Self Directed IRA’s & Real Estate Investments

IRA owned LLC’s and Case Studies

Michael J. Tucker, CPAmtucker@byxbee.com

& Konrad Sopielnikow, FortuneBuilders

Disclaimer

• In accordance with IRS Circular 230, any U.S. federal tax information provided in this document is not intended or written to be used to avoid tax penalties that may be imposed on the recipient or any other taxpayer, or to promote, market or recommend a partnership, entity, investment strategy, arrangement or other transaction addressed herein.

Disclaimer

• The information in these materials is believed to be current as of March 1, 2009, and is provided for general purposes only. It is not intended to render accounting, tax, consultative, investment, legal or other professional advice or services in any form. You should consult with a qualified legal advisor for professional advice on your specific situation.

Mike Tucker

• Lawyer, CPA, Ph.D.

• College Professor

• Consultant to regional accounting firm

• National speaker

• Fulbright Scholar

• mtucker@byxbee.com

IRAs and Real Estate - Review

• IRA can own

• Apartments

• Single-family homes

• Duplexes

• Raw, undeveloped land

• Commercial property

• And much more…

Investing in Real Estate - Review

• Although certain types of investments are prohibited in an IRA, real estate is not a prohibited investment

• Thus real estate owned by an IRA can generate rental income and gain on a sale which escapes immediate taxation

• The IRA does not get the related deductions (e.g., depreciation, mortgage interest, property taxes, etc.)

• In addition, the IRA could possibly be subject to the unrelated business income tax if the IRA borrows funds to purchase the real estate since this will generate unrelated debt financed income

Prohibited Transactions - Review

• Taxpayers with real estate in an IRA must avoid certain prohibited transactions with respect to that real estate

• IRA owner is prohibited from entering into any of the following transactions, directly or indirectly, with an IRA:     

• (1) selling, exchanging, or leasing property;• (2) borrowing or lending money or extending credit;• (3) furnishing of goods, services or facilities;• (4) buying property for personal use (present or future)

with IRA funds; and• (5) using the IRA as a security for a loan

Prohibited Transactions - Review

• If IRA owner or his or her beneficiary enters into a prohibited transaction, the IRA ceases to be an IRA and is treated as if it distributed all of its assets to the IRA owner

• The IRA owner has ordinary income equal to the FMV of the deemed distribution

Self-directed IRA’s & LLC’s

• First approach – set up IRA Buy RE in IRA• Second approach--form a LLC

– Self-directed IRA invests in the new LLC– IRA owns 100% or less of LLC (SMLLC or MMLLC)– LLC owns all the investments (real estate, stock,

promissory notes, etc.)– IRA is a member/the only member) of the LLC

Self-directed IRA’s & LLC’s

• LLC will have its own bank account and tax ID number

• Owner now has check writing control over the LLC bank account

• WARNING: one personal purchase from an IRA checkbook results in a deemed distributed of the entire IRA balance—a prohibited transaction

• Taxable in the year of distribution at ordinary income rates and a 10% pre 59 1/2 penalty

Self-directed IRA’s & LLC’s

• Using the LLC’s checkbook can ease the burden of dealing regularly with the custodian especially if an investment has many recurring expenses (8 unit strip mall complex for example)

• Documentation or lack thereof is the downfall of many complex transactions dependent on complying with IRS rules

Self-directed IRA’s & LLC’s

• Make sure the legal formalities are taken care of—LLCs are creatures of state law and often annual compliance requirements

• An MMLLC is probably a partnership for federal law purposes—must file Form 1065

• Property must be titled in LLC’s name• What about financing—no related party financing• What about expenses– property taxes, upkeep,

maintenance, capital repairs, etc.

Self-directed IRA’s & LLC’s

• An MMLLC must have an operating agreement—partnership agreement

• Liquidity is important—does the IRA have cash to meet anticipated and unanticipated expenses?

• VIP--At this point the MMLLC/SMLLC is running a business—no auto pilot for self-directed IRAs—you are the pilot!

