Can I Use a SEP IRA to Buy Real Estate?

A Simplified Employee Pension (SEP) IRA is a retirement plan for self-employed individuals and small business owners. It functions similarly to a traditional IRA but often allows for higher contribution limits, providing a tax-deferred growth environment. While a SEP IRA cannot directly purchase and hold real estate, funds can be transferred into a Self-Directed IRA (SDIRA) structure, which then enables real estate investment. This allows individuals to leverage retirement savings for alternative assets like real estate, provided Internal Revenue Service (IRS) regulations are followed.

Using a Self-Directed IRA for Real Estate

To invest in real estate with SEP IRA funds, transfer them into a Self-Directed IRA (SDIRA). An SDIRA allows the account holder to invest in a broader range of assets beyond traditional stocks, bonds, and mutual funds, including real estate. This flexibility is managed through a specialized custodian, which differs from conventional brokerage firms that typically do not offer alternative asset investments.

The SDIRA custodian plays a crucial administrative role, holding the assets and ensuring compliance with IRS regulations. However, the custodian does not provide investment advice; the account holder is responsible for identifying and vetting potential real estate investments. Real estate investments typically allowed within an SDIRA include residential and commercial properties, raw land, and even notes secured by real estate.

When the SDIRA acquires a property, the title must be held in the name of the SDIRA, not the individual. A common titling format involves naming the custodian “for the benefit of” (FBO) the individual’s IRA, such as “[Custodian Name] FBO [Your Name] IRA Account # [Your Account Number]”. All income generated by the property, such as rental payments, and all expenses, including property taxes, insurance, and maintenance, must flow directly through the SDIRA account. Personal funds cannot be used for property expenses, nor can property income be deposited into a personal account.

The process of moving SEP IRA funds to an SDIRA typically involves a direct transfer or rollover, which is a non-taxable event if handled correctly. The individual opens an SDIRA with a specialized custodian and instructs their current SEP IRA provider to transfer the funds directly to the new SDIRA custodian. This ensures the funds remain within a tax-advantaged retirement structure without triggering a taxable distribution.

Rules Against Prohibited Transactions

The IRS imposes strict regulations, particularly under Internal Revenue Code Section 4975, to prevent self-dealing and conflicts of interest when retirement funds are used for investments like real estate. Engaging in a “prohibited transaction” can lead to severe penalties, potentially causing the IRA to lose its tax-deferred status and the entire account value to be considered a taxable distribution. If the IRA owner is under 59½, an additional 10% early withdrawal penalty may also apply.

A central concept in these rules is the “disqualified person.” This term includes the IRA owner, their spouse, ancestors (parents, grandparents), and lineal descendants (children, grandchildren), along with entities controlled by these individuals. The IRS aims to ensure that the retirement account, and not the individual or disqualified persons, benefits from the investment.

Specific actions related to real estate that constitute prohibited transactions include purchasing property from or selling property to a disqualified person. For example, an IRA cannot buy a property currently owned by the IRA holder or their child. The IRA property also cannot be used for personal purposes by the IRA owner or any disqualified person. This means the IRA owner cannot live in the property, use it as a vacation home, or allow a family member to reside there.

Providing personal services to the IRA-owned property is generally prohibited. An IRA owner cannot personally manage the property, perform repairs, or conduct renovations, even if they possess the skills to do so. Any services must be performed by independent, third-party contractors paid from SDIRA funds.

Personally guaranteeing a loan for the property is also forbidden, as it introduces a personal benefit to the retirement account. All loans for SDIRA real estate must be non-recourse, meaning the lender’s only recourse in case of default is the property itself, not the IRA owner’s personal assets.

Recognizing Unrelated Business Taxable Income

While income generated within an IRA is generally tax-deferred, certain types of income can be subject to Unrelated Business Taxable Income (UBTI), sometimes referred to as Unrelated Debt-Financed Income (UDFI). This tax, outlined in Internal Revenue Code Sections 511-514, was established to prevent tax-exempt entities, including IRAs, from having an unfair advantage over taxable businesses when engaging in certain commercial activities.

The most frequent trigger for UBTI in SDIRA real estate investments is the use of debt financing. If an SDIRA purchases real estate with a loan, and that loan is non-recourse (the only type allowed for IRAs), a portion of the income generated from that property proportional to the debt used to acquire it can be subject to UBTI. This means if a property is purchased with 50% debt, 50% of the net income from that property could be subject to UBTI.

Another situation that can trigger UBTI is if the real estate activity is deemed an “active trade or business” rather than a passive investment. For example, frequently buying and selling properties (flipping houses) or operating a business like a hotel or bed and breakfast within the SDIRA could be considered an active trade or business. Rental income from real estate is generally exempt from UBTI, but this exemption does not apply if the rental activity involves significant services beyond passive collection of rents, or if it is debt-financed.

When UBTI is triggered, the income is taxed at trust tax rates, which can be considerably higher than individual income tax rates. Understanding these rules and their potential impact on investment returns is important, and consulting with a tax professional is often advisable to navigate the complexities of UBTI.

Steps for Real Estate Investment

Acquiring real estate through an SDIRA involves a structured process that ensures compliance with IRS regulations and proper handling of retirement funds. The first step for the IRA owner is to identify a suitable investment property. This involves performing thorough due diligence, such as obtaining appraisals and inspections, as the SDIRA custodian does not provide investment advice or conduct property research.

Once a property is selected, the offer and purchase agreement must be drafted in the name of the SDIRA, indicating the custodian “for the benefit of” the IRA owner. The IRA owner then submits a “buy direction letter” and other necessary documentation to the SDIRA custodian. This letter instructs the custodian to use the SDIRA funds for the purchase. The custodian facilitates the payment for the property from the SDIRA account.

Should the property be sold, the proceeds must return directly to the SDIRA. The IRA owner will again need to provide clear instructions to the custodian, typically through a “sell direction letter,” to initiate the sale and ensure the funds are properly redeposited into the retirement account. This procedural adherence is crucial for maintaining the tax-advantaged status of the SDIRA throughout the investment lifecycle.