Investing in real estate through a self-directed IRA offers many tax advantages to real estate investors. With these advantages, comes a set of rules and regulations that must be followed in order for the IRA to remain compliant and maintain its tax-advantaged status.
If these rules are broken, the account owner could face significant taxes and penalties.
This article covers four common mistakes investors make when investing in real estate with a self-directed IRA. To remain in good standing, avoid all of these scenarios, which break the rules regulating IRAs.
1. Personally Accepting Rental Income
One of the caveats of owning real estate through a tax-advantaged retirement account is that your assets are not supposed to bring you personal gain until you start distributing them upon retirement.
To put it another way, you and your IRA are looked at as two separate entities, and the lines between you and your account cannot be blurred.
This distinction means that a property purchased through your self-directed IRA must also be maintained through your self-directed IRA. All costs associated with the property must be paid directly from your account funds, and all profits must be paid directly into your account.
These rules apply to rental income, which should flow directly from the tenant into your IRA. It would be a mistake, for example, to accept a rent check made out to you personally, then write a personal check to your IRA for the same amount. Your tenants must make their checks out directly to your self-directed IRA .(Your administrator or custodian can provide a format for addressing checks to your IRA.)
If rental income passes through your hands before being deposited into your retirement account, you could face excess taxes and penalties.
2. Transactions with Disqualified Persons
Certain people are considered disqualified when it comes to your self-directed IRA transactions, and dealing with them could lead to prohibited transactions.
For example, you and your lineal ascendants/descendants, and spouses thereof, are considered disqualified, so buying property from one of them would be prohibited. Similarly, renting out one of your IRA-owned properties to a disqualified person, or hiring one of them to perform a repair, would also be prohibited.
Participating in a single prohibited transaction could eliminate all of the tax advantages associated with your IRA, as well as incur additional penalties. So be careful! More information: The Real Estate IRA – Prohibited Transactions and Disqualified Persons
3. Performing Property Services Yourself
As mentioned above, you are considered a disqualified person in relation to your self-directed IRA. Because of this, you cannot provide personal services to the property without risking a prohibited transaction.
You cannot perform repairs, cleaning, or other maintenance work that would typically require hiring outside help. For this reason, most real estate IRA investors hire a property management company, rather than managing the property on their own.
Similarly, it’s good to have a list of trusted service providers to handle any problems that arise with the property.
4. Anything That Eliminates Your Cash-Cushion
Because all of the costs associated with your IRA property must be paid directly from your IRA, most investors find it necessary to keep a cash-cushion reserved in their accounts to cover unexpected expenses.
Imagine that one of your IRA properties suffers $3,000 in damage, and your IRA only has $1,700 in cash available. Would you sell an asset to cover the remaining costs? Would you leave the damage to worsen until the cash was available? Would you take a non-recourse loan?
Avoid this dilemma by ensuring that your account has a comfortable cash-cushion to rely on.
Eliminating tax burdens can be a great help to real estate investors looking to build a nest egg, but any of the above transactions could eliminate all the benefits you have accrued and send you 10 steps backward.
Make sure you avoid transactions like these to keep your account working for you, instead of against you!