Can I partner with my own IRA on a real estate purchase?
Clever investors may have had the thought “can I partner with my own IRA for this property?” What if the investor is involved with a 1031 exchange? With careful planning and understanding of strict rules, specifically pertaining to prohibited transactions, it is in fact possible. Below, we will discuss some important considerations if exploring this structure on a future deal.
Partnering with Your IRA: How It Works
Partnering with your IRA involves co-investing in a real estate property, where the IRA and your personal funds each contribute a proportional share of the purchase price. For example, if you and your IRA purchase a $200,000 property, the IRA might contribute $100,000 (50%), and you personally contribute the remaining $100,000. The ownership structure is typically held as tenants-in-common, with each party owning an undivided interest in the property proportional to their investment.
This strategy allows you to leverage your IRA’s tax-advantaged status while using personal funds to increase your purchasing power. However, the transaction must comply with IRC rules to avoid prohibited transactions and maintain the IRA’s tax benefits.
Tax Implications and IRC Rules
Prohibited Transactions (IRC Section 4975)
The IRC strictly regulates transactions between an IRA and its owner or related parties, known as “disqualified persons” under IRC Section 4975(e)(2). Partnering with your IRA is permissible, but the transaction must be structured to avoid self-dealing or direct benefits to disqualified persons. Key considerations include:
Arm’s-Length Transactions: The IRA and personal portions must operate independently, with expenses, income, and ownership interests allocated proportionally. It is strongly suggested to hire a third-party management company to oversee the property for the duration of ownership.
No Personal Use: You cannot use the property personally (e.g., as a residence or vacation home), as this constitutes a prohibited transaction under IRC Section 4975(c)(1)(D).
Fair Market Value: All contributions and distributions must reflect fair market value to avoid indirect benefits.
Violating these rules can result in the IRA losing its tax-advantaged status, triggering immediate taxation and penalties.
Unrelated Business Income Tax (UBIT) and Unrelated Debt-Financed Income (UDFI)
If the property generates income (e.g., rental income), the IRA’s portion may be subject to UBIT under IRC Sections 511–514 if the income is from an unrelated trade or business. Additionally, if the IRA uses debt to finance its share (e.g., a non-recourse loan), the income attributable to the debt-financed portion is subject to UDFI under IRC Section 514. These taxes are paid from the IRA, preserving its tax-deferred status.
Leveraging a 1031 Exchange for the Personal Portion?
A 1031 exchange, governed by IRC Section 1031, allows investors to defer capital gains taxes by reinvesting proceeds from the sale of one property into a “like-kind” property. This strategy is particularly relevant for the personal portion of the co-investment, as IRAs are not eligible for nor need 1031 exchanges due to their tax-deferred nature.
How It Works
If you buy or sell a co-owned property, the personal portion of the proceeds can be sourced from / to a 1031 exchange, deferring capital gains taxes. For example:
Purchase: You and your IRA decide to purchase a $200,000 property, each contributing 50%.
1031 Exchange Portion: Following the rules and regulations of an exchange, you contribute $100,000. Keep in mind, the basis of the property you sold will follow you into this property for this equity portion.
IRA Portion: You direct your IRA funds — either through an IRA LLC/Trust or by directing your custodian to act — of $100,000.
Considerations: Consult your tax professional as this structure would be complex. For invested 1031 funds, the prior property’s basis would transfer into the personal share of the TIC for this new property. Likewise, your personal fund side would be eligible for traditional tax benefits from real estate ownership, like depreciation. As stated earlier, it is strongly advised to hire third-party management of the property as the rules around prohibited transactions apply for the whole property.
-or-
Sale: You and your IRA sell the $200,000 property, with each receiving $100,000 based on your 50% ownership.
1031 Exchange: You use your $100,000 to purchase another investment property with a 1031 exchange, either with or without the partnership of the IRA.
IRA Portion: The IRA’s $100,000 is returned to the IRA, remaining tax-advantaged.
Considerations: The funds from the personal ownership side would be subject to taxation, including applicable capital gains and depreciation recapture, unless entering into a 1031 exchange.
Strategic Considerations
Ownership Structure: Ensure clear documentation of ownership percentages and proportional allocation of income, expenses, and debt.
Property Management: Engage a third-party property manager to maintain an ‘arms-length’ transaction.
Tax Planning: Consult a tax professional to navigate UBIT, UDFI, and 1031 exchange rules, especially if leveraging debt or selling the property.
Qualified Intermediary: If choosing to do a 1031 exchange, engage a Qualified Intermediary who not only understands 1031 exchanges, but also the rules around self-directed retirement accounts.
Long-Term Goals: Align the strategy with your retirement and personal financial objectives, considering liquidity needs and risk tolerance.
Conclusion
Partnering with your IRA on a real estate transaction can be a powerful strategy to maximize investment potential, but it requires careful adherence to IRS rules to avoid prohibited transactions. Leveraging a 1031 exchange for the personal portion potentially adds a tax-deferral benefit, enhancing the strategy’s appeal. By understanding the tax implications and working with professionals, investors can effectively balance retirement savings and personal wealth-building goals.
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