3 reasons for using a self-directed IRA to flip houses

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Uncertainty about inflation and the possibility of equity market re-pricing have many people taking a hard look at their current asset allocation strategies and identifying ways to mitigate risk.

Some investors are emphasizing value stocks rather than growth stocks within equity allocations. Others are adding or increasing exposure to alternative investments, such as commodities and real estate, which have historically been used as hedges against inflation. 

One way to participate in real estate investment is buying and selling houses for profit, which is also known as flipping. According to a 2020 report from Attom Data Solutions, in the current, highly competitive home-buying environment, 5.9% of all houses sold in 2020 were flipped. The average gross profit earned was 40.5% return on investment compared to the original acquisition price, which was slightly lower than the previous year’s 41.5% gross return on investment. The average home resold in 181 days.

Using self-directed IRAs for real estate

As investors consider asset allocation options, some may decide to diversify retirement accounts by holding an alternative asset, such as real estate, in their individual retirement account (IRA). Since most IRA custodians will not custody real estate titled directly in the name of the investor like they might real estate investment trusts (REITs), investors may want to consider a self-directed (SD) IRA for this purpose.

The SD IRA solution could be beneficial for home flippers. SD IRAs give investors the flexibility to buy and sell properties as sole owners. In addition, SD IRAs allow real estate investors to invest in an asset they know and understand, access capital easily and gain tax advantages through a retirement account.

Here are three benefits of a self-directed IRA:

  1. Invest in what you know

The owner of an SD IRA decides how to invest the assets and directs the custodian appropriately. An investor who knows and understands real estate can decide to invest in real estate. An investor who knows commodities can choose to invest in commodities, and so on.

SD IRAs are generally offered by specialty custodians who specialize in and focus on administration of alternative assets, such as real estate, and compliance with laws and rules regarding the custody of such assets.

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  • Easily access capital

Another consideration for home flippers is access to another stream of capital. An investor may find an appealing real estate opportunity but have limited cash available to purchase it. However, the investor could transfer cash from an existing IRA to an SD IRA and use those funds to purchase the property.

However, it is important to keep in mind that when you invest in real estate with funds from an SD IRA, income and expenses for the investment property must flow through the IRA. You will need to make sure that the SD IRA has sufficient liquid cash available to meet those expenses.

To make this as easy and seamless as possible, look for a specialty custodian that allows you to pay for any real estate-associated expenses with a debit card. This is much faster, more efficient, and more convenient than requesting or writing a check. Also look for a custodian that will streamline the process to show money was spent for the benefit of the real estate held in the self-directed IRA.

  • Gain tax advantages

Any income or gains earned in an SD IRA is tax-advantaged, just as it would be in other types of IRAs or retirement accounts. Typically, income and/or gains in traditional IRAs grow tax-deferred until distributions are taken. In Roth IRAs, income and/or gains grow tax-free, and distributions are tax-free, as long as certain requirements are met.

That may mean investors have more money invested, working for them and available to fix-and-flip real estate.

Self-directed IRAs require disciplined adherence to the rules.

To reap the benefits of investing in real estate with an SD IRA, you need to understand the distinct requirements and IRS rules that must be complied with to preserve the tax advantages of investing with IRA assets. Investors and their advisors must understand and follow IRS prohibited transaction rules. The rules provide guidance regarding proper use of an SD IRA for real estate investment by the owner and any disqualified persons.

For example, disqualified persons, such as family members or business partners, cannot receive any current direct or indirect benefit from any asset in an SD IRA. In other words, they cannot:

  • Live or vacation in a property owned by the IRA,
  • Receive payment for managing the property, or
  • Be paid for working on the property.

Notably, the SD IRA can also only borrow money through non-recourse loans. This is particularly important since IRS rules impose annual contribution limits on IRAs. If new money is needed to purchase real estate or pay expenses, like property taxes, it can only be borrowed through a non-recourse loan. As a general rule, self-directed IRAs that hold real estate as an asset:

  • Must pay all expenses related to the real estate owned,
  • Cannot lend to or borrow from investors, and
  • Cannot otherwise do business with investors.

Work with a knowledgeable custodian and service team.

Choosing a custodian and smart support team with experience in the nuances associated with real estate investing through a self-directed IRA is key. When considering SD IRA custodians, investors should check out the quality and credentials of the custodians’ service teams. Are they knowledgeable about real estate? Do they understand prohibited investments and prohibited transactions?

It’s also a good idea to work with tax and legal adviser(s) who can help ensure transactions comply with the IRS prohibited transaction rules. When the rules are violated, the IRA could be disqualified, which can lead to the loss of tax advantages and potential IRS penalties.

SD IRAs may provide knowledgeable real estate investors the opportunity to invest in an asset they know and understand through tax-advantaged vehicles, while maintaining readily available access to capital. SD IRAs can be an attractive option for real estate investors, as long as they fully understand the associated IRS rules, investment strategy and its limitations.

Tom Kurinsky is senior vice president, regional director of custody services at Millennium Trust Company LLC. He oversees the investment sponsor, RIA, bank and broker dealer relationships in the Midwestern and Northeast regions and has over 20 years of investment distribution experience, focusing on both traditional and alternative asset classes. The material in this article is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Millennium Trust Company performs the duties of a directed custodian, and as such does not offer or sell investments or provide investment, legal, or tax advice. 

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