IRA owned LLC’s Specific Steps

• Form a Limited Liability Company• LLC Operating Agreement• Certificates of Membership –not always required• Obtain an EIN from IRS• Open Self Directed IRA LLC Bank Account• Self Directed IRA Custodians• Transfer Funds to New Custodian• Custodian Purchases LLC Membership • Invest From LLC• Choosing Investments for LLC

Mechanical Rules

• A Self Directed IRA is uniquely titled [Reliable Trust Company, Custodian FBO (for benefit of) Michael Tucker IRA

• Expenses Incurred Must Be Paid from Self Directed IRAs

• Real Estate IRA Income Must Return to IRA

Case Study

• Harry Houdini became interested in a self-directed IRA after hearing about it on a webinar. He directed his IRA custodian to wire money from his IRA to a professional association for the purpose of setting up a real estate IRA.

• Harry was told the association would set up such an IRA for him.

• Later the association told Harry it was not able to set up a real estate IRA for him and he had to find another custodian.

Case Study

• Harry contracted with another professional organization which, through another custodian, was able to set up a real estate IRA for him.

• That IRA was established within the 60-day IRA rollover period.

• Did Harry properly set up his self-directed IRA?

Case Study

• Unfortunately for Harry he may not purchase real estate with funds distributed from an IRA and then roll that property into another IRA.

• Contributing real estate property purchased with an amount distributed from an IRA to a rollover IRA will not be considered a valid rollover

• The original distribution is fully taxable• This is what NOT to do

What To Do?

• Have the self-directed IRA or the LLC owned by the IRA buy the property within the IRA

• Make sure to honor all the formalities—title property in the name of the IRA or the LLC

• Remember avoid all prohibited transactions!

FortuneBuilders Deal Examples

• Assignment Deals

• Double Close Deals

• Private Money Loan Deals

• Double Close Deals with Outside Financing (non-recourse)***

Case Study 1 - Assignment

• Ex. 255 Smith Street, New Haven

• Contract PP $100k

• Assignment Fee of $10k

• Deposit of $1k

Process - Assignment

• Direction of Investment – Contract Deposit/Escrow Funds– Escrow Agent Authorization Letter

• Direction of Signature– Purchase and Sale Agreement– Assignment of Contract Form

• Direction of Sale + Funds + Closing Statement

60 Day Rollover

• General rule: any amount paid or distributed out of an IRA must be included in gross income by the payee

• General rule does not apply to any amount paid out of an IRA to the individual for whose benefit the IRA is maintained if the entire amount received is paid into an IRA for the benefit of such individual not later than the 60th day after the day on which the individual receives the payment or distribution

60 Day Rollover

• IRS may waive the 60-day requirement where the failure to waive such requirement would be against equity or good conscience

• Grounds for waiver include casualty, disaster, or other events beyond the reasonable control of the individual, including

• 1) errors committed by a financial institution• (2) inability to complete a rollover due to death, disability,

hospitalization, incarceration, restrictions imposed by a foreign country or postal error,

• (3) the use of the amount distributed (for example, in the case of payment by check, whether the check was cashed); and

• (4) the time elapsed since the distribution occurred.

60 Day Rollover Case Study

• Sandy has an IRA with Behemoth Bank and wants to roll $200,000 from her IRA into another IRA that would hold real estate mortgages.

• Bank advised Sandy that it could set up self-directed IRA if she transferred $200,000 into a checking account and then wrote a check for the purpose of purchasing the mortgages for her IRA. 

• Sandy signed a "Traditional IRA Distribution Form“ believing that she was transferring $200,000 into a self-directed IRA that would hold mortgages

60 Day Rollover Case Study

• Sandy wrote a check to cover the purchase of the mortgages which she then recorded with the country clerk in Crawford County, Missouri. 

• Sandy discovered that the mortgages which she owned was not in an IRA in January, 2009, when she was in the process of completing her calendar year 2008 Form 1040.

• Sandy’s accountant, Dudley Doright, subsequently discovered that, although Sandy’s mortgages were not held in an IRA, the interest thereon was being contributed to an IRA

• Is there a way for Sandy to get the mortgages inside an IRA? 

60 Day Rollover Case Study

• Will the IRS waive the 60-day rollover requirement with respect to the $200,000 distribution because the failure to waive such requirement would be a hardship and against equity or good conscience?

