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Investing in Real Estate Using Self Directed Retirement Accounts

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Investing in Real Estate Using Self Directed Retirement Accounts Address: 14034 S. 145 E. STE 100 Draper, Utah 84020 N A R E A (801) 931-5571 [email protected] INVESTING IN REAL ESTATE USING SELF-DIRECTED RETIREMENT ACCOUNTS By Ken Holman The most recognized types of retirement accounts are the 401(k) plan for private employers, the 403(b) plan for non-profit employers, the 457(b) plan for government employers and the SEP IRA (Simplified Employee Pension Individual Retirement Account (SEP) for employers and Individual Retirement Account (IRA) for individuals which the Internal Revenue Service calls Individual Retirement Arrangements. In 1974, Congress passed the Employee Retirement Income Security Act (ERISA) that, among other provisions, provided for Individual Retirement Arrangements, which permitted individuals making below a certain income to make annual tax-exempt contributions to their retirement account. In 1997, Senator William Roth of Delaware spearheaded the Taxpayer Relief Act of 1997, which did not permit a tax deduction for annual contributions but enables the earnings on such plans to grow tax- free. Modern pension plans, called defined benefit plans, began around 1920 but by the 1970’s it became apparent they we no longer sustainable for most companies. In 1978, Congress passed Section 401(k) of the Internal Revenue Code permitting high-earning individuals to invest in the stock market using income that was exempt from taxes. By 1980, Ted Benna, a benefits consultant and attorney, used the law to create a simple, tax-advantaged way to save for retirement, called defined contribution plans, which shifted the burden of saving for retirement from the corporation to the individual. Even though these plans have only been around for less than 45 years, the stock market, insurance companies, and other financial institutions and the financial planners who consult for them have made billions of dollars on the trillions of dollars in these accounts. Real Estate Advisors, on the other hand, have been late to party. Most don’t even know these funds can be invested in real estate, but to do so, requires knowing some rules. First, before the money can be invested in real estate, the retirement account must be self-directed, meaning the account is structured so that the account owner has the discretion to invest in both traditional and alternative investments. Traditional investments being mainly bonds and public equities like stocks, including mutual funds, and Alternative investments being real estate and other private equity investments. Most real estate professionals and owners of retirement accounts don’t realize they can invest in both traditional and alternative investments. The IRS permits all types of investments for retirement accounts, but stock brokerages, insurance companies and other financing institutions prohibit their clients from investing in alternative investments. w w w.nar eag r oup .or g Permitted Self-DireCted Retirement AcCount Investments Real Estate-Related Products Non-Real Estate Products Agricultural (Farm) Real Estate Annuities Build-to-Suit Real Estate Developments Bonds Commercial Real Estate Commercial Paper Construction Loans Commodities Fix-and-Flip Properties Convertible Notes Hard Money Loans Equipment Leasing Home Equity Loans Factoring Accounts Payable Home Mortgages/Take Out Loans Franchises International Real Estate Hedge Funds Discounted, Mezzanine & Bridge Loans Mutual Funds Participating Loans Personal Property (see exceptions) Privately-Traded Real Estate Investment Trusts Privately-Held Companies Publicly-Traded Real Estate Investment Trusts Privately-Traded Stocks Real Estate Leases Publicly-Traded Stocks Real Estate Options Rights & Warrants Residential Real Estate Start Up Companies Tax Deeds & Tax Liens U.S. Treasury Bills/Gold w w w.nar eag r oup .or g In my opinion, the very best self-directed retirement account is what the government calls a One- Participant 401(k) plan. These plans are usually set up through a Third-Party Administrator (TPA) who has a relationship with a Custodian, which is typically a bank. THIRD PARTY ADMINISTRATOR / CUSTODIAN There are usually two entities that handle the administration of self-directed retirement accounts, i.e., the Third Party Administrator (TPA) and the Custodian. In a self-directed situation, the TPA and the Custodian could be the same entity, but generally they are not the same entity. A Third Party Administration (TPA) is the individual or organization who sets up, manages, an handles the administration of the account and reporting to the IRS. The Custodian is always the financial institution that holds the money, regardless of who handles the account administration. Sometimes the TPA and the Custodian are referred to as the Custodian, but don’t be confused, the