IRA Real Estate Investment: Loan or Own? By Clay Malcolm
The decision to have your IRA, HSA, or 401(k) invest in real estate is only one of the strategic decisions that you, as the account holder, will make for your retirement savings. Of course, your IRA can purchase residential or commercial real estate, agricultural or raw land, etc. In addition to this strategy, it is becoming more and more common for self-directed IRA holders to invest in real estate by either making a loan or buying an ownership share of a private company. Both of these investment “structures” are viable ways to put your IRA funds to work in the real estate marketplace. The decision of which to choose can be influenced by a number of factors. Let’s take a look at some of the most common considerations that go into the decision of whether to “Loan or Own”.
One of the major distinctions between being a lender and being an owner (or part owner) of a private entity (commonly an LLC, but can also be an LP, C-corp.,…though not an S-corp.) is the nature of the monetary returns. An IRA can make almost any type of real estate loan: bridge loan, construction loan, hard money, mortgage, etc. And the IRA holder decides whether the loan (or note) is secured by collateral or not. The IRS does not concern itself with the specific terms (interest rate, payment timeline, etc.) of the note as long as it is a real economic transaction (i.e. not a gift disguised as a loan). Regardless of the purpose and terms of the loan, the principal and interest paid back to the IRA are determined by the agreement specified in the note. Thus, assuming all goes as planned, the returns are predetermined. (Variable interest rate loans are allowed as long as the “trigger(s)” for the variability are clearly specified.)
In contrast, the monetary performance of an ownership percentage of a private entity is almost always tied to the performance of the entity’s investment(s) and, thus, is unknown ahead of time.
For example, let’s say that an IRA is investing $50,000 in a flip project that is being put together by someone other than the IRA holder. The entire budget of the project is $200,000 for acquisition, rehab, and holding costs. The expected profit is $40,000. If the IRA makes a loan to the flipper who has agreed to pay back $60,000 ($50,000 principle + $10,000 interest) to the IRA at the end of the project; then, assuming no default, the IRA will receive this money whether the project yields the expected profit or not. If the IRA buys a 25% share of an LLC to put money into the deal, and the project goes as planned, the IRA may receive the same $10,000 return. However, if the final sale price is higher or lower, the IRA will presumably receive more or less than the $10,000.
The nature of the risk associated with the two investment “structures” can be different, and one may be more or less attractive to an IRA holder. With either a loan or ownership, there are “due diligence” strategies that the IRA holder can use to minimize their risk. Some of the most common areas of due diligence inquiry are: finding out about the other investors/managers/participants, analyzing the probability of success for the proposed investment(s), and getting comfortable with how you will receive progress reports/updates.
Investigating a borrower is a common risk mitigation practice for IRA lenders. When it comes to loans, the decisions regarding the type of collateral, if there is any, and when and how the IRA takes possession if there is default can also be a significant influence on risk.
Similarly, IRA investors that buy into a private entity often assess the other investors and managers that are involved in the deal. In addition, a myriad of other factors may come into play with the ownership structure, some of them include: insurance, assignability of ownership, the possibility of capital calls, etc.
A loan scenario is not inherently more or less risky than the private ownership scenario. What seems to be important is that the account holder is comfortable with the level of risk associated with whichever structure they choose.
UBIT (Unrelated Business Income Tax)
UBIT may be triggered by some investment tools and strategies used by an IRA. Keep in mind that UBIT is a “cost of doing business”, not a penalty, but it does obviously affect the IRA’s bottom line.
The Internal Revenue Code has a specific exception for loans made by IRAs, meaning that loans are considered “passive” income and are not subject to UBIT. IRA ownership in an entity may incur UBIT or may not. If the entity is operating an ongoing business and not paying business taxes on that business, then the IRA may owe UBIT.
For example, if an IRA owns 25% of an LLC that is an active fix-n-flip business, it is likely that the IRA holder will need to file an IRS form 990-T for the IRA to calculate possible UBIT. However, if the LLC is only making “passive” investments, like buying rental properties and holding on to them, then there would be no UBIT.
Another scenario that may trigger UBIT for an IRA is debt leverage. For example if an IRA is a 25% owner of an LLC that buys and holds real estate, but does so using borrowed money, then the returns that the IRA receives may be subject to UBIT.
Most self-directed account holders are active participants in the details of their IRA investments. However, you can have an impact on how much time and attention your account requires by the investments you choose and the way that you set up their machinations.
Having your IRA make a loan typically takes time at the beginning of the process, as the account holder does their due diligence on the borrower, negotiates the terms, and generates the loan document. If all goes well, the process after that is mostly keeping track of payments and, perhaps, reinvesting the incoming cash. An IRA can hire a loan servicing company for added convenience.
The nature of an IRA’s ownership in a private entity may be time-consuming or not. Again, the inception of the investment will probably require some time and attention. After that, it would largely depend on how many decisions the account holder is involved in making. Keep in mind that the IRA holder is not allowed to provide services to their IRA-held assets: no “sweat equity”, no working for the entity for pay or for free. The IRA holder’s participation is limited to making strategy decisions for the IRA.
Considering your distribution needs can have an impact on which investment structure that you choose, especially if you are over 59.5 years old and/or are taking required minimum distributions (RMDs).
Having your IRA make a loan may provide a consistent cash return which could be part of your distribution strategy. This may also be true with an investment into a private entity but it may not. Each investor chooses the structure that fits best with their individual needs.