What is not well known is that with some very strategic planning, a real estate investor can use the assets in their existing IRA's and Roth IRA's to purchase real estate. Ideally, the process is fairly simple to implement. In addition, to using your IRA's and Roth IRA's to invest in real estate, you can also use funds from a Solo 401(k) with a Designated Roth 401(k) account to purchase a new business, a franchise or an existing business. However, you cannot use any of the funds to buy your own existing business or the existing business of a family member. However, you can use your Solo 401(k) with a Designated Roth 401(k) account to purchase a New business! It has to be an arms length transaction, not a transaction structured merely for the purpose of evading taxes.
Let's look at using your existing IRA to invest in Real Estate first. How does this work?
Real Estate IRA LLC
There are just a few steps involved. You need a tax attorney firm knowledgeable in this area of expertise, not fly-by-night promoters who are here today and gone tomorrow. We can refer you to a top flight tax attorney firm that handles this from start to finish.
The Self Directed IRA LLC involves setting up a new Limited Liability Company (LLC) that is owned by the IRA and managed by you. Alternatively, you can have any third party be the manager. As manager of the LLC, you simply open an LLC account at a bank and obtain check writing privileges. You do not need a custodian to approve every transaction. Since you are the manager of the LLC, this gives you wiring authority and checkbook control. Your IRA purchases your LLC as a security. You fund the LLC with the proceeds of your IRA in any amount that you choose up to 100% of your IRA. The IRA holds a position in the account which is your new LLC. The LLC position is treated as a security in your IRA.
For example, if you had $200,000 in stocks, bonds and cash in your IRA and you use the whole $200,000 to fund your LLC, then your IRA would own a new security, the LLC, which is now worth $200,000. This is a non-taxable transaction because it is done within your IRA.
When you are ready to purchase the real estate property, you simply wire the funds to the escrow agent from the LLC. Since you purchased property with the proceeds of your IRA that are now in your LLC, you now have an accurate valuation for your LLC security in your IRA account. This information can be provided to the bank for whom you have the LLC account and they will list the value of the real estate as the total all in price you paid for it. Of course it is a good idea to have an annual appraisal done for valuation purposes. It is mandatory when a distribution is made.
Growth of the real estate owned by the IRA via the LLC is tax deferred and just like if you were holding any other investments, you are required to start taking a distribution by April 1st of the year following when you turn 70 1/2. Of course, you can take withdrawals any time after your turn 59 1/2, too without the 10% early withdrawal penalty.
There are a few things to understand when purchasing real estate in an IRA. One is that you cannot deduct your real estate taxes from your tax return. Nor can you deduct your home mortgage interest if this is your second home. Further, you cannot take any depreciation on the property either. Lastly, you do not have a cost basis in your IRA when you start to pull things out. Everything that comes out is taxed as ordinary income. However, if you had $200,000 in stocks and bonds today in your IRA and you purchased $200,000 worth of real estate with an LLC Real Estate IRA, then you would be in the same boat from a tax perspective.
If you think of this in terms of holding one stock worth $200,000 in your IRA and selling it and buying another stock worth $200,000, then there is no tax consequences, because it is done within the IRA. It is the same concept with the real estate purchase. All you are doing is selling the stock for $200,000 and buying the LLC inside your IRA for $200,000 to replace it.
Real Estate Roth IRA LLC
You may be thinking... "What about a Self Directed Roth IRA LLC?" You would be thinking correctly. It would be better to buy real estate with the proceeds of your Roth IRA. Of course this is assuming that you have enough funds in your Roth IRA to make such a purchase. However, there are ways to solve this dilemma if you have a larger IRA that you can convert to a Roth IRA. Of course, when you convert your IRA, then you have to pay taxes. Fear not! There are ways to do this without feeling the entire tax bite all at once. Let me explain.
When you convert for example, $200,000 to a Roth IRA, then you add the $200,000 to your AGI and you are taxed on that figure. So, let's assume that you are taxed at the 33% rate. This means that you would owe roughly an additional $66,000 in income taxes. However, if you have a Home Equity Line of Credit (HELOC), you can borrow $66,000 and pay the taxes. This allows the full $200,000 to be used in our now new Roth IRA account. So, instead of having an Roth IRA worth $133,000, you have a Roth IRA worth $200,000 with a Home Equity Line of Credit obligation for $66,000. You can buy more real estate with $200,000 than you can with $133,000.
