IRS Rules for Self-Directed IRA Real Estate

A self-directed individual retirement arrangement (IRA) provides a vehicle for holding alternative investments, such as real estate, within a tax-advantaged account. This strategy allows investors to diversify their retirement portfolios beyond traditional stocks and bonds. The Internal Revenue Service (IRS) permits this activity, but it is governed by a set of regulations. Adherence to these rules is required to maintain the IRA’s preferential tax treatment and avoid significant penalties.

An SDIRA requires a specialized custodian or trustee that permits alternative assets. This custodian is responsible for holding the title to the assets and ensuring that all transactions comply with federal regulations. The IRA owner directs the investment decisions, but the custodian executes the transactions on behalf of the IRA.

There are two primary methods for an SDIRA to hold title to real estate. The most direct method is for the property to be titled in the name of the IRA, such as “ABC Trust Company FBO [Your Name] IRA.” In this arrangement, the custodian holds the deed and directly processes all financial transactions, including the purchase, expenses, and income.

Another structure involves creating a limited liability company (LLC) wholly owned by the SDIRA, often called a “checkbook IRA.” The IRA contributes capital to the LLC, and the IRA owner is appointed as the non-compensated manager. The LLC then purchases the real estate, and the manager executes transactions by writing checks from the LLC’s bank account, which gives the owner more direct control.

Prohibited Transactions and Disqualified Persons

A self-directed IRA investment in real estate requires avoiding prohibited transactions as defined by Internal Revenue Code Section 4975. These rules prevent self-dealing and conflicts of interest that could improperly benefit the IRA owner or other specific individuals. A prohibited transaction is any improper use of an IRA by the account owner, their beneficiary, or any “disqualified person,” which can lead to the disqualification of the entire IRA.

A “disqualified person” includes a wide range of individuals and entities related to the IRA owner, including:

• The IRA owner
• The owner’s spouse
• The owner’s ancestors (parents, grandparents)
• The owner’s lineal descendants (children, grandchildren) and their spouses
• Any corporation, partnership, trust, or estate in which the IRA owner holds a 50% or greater interest

The IRS forbids any direct or indirect sale, exchange, or leasing of property between the IRA and a disqualified person. For example, an SDIRA cannot purchase a property from the owner’s parents or sell it to their child. The rules also prohibit lending money or extending credit between the IRA and a disqualified person.

Another prohibition involves furnishing goods, services, or facilities. The IRA owner cannot perform substantial work on the property, as this “sweat equity” is forbidden. A disqualified person also cannot receive any personal benefit from the property, which means they cannot live in it, use it as a vacation home, or store personal belongings there.

The consequences of a prohibited transaction are significant. If one occurs, the entire IRA is treated as distributed on the first day of the tax year of the transaction. The full fair market value of the IRA’s assets becomes taxable income to the owner. If the owner is under age 59½, a 10% early withdrawal penalty may also apply.

Managing the Real Estate Investment

Financial administration of an SDIRA-owned property requires a complete separation between the IRA’s finances and the personal funds of the owner. The IRA is a distinct financial entity that must operate independently. All financial activities related to the investment must flow through the IRA without any commingling of funds from disqualified persons.

All funds for the property’s acquisition, including earnest money and closing costs, must originate directly from the SDIRA. The IRA owner cannot use personal funds to cover any portion of the purchase price. This financial separation extends to all ongoing property expenses, such as taxes, insurance, and repairs, which must be paid directly from the SDIRA.

Similarly, all income generated by the investment must be deposited directly back into the SDIRA. This includes rental payments from tenants and the proceeds from the property’s sale. Rental checks should be made payable to the IRA or its LLC and deposited into the IRA’s custodial account.

Understanding IRA-Specific Taxation

Certain tax liabilities can arise within a real estate SDIRA, most commonly the Unrelated Business Income Tax (UBIT). The primary trigger for UBIT is Unrelated Debt-Financed Income (UDFI), generated when an IRA uses debt to acquire property. When an SDIRA uses a loan, a portion of the net income is considered debt-financed and becomes subject to UBIT because income from borrowed funds is a business activity.

Using leverage is a permissible strategy, not a prohibited transaction, but it has tax consequences. The loan must be “non-recourse,” meaning the lender’s only collateral is the property itself.

The income subject to UDFI is proportional to the debt on the property. For example, if a property is purchased with 60% debt, then 60% of the net rental income and 60% of the capital gain upon sale would be subject to UBIT. The IRA owner is responsible for calculating this tax, filing Form 990-T, and paying it from the IRA’s funds.