.
Also, research that the custodian has a solid reputation for timely responses. The good ones can approve and disburse funds within a day. Crowdfund platforms typically look for funds to be wired within several days to a week after an investment commitment is finalized. [iFunding notes that, on sites like biggerpockets.com, the real estate community has highlighted certain custodians that take much longer to approve wires; buyer-beware].
A few custodians have made a specialty out of working with crowdfund investors, and are more familiar, and fee-compatible, with crowdfund sites. I am familiar with IRA Services Trust Company in Northern California, and Pensco Trust Company based in Denver.
Can we run through deal examples to see how SDIRAs work with respect to tax deferral?
(a) a debt/loan deal in a new building construction, and
(b) equity in a home fix-and-flip
(c) equity into an apartment building’s improvement then rental.
In the first case, assume the investor is participating in a loan to a new condo construction project. The crowdfund structures financing this as a promissory note. In this situation – a loan or promissory note that strictly pays interest as the return on investment to the individual– then 100% of the profits are tax-deferred (or tax-free for a Roth IRA). If this was a traditional (non-Roth) self-directed IRA, then you wouldn’t pay any taxes on the gains until you take out the money for retirement.
In the second case of a home fix-and-flip, let’s say the crowdfund site raised $300,000 in an all cash project investment. One investor puts in $15,000, or 5% of the total. In 10 months, the real estate operator finishes the project and sells the home for $360,000. That’s a $60K total profit. Fix-and-flip businesses are subject to UBIT (tax). This investor receives 5% of the profit or $3,000. If this is their only SDIRA investment subject to UBIT that year, than the IRS tables say the taxes will be $500. In Q1 of the year after the investment ends, the crowdfund platform issues a K-1 tax filing and copies the SDIRA custodian, and the custodian pays taxes from the SDIRA, on your behalf, usually during the traditional April filing period.
In situation ‘c’ with an apartment building, there are some improvements being made, but the primary purpose is to buy-and-hold the property and generate rental income. There is no UBIT that applies to these profits. However, let’s take a case where the total project receives $600,000 from a crowdfund company’s investors as equity, then takes an additional bank loan for $400,000. In year one, the project generates $30,000 in net operating income. In this situation, there is a loan on the property as well as the investors’ equity, so UDFI tax will apply. The proportion of debt into the project financing is 40% (= $400,000 / ($400K + $600K)). Therefore, 40% of the profits of $30,000 are subject to UDFI, or $12,000 (= 40% * $30K). The amount of tax for one investor will be based on the IRS tables and that investors’ proportion of the equity investment.
What are the main caveats using an SDIRA?
The custodian companies vary in degree of experience and funds under management, as well as in customer responsiveness and turnaround times to approve investments and wire funds. So, choose carefully. Look for FDIC protection. Custodians use a variety of fee structures, some of which are much better suited for crowdfunding and real estate. Fees can be based on IRA value, or number of assets owned, or driven by activity including wires or tax reports generated. The weightings of setup fees, ongoing fees and termination fees vary significantly and typically range from a few hundred dollars to a thousand or more, assuming you aren’t actively managing each bit of income and each payment from a property yourself. Be sure to investigate which structure is most cost-efficient for your investing.
The custodians need to approve the transfer of funds for investments, but are only verifying that the types of investments you are making fall within the guidelines for SDIRAs. They are not evaluating the soundness of the investment itself. That’s the responsibility of the individual. In my book, you can read an extensive checklist of due diligence steps that should apply to any SDIRA investment.
Finally, seek out sound legal and accounting advice when creating, using, and reporting on your SDIRA. When properly set-up, the accounts can be very tax efficient and rewarding, and avoid IRS-related or other issues from occurring later on.
Thanks very much for your insights, Mat.
Thank you. I welcome questions on the subject, and can be reached at (602)761-9798 or firstname.lastname@example.org. You can also find my book, The Self Directed IRA Handbook, on my website and on Amazon.com.