The interest on the Home Equity Line of Credit is typically interest only, so you only pay the interest on the $66,000. Suppose this interest was 5%, then you would owe $3,300 in annual interest. The strategy is to pay the HELOC interest for 5 years, then pay it off from the growth of the real estate in your Roth IRA LLC.
You see, once you converted the $200,000 IRA to a Roth IRA for $200,000, then the entire $200,000 is considered your Roth IRA cost basis. You can withdraw cost basis from a Roth IRA without penalty. After 5 years, with a wise real estate purchase or purchases, you can sell the property for a profit and use some of the proceeds to pay off the HELOC without any penalty or taxes due. The choice is to pay $66,000 in taxes in the beginning all at once, or use the growth of your Roth IRA to pay off the $66,000, thus only costing you the annual HELOC interest of $3,300 for 5 years.
You are using the bank's HELOC money instead of your IRA money!
Instead of paying $66,000 and kicking you up into a higher tax bracket, you leverage the HELOC and pay $16,500 ($3,300 x's 5 years.) You would stay in your current tax bracket which may be 28% or 25% which will save you in taxes if you do this instead of paying the taxes all at once on a conversion to the Roth IRA.
It doesn't take a smart person to figure out that $16,500 is much better than $66,000. Plus, do not forget to factor in the savings in taxes which could be another 8% on your current income that you had to pay because you paid for the IRA to Roth IRA conversion in one lick.
Does you financial advisor or for that matter, your real estate agent know this stuff?
This obviously works better if you are successful at flipping houses during that five years. See the next section on that subject.
You may be thinking..."What if I wanted to flip houses?" Not a problem. If you are successful at flipping houses, then you should be able to pay off the HELOC even quicker than 5 years. You would simply buy a property, flip it, receive the proceeds, then buy your next flip property. Each time you do a successful flip, the profit stays in your IRA or Roth IRA and gives you more money to flip with and pay off your HELOC sooner via a perfectly legal cost basis withdrawal.
There are some rules around contributing your own personal labor to the flip that can cause problems, so it is best to fully understand the rules around flipping houses and contributing yourself as "free labor" or the free labor of a disqualified person. The IRS could look at it as a business and not a security in your IRA or Roth IRA. If they do that, then you risk the whole account being disqualified. The best way to do flips is to hire out all labor and contractors and keep good records, then you will be fine.
Buying Real Estate with both an LLC IRA and an LLC Roth IRA
You may also be thinking... "What if I wanted my IRA and my Roth IRA to both own the real estate?" Not a problem, either. You would simply have two LLC members. The IRA would own a percentage of the real estate property and the Roth IRA would own the balance of the property. This is especially advantageous when you have a large IRA (and you do not want to convert it) and a smaller Roth IRA. However, when you add the total of the two, then you have enough to purchase the real estate in question.
Special Allocations with two LLC members
You can actually have special allocations built into your LLC operating agreements. For example, the IRA LLC member could get the Applicable Federal Rates (AFR) 130% of Mid-term rate which today is 1.44% interest for the entire time the property was held, then the smaller Roth IRA LLC member would get to split the balance with the larger IRA LLC member 50/50 after that. Wow! Wait a minute. Please explain more.
Suppose your IRA LLC was a member who contributed 75% of the funds to purchase the real estate and the Roth IRA LLC member who contributed 25% of the funds to purchase the real estate. Since the IRA LLC member contributed the most, they get a 1.44% interest contribution for the entire time the property was held before the Roth IRA LLC member gets a dime. However, once the 1.44% interest is paid to the IRA LLC member, then the Special Allocation says that everything is split 50/50.
