Be Cautious When Investing Your IRA Assets in Real Estate

It may be surprising to many ordinary people, but an IRA can legally own real estate and a lot of other alternative investments, too, ranging from private equity and promissory notes to gold, oil and gas and cattle (It can’t own insurance, collectibles or stock in S corporations.). Cautions, however, need to be taken before you take any substantive steps.

Caution#1: Do Not Contribute any Real Estate or Other In-kind Assets to Your IRA.

Any noncash contribution to your IRA might be treated as nondeductible excess contributions. For example, in 2014, Tony establishes an IRA by conveying from himself to his IRA trustee title to a parcel of real property worth $1,800. Unless the property had been distributed to him from a qualified plan or an IRA and qualified as a rollover contribution to the IRA, the contribution is an excess contribution because IRA contributions other than rollover contributions must be in cash. Similarly, a contribution to a Roth IRA might be an excess contribution if it is made in kind rather than in cash.

An excess contribution will not automatically cause the IRA to lose its special tax exempt status, but the IRA owner must pay an excise tax. I.R.C. §4973(a). Prop. Regs. §54.4973-1 imposes an excise tax of 6% on the amount of excess contributions for the taxable year in which they are made and for each subsequent year at the end of which the excess contributions remain in the IRA. The IRA owner is liable for the tax. Therefore, Tony has to pay 6% exercise tax on the $1,800 excess contribution ($108) for 2014 and for each subsequent year if the real property remains in the IRA at the end of such tax year.

Moreover, the prohibited transactions rules (discussed below) prohibit any sale, exchange or lease of any property between an IRA and a disqualified person (an IRA owner is a disqualified person). The IRS might take the position that the contribution of real property or other in-kind property made to an IRA is a deemed sale of such real property to the IRA and thus violates the prohibited transaction rules. If the IRS prevails, the IRA will lose its tax-exempt status.

Caution# 2: Your IRA Needs to be Managed by an Independent Third Party.

The prohibited transaction rules (discussed below) prohibit an IRA owner from providing, directly or indirectly, any service, goods or facilities to his/or own IRA. I.R.C. 4975(c)(1)(C). Accordingly, independent third parties need to be hired to manage the real estate business owned by IRAs.

In addition, an IRA owner probably cannot personally guarantee any loan made to his/or IRA because this will likely be viewed as the lending of money or other extension of credit between a plan and a disqualified person, which is also prohibited by the Code. I.R.C. 4975(c)(1)(B).

Caution #3: Your IRA Cannot Directly or Indirectly Benefit Yourself

The Code prohibits certain transactions between an IRA and “disqualified persons.”

Under I.R.C. 4975(e)(2), disqualified persons include:

1. A fiduciary (a self-directed IRA owner is also regarded as a fiduciary to such an IRA);

2. A person providing services to the plan;

3. An employer any of whose employees are covered by the plan;

4. An employee organization any of whose members are covered by the plan

5. An owner, direct or indirect, of 50 percent or more of

• The combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation,
• The capital interest or the profit interest of a partnership, or
• The beneficial interest of a trust or unincorporated enterprise,

Which is an employer or an employee organization described in subparagraph (3) or (4);

6. A member of the family of any individual described in subparagraph (1), (2), (3), or (5).

7. A corporation, a partnership, or trust or estate of which 50 percent or more of

• The combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of such corporation,
• The capital interest or profits interest of such partnership, or
• The beneficial interest of such trust or estate,

is owned directly or indirectly, or held by persons described in subparagraph (1), (2), (3), (4), or (5);

8. An officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10 percent or more shareholder, or a highly compensated employee (earning 10 percent or more of the yearly wages of an employer) of a person described in subparagraph (3), (4), (5), or (7);

9. A 10 percent or more (in capital or profits) partner or joint venture of a person described in subparagraph (3), (4), (5) or (7).

Under both the Code and ERISA, the following transactions are prohibited:

1. Sale or exchange, or leasing, of any property between a plan and a disqualified person, including (a) borrowing by its owner from an IRA; (b) sales of property by the IRA owner to the IRA, the IRA’s owner’s receipt of unreasonable compensation for managing the IRA’s investments, or using the IRA as security for a loan; (c) an IRA trustee using corporate funds to purchase life insurance on behalf of individuals who establish an IRA with that trustee; (d) a savings and loan association serving as IRA trustee and causing its IRAs to enter into a repurchase agreement; (e) a self-directed IRA owner directing the lending of funds in the IRA to a business he/she owns; and (f) an IRA owner directing the investment of IRA funds in notes being offered by a corporation, in which relatives of the IRA owner are the majority owners and stockholders. I.R.C. 4975(c)(1)(A).

2. Lending of money or other extension of credit between a plan and a disqualified person I.R.C. 4975(c)(1)(B);

3. Furnishing of goods, services or facilities between a plan and a disqualified person I.R.C. 4975(c)(1)(C);

4. Transfer to, or use by or for the benefit of, a disqualified person, of any assets or income of a plan I.R.C. 4975(c)(1)(D);

5. A fiduciary dealing with the assets or income of a plan in the fiduciary’s own interest or for the fiduciary’s own account I.R.C. 4975(c)(1)(E); or

6. The receipt of consideration by a fiduciary for the fiduciary’s own account from any party dealing with a plan in connection with a transaction involving the assets or income of the plan I.R.C. 4975(c)(1)(F).

I.R.C. § 4975(d) provides for some exemptions to the prohibited transaction rules described above. One of the most important exemptions is § 4975(d)(10), which covers receipt of compensation for services rendered to the plan.  However, frequently in many situations, these exemptions do not apply.

In addition, a 2013 U.S. Tax court case, Ellis v. Commissioner, T.C. Memo. 2013-245, reinforced the Tax Court’s position in applying broadly these prohibited transaction rules. In this case, the taxpayer caused his self-directed IRA to invest in a corporation for which he is the only officer. The IRA owned 98% of the outstanding shares of the corporation. The corporation paid the taxpayer compensation of $9,745 in tax year 2005 for managing its used car sales business. The Tax Court concluded that the corporation and the IRA were substantially the same entity. In causing the corporation to pay the taxpayer compensation, the taxpayer engaged in the transfer of plan income or assets for his own benefit in violation of §4975(c)(1)(D). Furthermore, in authorizing and effecting this transfer, the taxpayer dealt with the income or assets of his IRA for his own interest or for his own account in violation of section 4975(c)(1)(E).

Because of the reasons mentioned above, most tax law experts have suggested that IRAs should never invest in real estate which directly or indirectly benefit the IRA owner for his own account prior to or when receiving distributions from the IRA upon retirement because the risk of violating the prohibited transaction rules is very high.

Do you have questions about investing with your IRA? Contact our office at 816-561-5000 or send us a message through the form below to schedule an appointment.

*This post was originally published on August 20, 2014