• The IRS may waive the 60-day requirement where the failure to waive such requirement would be against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to such requirement

60 Day Rollover Case Study

• In determining whether to grant a waiver of the 60-day rollover requirement the IRS will consider all relevant facts and circumstances, including:

• (1) errors committed by a financial institution; • (2) inability to complete a rollover due to death, disability,

hospitalization, incarceration, restrictions imposed by a foreign country or postal error,

• (3) the use of the amount distributed (for example, in the case of payment by check, whether the check was cashed); and

• (4) the time elapsed since the distribution occurred.

60 Day Rollover Case Study

• The IRS would probably hold that Sandy could demonstrate that she failed to accomplish her intended rollover because of her misplaced reliance on the advice of bank personnel, and the bank misunderstood Sandy’s instructions with respect to the $200,000 investment

• Due to a misunderstanding, the bank neither took appropriate steps to insure that the $200,000 was contributed into an IRA authorized to invest in and hold real estate notes nor advised Sandy with respect to the proper protocol with respect to setting up and maintaining an IRA authorized to hold real estate investments

60 Day Rollover Case Study

• Result—the IRS would probably waive the 60-day rollover requirement with respect to the withdrawal of $200,000 and give Sandy another 60 days to make a rollover contribution of $200,000 to another IRA

• But Sandy would have to go to the time, expense (and uncertainty) of asking the IRS

• Best advice—do it right the first time.

Purchasing real estate inside an IRA

• Transfer IRA to an IRA custodian that specializes in holding real estate

• Generally only a bank can be custodian of an IRA• The bank-custodian purchases the real estate

investment inside IRA• Don’t buy the real estate first outside of the IRA and then

transfer it to the IRA• Only cash can be contributed to an IRA• Cannot buy real estate outside the IRA then sell it to the

IRA—one of many prohibited transactions

Managing the real estate inside the IRA

• Can either manage real estate yourself or hire a professional real estate management company to manage the property

• Managing the property risks commingling IRA assets with IRA owner’s assets

Case Study

• Anita Cross owns a 4-family unit inside her IRA

• Anita fully funded her IRA for 2009 already• In March, 2009, things being what they

are, two rent checks are late and utility and other bills are due

• Anita paid some of the bills herself

• What result?

Case Study

• The payment is an excess IRA contribution and would produce a 6% penalty tax

• What if the IRA paid a repair bill for Anita’s person residence?

• Result—a prohibited transaction--a taxable distribution from the IRA

Avoid prohibited transactions

• First commandment of self-directed IRAs--Do not have the IRA transact with you or with anyone you have a relationship with outside the IRA

Required minimum distributions

• 70 ½

• Calculation

• Penalty for not taking

• Waiver for 2009

• Applies to account owners and beneficiaries

RMD case study

• Anita turned 70 ½ in March, 2008

• Her IRA owns Blackacre, a parcel of real estate located in Sullivan, MO as its only investment

• How does Anita take her RMDS?

RMD case study

• Option #1—have the IRA distribute undivided interests in the IRA-owned real estate

• Assume the RMD for 2008 is /25.6th of the IRA account

• The IRA can deed a 1/25.6th undivided interest in Blackacre to Anita

• But is a 1/25.6th undivided interest in Blackacre worth 1/25.6th of the total value of Blackacre?

• An annual appraisal is probably required

RMD Case Study

• Determine the amount of the RMD (based on the appraised value of the IRA's total assets) and

• Determine the value of the undivided interest distributed to the participant (to make sure it's worth at least the RMD amount)

• Warning--distributing undivided interests in Blackacre requires a closing with expenses relating to lawyers, deeds, and recording fees

• Where will this money come from?

RMD Case Study

• Option #2--have an LLC own the real estate

• IRA owns the LLC

• IRA distributes interests in the LLC to satisfy the RMD requirement

• Annual appraisals probably necessary

RMD Case Study

• If the IRA owner is taking RMDs as LLC interests, Blackacre is partly owned by the IRA and partly by Anita directly

• Does this split ownership substantially increase the risk of inadvertent prohibited transactions

• High risk of commingling of personal and IRA funds

Unrelated Business Taxable Income

• If the self-directed IRA borrows in order to purchase real estate—result is rental income from debt-financed property

• This generates UBTI

• Generates taxable income

• File Form 990-T if UBTI $1,000 or >

Generating UBTI

• UBTI results if the IRA operates a business

• Ongoing controversy between IRS and taxpayers whether real estate is an "investment" or a "business"

• Probably managing real estate management is an investment—but a very “active” investment

• Collect rents, interview tenants, hire plumbers, pay invoices, monitor and update the insurance policies

• In the end these activities are probably managerial and not an active business—IRS is not litigating this issue at the moment

UBTI case study

• Anita’s self-directed IRA purchases a rental duplex in Sullivan, MO for $400,000

• Cash $200,000 and mortgage of $200,000

• Rental income in 2009 is $25,000

• Is any of this income UBTI?