Let's look at an example. The property purchased by the two member LLC's is worth $200,000. The IRA LLC member contributes $150,000 and the Roth IRA LLC member contributes $50,000. The property appreciates to $300,000 five years later and is sold. The IRA LLC member gets their original principal back plus the 1.44% interest on his $150,000 contribution for those 5 years, or $11,115.55 in interest, before the Roth IRA LLC member gets a dime. This operating agreement stipulates that the LLC members share 50/50 after that. So, for a $300,000 sales price, minus the 1.44% figure of $11,115.55 paid to the IRA LLC member, this leaves $88,884.45 to be split 50/50. So, an additional $44.442.23 goes to the IRA LLC member and then the remaining 50% share of $44,442.23 plus their original $50,000 goes to the Roth IRA LLC member.
Now let's look at how this benefits the each member. The IRA LLC member gets their original principal of $150,000 plus the 1.44% ($11,115.55) plus the 50% special allocation share of $44,442.23 for a grand total of $205,557.78. This is a 5.33% annualized return. Not bad!
The Roth IRA LLC member gets their original investment back of $50,000, plus the 50/50 split amount of $44,442.23 for a grand total of $94,442.23. This is a 13.56% return!
Without the special allocations wording in the LLC operating agreement, this would not have been possible. The ratio for future purchases between the two LLC members is now 69% to the IRA LLC member and 31% to the Roth IRA LLC member. The special allocation has allowed the Roth IRA LLC member a slight advantage.
Of course this is all contingent on good real estate purchases, but I think you can see the idea of how special allocations can allow you to leverage up your Roth IRA to get a little extra kick as opposed to a straight 75/25 split where the Roth IRA LLC member would have only gotten $75,000 instead of the $94,442.23 they could get with a properly drafted special allocation clause in the LLC operating agreement. The special allocations allowed an extra $19,442.23 to go to the Roth IRA LLC member.
This is why I recommend these experienced tax attorneys who know how to properly draft LLC operating agreements taking into account special allocations.
LLC with a Solo 401(k) for the Self Employed (Real Estate Agents)
You may be further thinking..."What if I wanted to buy a new business, a franchise or an existing business?" This is also permissible as long as you were not buying it from yourself or a disqualified person. It has to be an arms length transaction with an unaffiliated party. However, when you want to buy a business, a franchise or an existing business, then will want to have an existing LLC business, or new one where you establish a Solo 401(k) with a Designated Roth 401(k) account. Further, you want to be self employed with less than 5 employees, preferably however, it is much easier if it is just one, like a real estate agent!
You have to have both a pre-tax 401(k) and an after tax Roth 401(k) account in the plan documents, but our tax attorney firm will prepare all this for you. You have to have both the pre-tax and after tax feature, but you can allocate 100% of the contributions to one or the other, or split the contributions any way you like.
Once you fund your Solo 401(k), then you do something similar to above and establish an LLC that the Solo 401(k) owns. You fund the LLC with proceeds from your Solo 401(k) and Designated Roth 401(k) account, then purchase the new business, franchise or existing business.
Funding your Solo 401(k) in a hurry
You may be thinking... "What if I do not have that much in my Solo 401(k) at first?" If you rolled over a previous 401(k) to a Rollover IRA, then you can re-roll it right back into your new Solo 401(k). Depending on your eligibility, this can get you there in a hurry. Secondarily, you can make up to 100% of your income and put it in a Solo 401(k) up to about $56,500 for 2013. In other words, if your business paid you a salary of $60,000, then you could contribute $56,500 of that and put it in your Solo 401(k). You income would be reduced to $3,500 and you would owe no taxes and probably get a refund with deductions and exemptions.
Creditor and Bankruptcy ProtectionAnother benefit of the Solo 401(k) is that it has creditor protection in Florida. Further, it qualifies for full bankruptcy protection.
What's my angle in this?I am a licensed real estate agent and can earn either normal real estate commissions for property purchased within an Real Estate IRA LLC or Real Estate Roth IRA LLC or a Solo 401(k) used to buy real estate. Further, if you prefer to use your own real estate agent, then I would charge a flat fee for each transaction, typically $1,000 or less either as a real estate referral fee or an investment advisory fee, one or the other.
Obviously, there is a lot more to these topics and I am sure that you might have some questions. Please feel free to contact me at 904-547-2913. I am here to help.