Answering your frequently asked questions
Buy low, sell high. Finding stocks or other publicly traded securities at the right bargain may prove difficult, but an under-priced property can be tough to miss. Unlike the countless factors that may affect stock values, a leaky roof, outdated appliances, and shag carpet from the 80s can be replaced and the value of a property can be directly restored. That’s what has motivated fix and flip investors for decades.
As with any alternative strategy, more investors are beginning to understand the lucrative potential of supplementing their personal investments with a real estate individual retirement account (IRA) . You may have seen advertising about retirement plans that hold property, precious metals, promissory notes or other such assets and wondered about the viability or flexibility offered through self-direction.
Let’s address a few common inquiries about flipping real estate with an IRA.
When putting the “fix” in “fix and flip,”what are my options for completing major repairs?
When investing with personal money, you can implement any measures to repair or upgrade a property. Real estate investors may view flipping as an opportunity to combine their business talents with their expertise in plumbing, construction, electrical work or other related fields. Using the do-it-yourself approach, an investor can mitigate costs and earn a greater profit on the back end. If you’re not well-versed in renovations, services for hire can handle the dirty work while you tack any expenses onto the final sale price.
IRA investors only have the latter option. The IRS requires a degree of distance between account holders and their retirement assets. As such, an IRA holder could not perform physical upkeep or contribute sweat equity of any kind. Doing so would constitute a prohibited transaction and risk the taxable distribution of the asset. You may hire professionals to perform services on behalf of your IRA. Any applicable expenses have to be paid by the IRA and never from your own pocket. Platforms for account management that feature free online bill pay make it easier than ever to issue IRA funds for repair costs, allowing you to ensure full IRS compliance without sacrificing convenience. That means you’ll not have to budget your personal income for the periodic expenses that arise with your IRA-owned real estate.
How can I find a buyer for my flip?
You may qualify and select a buyer in the same way you would when investing your personal funds. The only key difference lies in a short list of disqualified persons from whom an IRA may not derive direct benefit. These persons include the account holder, direct family members such as parents or children, their spouses or any fiduciaries to the IRA. Non-disqualified individuals include indirect family members (siblings, cousins, etc.), close friends or existing business partners, so the spectrum of potential buyers is still very broad.
What if my IRA can’t afford the house?
Some believe that an IRA cannot finance a property, but this is entirely untrue. When you pursue a personal loan, a bank or third-party lender will examine your credit, determine an appropriate term and interest rate, and request collateral as security. A retirement plan won’t be viewed as a human being with a credit rating, but that doesn’t mean you can’t finance a real estate project with your IRA. Typically, a retirement plan will need to seek a non-recourse loan. Your personal (i.e., non-IRA) holdings could not be offered as leverage in this loan structure. The IRA-owned investment property would serve as collateral, and you would not be allowed to pledge your own cash or assets.
Given the limited security involved with non-recourse financing, you may expect a somewhat arduous process in finding a lender willing to take a chance on your retirement asset. This is merely another myth surrounding loans available to IRAs. The market for non-recourse lenders has steadily risen, and access for IRA investors has never been greater. In fact, hard money non-recourse loans for 90 percent, 95 percent, or other considerable percentages of property deals are becoming commonplace. As real estate IRAs become more popular, there’s a possibility that your neighborhood bank has already dedicated a portion of its business to non-recourse financing. If it doesn’t, there are resources available to identify potential lenders for your IRA.
Once the sale is complete, how do I manage capital gains taxes?
Profits from personal real estate sales will generally be subject to capital gains taxes. The exact conditions of your situation may warrant a conversation with your accountant or tax professional.
Self-directed IRAs with the traditional IRA tax advantage, on the other hand, allow investors to defer taxes on earnings until the funds or assets are distributed (withdrawn). Rather than pay taxes on capital gains in the year you earn them, you’ll pay income taxes on distributions (hopefully, at a lower tax rate). Qualified distributions from a Roth IRA can be completely tax-free, regardless of how well your assets performed over the years. Therein lies the beauty of IRA investing—earnings can be retained and reinvested instead of taxed on an annual basis. You have the power to schedule taxable events according to your goals and financial circumstances.
Will I ever have to worry about taxes with a real estate IRA?
As discussed above, you won’t have to pay taxes on your IRA earnings until you begin taking distributions, or not at all with a Roth. However, your IRA may incur taxes with real estate strategies that use non-recourse financing. Some ongoing earnings or sale profits from a financed property will be considered unrelated debt-financed income (UDFI), on which your IRA may have to pay unrelated business income tax (UBIT). Taxes will apply only in relation to the debt percentage. For instance, if your IRA owns 50 percent of a property, finances the other 50 percent, and sells it for a $100,000 gross profit, only the net profit related to $50,000 of those earnings will be subject to UBIT, which is calculated using the current trust and estate rates.
Unrelated business taxable income (UBTI) may also affect your fix and flip investment model, and therefore, UBIT. UBTI occurs when taxes on operating business income are passed through to investors prior to the payment of business taxes at the corporate level. Because the IRS often regards a flipping operation that is not “housed” in a C corporation as a business, profits for your real estate sales may fall under UBTI. Your retirement plan may therefore owe UBIT on fix and flip earnings even in the absence of debt leverage.
UBIT may seem to contradict the tax advantages that an IRA provides, but always remember that these taxes only apply when your account is making money and only after debt has boosted your purchasing power. Your IRA may not have the funds to flip properties outright, for which debt leverage can provide a leg up and UBIT may exist as a cost of doing business. When addressing UBTI, it may prove useful to weigh your options in light of the new tax legislation. Adjusted tax brackets for C corporations, pass-through entities and limited liability companies have prompted new considerations for business structures and are certainly worth bearing in mind when thinking about flipping properties with an IRA.
Can I execute a 1031 exchange with an IRA?
Internal Revenue Code section 1031 stipulates a particularly intriguing tax advantage that all real estate investors using debt should be aware of. In a transaction known as a 1031 exchange, any taxable earnings (UBIT in this scenario) from a real estate sale may be deferred if those earnings are reinvested into a like-kind investment property. In other words, as long as your sale profits roll into your next project, you won’t have to pay any taxes until you eventually break the cycle. This applies to capital gains taxes for personal investors and UBIT for an IRA. IRA investors can initiate a series of 1031 exchanges to gradually eliminate UBIT altogether, though the debt amount from the previous investment property must be matched to maintain a like-kind status.
UBIT is not a penalty, but rather a cost, to your IRA for certain investment situations. It is always prudent to know the UBIT rules when deciding which investment structure to initiate. For instance, the debt percentage of a property is calculated using the previous 12 months’ debt percentage. One application of this fact is that an IRA can pay off the debt service on a property, wait until 12 full months have elapsed and sell that property with no UBIT calculated on the sale proceeds. Why? Because the debt percentages of the previous 12 months average out to zero. There’s no UDFI and, therefore, no UBIT.
In many ways, making money by fixing and flipping real estate is very similar when comparing investments with personal funds and those with tax-advantaged retirement dollars. However, as we’ve seen, using a self-directed IRA not only allows you to leverage your existing experience but also presents opportunities for even greater earnings once the tax benefits of your specific plan are realized later in life.