A self-directed retirement plan is a type of structure that allows the holder to transfer tax free funds from a retirement account to acquire real estate. There are a number of rules however that must be followed in order to make such a transaction work. Let’s first start with a basic retirement account. Retirement accounts (such as IRAs and 401K plans) can be created by contribution subject to annual dollar limits or by rollover from a qualified plan. The owner usually cannot take out distributions prior to age 59 ½ without penalty.
Understanding the Prohibited Transaction Rules of the Internal Revenue Code
Anyone considering establishing a self-directed retirement plan to invest in real estate must be aware of the prohibited transaction rules discussed in the Tax Code. Internal Revenue Code Section 4975 addresses prohibited transactions. The main focus of this section is self-dealing. If a transaction within a self-directed plan is deemed to be prohibited, it can result in the disqualification of the entire account as of the first day of the year within the year that the transaction occurred. If a transaction is deemed to be prohibited, the beneficiary of the IRA or 401K plan will potentially recognize a serious tax liability and penalties. What exactly is self-dealing? Internal Revenue Code 4975 and its regulations define what is prohibited:
- The sale, or leasing of any property between the IRA and any disqualified persons.
- The lending of money or extension of credit between an IRA and any disqualified person.
- The furnishing of goods, services, or facilities between any disqualified person and the IRA.
- The transfer to any disqualified person or use by any disqualified person of income or assets of an IRA; or
- The receipt by any disqualified person of any consideration in connection with a transaction involving an IRA.
A “disqualified person,” as defined under Internal Revenue Code 4975 includes the following:
- The IRA owner;
- The IRA owner’s spouse;
- The IRA owner’s ancestors and lineal descendants;
- Spouses of the IRA owner’s lineal descendants;
- Anyone providing services to the IRA, including the IRA Custodian and any investment managers or advisors;
- Any corporation, partnership, trust, or estate in which the IRA owner individually has a 50 percent or greater interest.
Purchasing Real Estate with the Self-Directed IRA or 401K Plan
Once a self-directed plan has been established and the self-dealing rules are understood, the next step is to transfer money from the retirement account as a custodian to purchase specific investment property. This is typically done through a real estate letter of direction. When purchasing real estate property through a self-directed plan, there are four rules that must be understood.
1. Deed: it is imperative that the purchase is properly titled. This requires an understanding of the state law where the real property is located. Understanding state law regarding titling property held by a self-directed plan can be confusing. For example, Florida has a specific statute that dictates exactly how real estate held by a self-directed plan must be titled. In our practice, we have noticed real property held by self-directed plans titled as “IRA or Retirement Plan Custodian, Inc FBO #16879845.” This does not comply with Florida state law and could have disastrous consequences. Florida Statute Section 689.072 requires that real estate held by self-directed plans to be titled as either, “IRA or Retirement Plan Custodian Inc., as custodian or trustee for the benefit of (name of individual retirement account owner or beneficiary) individual retirement account.”
2. Acquiring Property: when purchasing real property for a self-directed investment plan, the funds required must come directly from the retirement plan.
3. Accounting: any expenses or income associated with the self-directed plan must be originated or remitted to the self-directed plan.
4. Execution of Document: any documents regarding the self-directed account’s real estate must be signed by the custodian of the plan who acts on behalf of the plan.
Given the recent upsurge in the real estate market and the possible drop in the stock market, many individual will consider moving some or all of their retirement plans into the real estate market. Although moving a portion of one’s retirement plan probably makes good sense from an investment and tax planning point of review, anyone considering establishing a self-directed retirement plan must understand the rules of qualified retirement plans and state law governing titling real estate in order to avoid an unexpected tax bill.
Anthony Diosdi is one of the founding partners of Diosdi Ching & Liu, LLP, a law firm with offices located in San Francisco, California; Pleasanton, California; and Fort Lauderdale, Florida. Anthony Diosdi concentrates his practice on tax controversies and tax planning. Diosdi Ching & Liu, LLP represents clients in federal tax disputes and provides tax advice throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: Anthony Diosdi – firstname.lastname@example.org
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.