UBTI case study

• Anita has UBTI through UDFI

• How much UBTI?

• $200,000/$400,000 x $25,000 = $12,500

• Where is this income reported?

• How is this taxed?

• Any expenses to offset the income?

Case Study 2 – Double Close

• Ex.134 Hazel Street, New Haven

• Contract PP – $15k

• Contract SP - $45k

• Deposit – $1k

Process – Double Close• Direction of Investment/Purchase

– Purchase and Sale Agreement - Buy– Escrow Agent Authorization Letter

• Direction of Investment/Sale– Purchase and Sale Agreement – Sell– Deed– Escrow Agent Authorization Letter

• Funds + Closing Statement

Active business Case Study

• Anita decides that her IRA will go into the tour guide business. She will hire a couple of employees as guides to take people on fishing trips and sight-seeing guides on the Meramec River in the Missouri Ozarks.

• Any tax or other issues we should be concerned about?

Active business Case Study

• The IRA is operating a business and so it has UBTI on which it must pay income tax For an IRA to operate a business is not illegal—but it produces taxable income

• What if Anita decides to manage the business and receives compensation?

Active business Case Study

• Since Anita, the IRA owner, is personally working for the IRA’s business the IRS would almost certainly conclude the arrangement is a prohibited transaction

• A less likely alternative is that the IRS would reallocate the IRA's business income to Anita’s Schedule C

• Accordingly she would owe income and self-employment taxes on it (plus penalties for failure to report the income and pay the taxes)

• The IRS would also say she was deemed to have contributed that income to the IRA--an excess IRA contribution

Case Study—Managing real estate inside an IRA

• Susan Smith, age 42, is the owner of a Roth IRA that invested in a rental apartment located in Sullivan, MO.

• The City of Sullivan billed $15,000 in property tax for the building, due August 1, 2009.

• As of late July, 2009, Susan’s Roth IRA's has only $2,000 available to pay the property tax by August 1, 2009.

• Susan has personal funds to pay the tax• Susan’s traditional IRA does also.• May Susan’s Roth IRA use either her individual bank

account or her traditional IRA’s bank account so as to pay the property tax by August 1, 2009?

•

Case Study—Managing real estate inside an IRA

• Finding an unrelated lender may be the best option—but such a lender may be hard to find.

• The lender cannot be a disqualified person since a loan from such a person would be a prohibited transaction that would result in a complete distribution of the IRA to Susan.

• If a third party loan is arranged, such a loan would cause some the Roth IRA's income to be UBTI, potentially making the Roth IRA liable for income taxes in any year the loan is outstanding.

Case Study—Managing real estate inside an IRA

• Because the facts indicate that Susan had sufficient cash in her traditional IRA to pay the tax on the real estate in question, she could make a partial Roth conversion

• Susan would transfer $13,000 from her traditional IRA to her Roth IRA, thus enabling the Roth IRA to pay the property tax.

• The $13,000 would be included in Susan’s gross income for the year the conversion

• In order to make the partial Roth conversion, Susan would have to have MAGI of < $100k

Case Study—Managing real estate inside an IRA

• If Susan were ineligible to make a Roth conversion, she would have until the due date of her income tax return for the year of conversion—April 15, 2010--to recharacterize the Roth IRA conversion and move the money back to her traditional IRA

• A recharacterization involves moving the $13,000 and any earnings thereon while in the Roth IRA back to the traditional IRA

• Such an approach might give Susan the opportunity to pay the property tax and generate cash inside the Roth IRA to make the recharacterization.

Case Study—Managing real estate inside an IRA

• Another approach is for Susan to contribute $13,000 in cash to the Roth IRA from her taxable account.

• The custodian for the Roth IRA may refuse to accept the $13,000 because the custodian may not accept non-rollover cash contributions in excess of the annual contribution limit--$5,000/$6,000 in 2009.