TPA handles the administration of the account and the Custodian is the depository where the liquid funds are kept until they are invested in an asset. It is possible for the plan owner to act as the Trustee on the account, but the regulations, reporting, and compliance issues are complex enough that it would be unwise to do so, unless you are familiar with all the requirements of self-directed retirement account compliance and reporting. Different TPA/Custodians call these accounts by different names, i.e., a Solo or Individual 401(k). Some of the best known are Equity Trust and The Entrust Group. Although I am familiar with both entities, I like using a smaller company out of Boise, Idaho called Mountain West IRA. Mat Sorensen, attorney and best-selling author of Self-Directed IRA Handbook, has created a TPA entitled Directed Trust Company. Directed Trust Company is a model that works for sophisticated self-directed IRA and 401(k) investors who want to handle the responsibilities of managing their own self-directed retirement accounts. One PartiCipant 401(k) Plans One Participant 401(k) plans are ideal for most real estate professionals and other small businesses where the owner is self-employed. To be eligible for such an account, requires basically three things: 1) The presence of Self-Employment activity; 2) Taxable compensation during the year; and 3) The absence of full-time employees. Since a 401(k) is tied to an employer, there needs to be a business entity set up for the 401(k) to reside. The business can be a sole proprietorship, a partnership, a C-corporation, an S-corporation or a limited liability company (LLC). Both you and your spouse can be employed by the company, but all other employees must be part-time. Contribution limits for 401(k) in 2019 are $19,000 for individuals under 50 years of age and $25,000 for individuals age 50 or over. The $6,000 difference in called a catch-up contribution. Additionally, the business (your employer) can make non-elective contributions to your 401(k) retirement account of up to $37,000 for a total annual defined contribution limit of $56,000, if you’re under 50 years old and $62,000, if you’re age 50 or older. These contributions can be made for both you and your spouse. The contribution limits not only apply to 401(k) plans but also to 403(b) and 457(b) retirement plans. Plus, there is no income limit that will limit your contributing to your plan. And, not only can you contribute more to a One Participant 401(k) plan than to an IRA, but there is another huge advantage; 401(k) plans are exempt from Unrelated Business Income Tax (UBIT) and Unrelated Debt Financed Income (UDFI), which will be discussed later. w w w.nar eag r oup .or g Example: Ben, age 51, earned $120,000 in W-2 wages from his S Corporation in 2019. He deferred $19,000 in regular elective deferrals plus $6,000 in catch-up contributions to his 401(k) plan. His business also contributed 25 percent of his compensation to the plan, $30,000. Total contributions to the plan for 2019 were $55,000. Ben could have actually contributed $62,000 to the plan if his earned income were $148,000 ($19,000 regular elective deferral plus $6,000 in catch-up contributions plus 25 percent of $148,000 or $37,000 for a total of $62,000). Matching Contributions. If the plan documents permit, the employer can make matching contributions for an employee who contributes elective deferrals to the 401(k) plan, however, the sum of all contributions to the plan cannot exceed the total allowed by law. Traditional 401(k) Contributions. A plan participant has the election to pay the employee elective deferrals either on a pre-tax basis or a post-tax basis. However, all employer plan contributions must be taken on a pre-tax basis which means any employer contributions and earnings attributable to those contributions will be tax at ordinary income tax rates when they are withdrawn. Roth 401(k) Contributions. It is possible to designate the employee elective deferrals as Roth contributions, where no tax deduction is taken, and the contributions are paid post-tax. These Roth contributions and the earnings attributable to these contributions are tax free when they are withdrawn. https://www.iravs401kCentral.com/401k-inCome-limits/ INDIVIDUAL RETIREMENT ACCOUNTS There are four basic types of IRAs, two of which are for employees of small businesses and two of which are for individuals. The two IRAs for employees of small businesses are the SEP-IRA and the SIMPLE IRA. SEP-IRA FOR SMALL BUSINESSES A SEP-IRA (Simplified Employee Pension Individual Retirement Account) is an employer-provided IRA that allows business owners to provide retirement benefits to the owners and their employees. The 2019 contribution limit for a SEP-IRA is 25% of total compensation up to a maximum of $56,000. There are some eligibility requirements, which will not be discussed here, for employees to participate in a SEP-IRA.
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