Can You Flip Homes in a Self Directed IRA?

Can You Flip Homes in a Self Directed IRA?

The strategy of buying a home, fixing it up and reselling it within a year or less (“flipping”) is once again popular. Interest rates remain low, and stocks have performed well for the past few years, begging the question of just how much longer stocks can continue to run up.  With many investors concerned about earning decent returns on typical retirement investments like stocks, bonds, ETFs and mutual funds, some have turned to alternative investments, like real estate, commodities, crowd funding, private equity investments, and all other sorts of “non-traditional” investments. These alternative investments can be made through self directed IRAs. Of the many types of real estate investments including multi unit apartments, land, mortgages, commercial real estate and tax liens, we consider the particular strategy of buying single family homes and renovating them in the hope of earning short term profits.

Before flipping a home in a self directed IRA, consult competent tax and legal counsel. A potential pitfall in using self directed IRA funds is unrelated business taxable income and that the IRS may construe consistent and repeated flipping activity as a trade or business, which is forbidden and could cause your IRA to be disqualified, triggering taxes, penalties and interest and the loss of

The Case for ‘Flipping’

Flipping was a favored strategy by many newcomers and developers during the years leading up to the collapse of the housing bubble. IRA investors can pursue this strategy through a self directed IRA, provided they follow certain tax rules, which can be very complicated and carry heavy penalties if not followed.  To flip houses, you need to have a pretty healthy balance in your accounts already. How much? It depends what part of the country you flip homes in, but we would suggest a minimum of $100,000.

Getting Started with the Third Party Administrator

Getting started with self-directed retirement investing in real estate is easy. It’s a matter of setting up a “self-directed” individual retirement account. Self directed IRAs require a third-party administrator that has experience specifically with the technical IRS rules of self-directed IRAs. A third-party administrator handles the record keeping of the real estate so you’re in compliance with IRS tax rules and regulations. The IRS does not allow individual investors to act as their own retirement account administrators. It has to be a third-party firm. Most regular brokerages don’t support self-directed IRAs and lack the technical tax expertise and support to manage self-directed IRAs. For a list of self directed IRA administrators, click here. Once you open the account, you can transfer existing retirement assets into it, and you can contribute new money to it – subject to the usual contribution limits and income restrictions that generally apply to IRAs.

The Legal Entity

The next step is to create a corporation or LLC within your self-directed account, and have that business open up a checking account at a bank or savings institution. You can have the third party administrator issue checks to pay house flipping expenses, but this requires written instructions to your self-directed IRA administrator. Often, these administrators charge a per transaction fee, which can be costly. Which is why many self directed IRA real esate investors opt for the LLC structure.

We caution investors to consider several other factors before jumping into self directed IRA investing.

Returns

Can the real estate in your IRA earn better or equal returns to stocks, bonds, mutual funds or ETFs? We recommend real estate as part of a properly balanced asset allocation strategy. For instance, you may hold 20% of your retirement investments in real estate, including the diversification and liquidity afforded by REIT investments. While we think REITs have merits, we likewise believe direct real estate investment does, too. Consider these risks for yourself and consult with a registered financial advisor.

Risks

Consider the unique risks, in light of the potential returns, of direct real estate investment. Know beforehand all the costs, legal, tax and financing aspects of real estate and their potential pitfalls like self directed IRA fees, attorney costs, the risks of disqualifying your entire IRA’s tax deferred status for a potential “small” mistake, the inability to get a traditional mortgage for real estate held in an IRA. In other words, make sure you’re fully informed of all the risks before jumping in.

Restrictions

If you plan to flip real estate, make sure neither you nor you spouse, kids, grandkids, parents, grandparents or in laws use, stay in or rent the home. This restriction also applies to any advisors who works with you or your IRA. You cannot buy property from your IRA nor sell property to it.  Nor may your spouse, kids, grandkids, parents, grandparents, in laws or advisors.  Also, make sure you are not being compensated for repairing, maintaining, or operating the home, as these are strictly prohibited by the IRS and could jeopardize the tax deferment of your entire IRA. Keep a nice financial cushion, too. If you need to put more money into the home to fix it up, these funds must come from your IRA, not your after tax personal money. And if you need that money soon because you are approaching or are past 59 ½ years of age, make sure you have enough ‘liquid’ investments and you will not rely on the funds invested in real estate to meet the minimum required distributions under IRS rules.

Unrelated Business Income Tax (UBIT) on Unrelated Business Taxable Income (UBTI)

If you plan to flip A home, as in ONE, a self directed IRA is likely a good vehicle. If you plan to  flip more than one home, be extra careful. The IRS’ UBTI/UBIT rules impose a tax on otherwise tax-exempt entities like IRAs, tax deferred entities and charities when it carries on for-profit activities, is deemed to have conducted an active trade or business or use debt.  This is a very technical and complex area of the tax rules. Part of determining if a self directed IRA is subject to UBTI or UBIT tax depends on how many home flipping transactions occur in a given year.

Another factor the IRS considers is the intent of the entity or person doing the transactions, whether the person sought to engage in a business or trade and to what extent (ie, was it a major or minor part of the entity’s activities?). We heard one knowledgeable tax accountant state two home flips or less a year is “safe.” More than that could invite scrutiny. Still another tax professional we know thinks doing any flips each year over multiple years could run the risk of UBIT. It’s important to seek a tax professional’s guidance here (we can’t reiterate that enough!).  Some risk averse investors may think that there’s too much “gray” area and uncertainty on this crucial tax issue, and conclude that self directed IRAs are a terrible vehicle for flipping homes.

Tax Deferral

Self directed IRAs allow you to realize the profits from any real estate flipping and reinvest those funds into another investment, tax free until the funds are withdrawn.

Bankruptcy

Real estate held in a self directed IRA are often afforded protection from federal and state bankruptcy law, so creditors cannot easily access the real estate held in an IRA.

Debt Financing   

IRAs may borrow money from a third-party that’s not a prohibited individual or an entity controlled by a prohibited individual under a non-recourse loan. Non-recourse lenders cannot place any lien, claim on any security or collateral on anything outside the IRA itself. You cannot pledge your IRA as collateral on a debt to borrow money outside your IRA. But your IRA can borrow money for its own purposes, as long as the funds borrowed are invested within the IRA.

You Can Flip a Home in a Self Directed IRA, But Should You?

Seek competent tax and legal advice. Flipping homes on an infrequent basis is not likely to invite IRS scrutiny, but be certain you understand the issue at hand by consulting a trained professional who knows and understands tax law.

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