• If the custodian does accept the $13,000 excess contribution, the Roth IRA could then use it to pay the property tax bill.

• Penalty tax on excess contribution• In the alternative, Susan could pay the property tax bill personally.• This could be a disqualified transaction• It could be considered a noncash contribution that could disqualify

the Roth IRA.

Case Study—Managing real estate inside an IRA

• The amount of the excess contribution is either the entire contribution of  $13,000 (if Susan is not eligible to make "regular" Roth IRA contributions at all in 2009) or the excess of $13,000 over the maximum contribution Susan could make in 2009--$5,000

• An excess Roth IRA contribution generates a cumulative annual 6% penalty unless the excess contribution is returned (plus earnings thereon) to the participant.

Case Study—Managing real estate inside an IRA

• Warning—the tax rules do allow for the return of excess IRA contributions and for recharacterization of Roth IRA conversions

• BUT these provisions are designed to help when individuals changed their mind after making a contribution and/or they made a contribution by mistake

• In the examples discussed previously the IRA owner intentionally made an excess contribution—knowing full well that the amount in question is not allowable.

• Would the IRS accept these intentional over contributions? We really don’t know

Case Study—Inheriting Real Estate

• Frank Murphy died in 2008, leaving his IRA to his three children, Moe Murphy (age 45), Larry Murphy (age 35) and Curley Murphy (age 21), equally.

• Frank’s IRA account is titled, “Frank Murphy, deceased, IRA, payable to Moe Murphy, Larry Murphy and Curley Murphy as beneficiaries."

• In 2009 Moe, Larry and Curley want to divide up their father’s IRA so that each can make separate investment decisions and also use his own life expectancy to measure RMDs

• What planning alternatives are there for the children?•  

Case Study—Inheriting Real Estate

• Moe, Larry and Curley may set up three inherited IRA accounts, one for each of them

• Each new inherited IRA is titled “Frank Murphy, deceased, IRA, payable to [name of child] as beneficiary."

• The custodian who holds the existing IRA transfers an equal amount from the original account into each of the three new accounts

• This would entail transferring a 1/3 interest in the real estate to each IRA

Case Study—Inheriting Real Estate

• The transfers must be made directly from the old IRA into the new IRAs (plan-to-plan transfer)

• If the custodian of the old IRA distributes funds directly to a child-beneficiary, the child cannot roll over that distribution into any other IRA (inherited or otherwise)

• Essential that the funds move only by means of direct account-to-account transfer

•  

Case Study—Inheriting Real Estate

• It is not necessary to transfer an equal amount of each and every asset to each new account, as long as the total value transferred to each child's new "inherited" IRA is equal

• Thus if there were multiple properties in Frank’s IRA, an equal allocation might entail putting one complete property in one of the IRAs 

Case Study—Inheriting Real Estate

• The deadline for establishing separate "inherited IRAs" so that each child can use his own life expectancy to measure RMDs is December 31 of the year after the year the IRA owner died

• In this case Frank Murphy died in 2008, so the deadline is December 31, 2009.

•  • If this deadline is missed, the sons can still split up an inherited IRA

later in time so as to control their own investments• A division occurring after December 31, 2009 would not be effective

to change the applicable life expectancy for measuring RMDs. • Thus, Moe, Larry and Curley would have to use Moe’s life

expectancy to measure RMDs if the separate IRA accounts are not established by the end of the year after the year of death.

Case Study—Inheriting Real Estate

• If the beneficiaries establish their "separate accounts" in the year after the year of the owner's death, the separate accounts are effective the same year. Thus, each beneficiary's RMD for the year after the year of the owner's death will be based on his/her own life expectancy, not the oldest beneficiary's life expectancy. 

Case Study 3 – IRA Private Investor

• Ex. 38 Donald Street• Contract Purchase Price 100k• IRA Funding from Investor 100k• Rehab 20k• Rehab Funding from Investor 20k• Sale Price 200k • Deposit $100

Process

• Investor sets up / funds Self Directed IRA

• Direction of Investment in Promissory Note

• Mortgage Deed and Promissory Note

• Funds Sent to Attorney/Title Co.

• Closing

• Filed Mortgage Deed to Custodian

• 2nd Mortgage and Promissory Note filed