If you are reading this, you already know that investing in real estate or real estate-related investments (after performing in-depth due diligence on each opportunity) is one of the best ways to reliably generate ongoing income and long-term wealth.
There is also a very good chance that you know that investing using self-directed retirement funds, IRA or 401(k), is one of the most effective ways to fund real estate opportunities, especially using Roth funds as highly efficient “magic money.” I have been investing in real estate using self-directed Roth 401(k) funds for more than a decade and I have been using self-directed Roth 401(k) funds for real estate-related investments exclusively since 2015. There are multiple reasons for that, which is the subject of another article.
The popularity of using self-directed retirement funds for real estate investing has grown significantly in recent years. However, the popularity of studying compliance with IRS rules and interpretation of the spirit of those rules, appears to be less than the popularity of using those self-directed retirement funds.
In this article, I will share some practices I have used when investing self-directed 401(k) and Roth 401(k) funds in real estate. At the same time, I must disclose that I am not a licensed accountant, not a licensed tax attorney and not a licensed financial advisor. Please do not make decisions or take any action based in whole or in part on the content of this article. Consult with appropriate licensed professionals for qualified information.
The following practices that I have used when investing my self-directed 401(k) or Roth 401(k) funds in real estate are related to avoiding doing any work myself on the property, including any work for which someone else would be compensated, avoiding mingling of funds from another entity and other activities that common sense dictates would be consistent with the spirit of the law.
1. All repairs or other work on the property is done by contractors
This is the first big no-no and it is obvious. The owner of the self-directed retirement plan should not fix faucets, do any painting, clean a rental unit between tenants or perform any other work normally done by contractors for compensation.
2. Project Manager handles the money, all of which comes from the self-directed retirement plan
When the property is purchased, the owner of the self-directed retirement plan directs he custodian to send money from the self-directed retirement plan to the title company to purchase the property. The owner of the self-directed retirement plan can also direct the custodian to send money to a VERY trusted person of the plan owner-taxpayer’s choice (not a spouse, child or parent of the owner-taxpayer of the retirement plan) who is designated Project Manager. The Project Manager pays for ALL goods, services, utilities, property taxes, etc., preferably from a dedicated account. This includes paying contractors, writing checks to Home Depot for supplies, paying the electric bill, paying property taxes and pretty much all other expenses that arise. A project management agreement should be composed by a tax attorney with expertise in self-directed retirement plans (we used Wayne Kerr in the Philadelphia area). The Project Manager maintains a file with all the invoices and receipts and reconciles the account, preferably in Quickbooks. At the end of the project, the Project Manager sends the excess funds, less the project management fee, back to the custodian for re-deposit into the self-directed retirement account. In other words, the owner of the self-directed retirement account does not touch any money going in or out of the account, does not charge purchases or payments to personal or business credit cards.
3. No comingling of services
Even though I have a New Jersey real estate salesperson’s license, I do not represent my self-directed 401(k) or Roth 401(k), or get paid any commission when buying, renting or selling properties titled in my self-directed 401(k) or Roth 401(k). My broker serves as the agent and retains 100% of the commission.
More importantly, I do no marketing to generate leads for the properties bought in my self-directed 401(k) or Roth 401(k). That means that I don’t send letters to motivated sellers, I don’t post We Buy Houses signs and I do no prospecting. All the properties bought are REO’s (bank owned homes), HUD homes or pre-approved short sales, all bought using my broker as the agent for the transaction.
My thought process is as follows. Let’s say that I want to buy Nike stock in my traditional IRA. I am allowed to do as much research as I want to study the performance of Nike stock but when the time comes to purchase the stock in my traditional IRA, I call the broker-custodian of my IRA and I instruct him-her-it to purchase the stock using the IRA funds and hold the stock in my IRA account until I decide it is time to be sold. If we apply that thought process to buying real estate in a self-directed retirement plan, I should be able to study a property, evaluate its underlying fundamentals, then when I think that the investment meets the investment criteria, I instruct the responsible parties and fiduciaries (custodian, broker, title company) to purchase the property using the funds of the self-directed retirement plan and hold it titled in that plan until sale or during the rental period until the eventual sale. You must consult with a licensed tax attorney with specialized expertise in this field to get a qualified opinion about whether this process is valid for compliance with IRS rules.
In addition, just like I do not use my license to collect commissions upon purchase or sale of a property titled in my self-directed 401(k) or Roth 401(k), I also do not collect rent from tenants in rentals owned by my self-directed 401(k) and Roth 401(k). Rent is collected by an independent third party that also maintains records of the rent collection and can report that to the IRS in case of audit. As already noted above, contractors do all the repairs and maintenance, so that I do not do any of the work or provide any of the services to maintain the rental properties.
4. Invest in other real estate-related passive investments
As I disclose in my lectures and articles, I am a part-time investor and my primary occupation is in chemical technology which is outside of the real estate profession. As such, I only do 1-2 real estate deals in a given year. In the mid-2000’s I sent direct mail to prospective motivated sellers, but I haven’t done so since 2008. In contrast, wholesalers do direct marketing to prospective motivated sellers and some of them do a portion of their wholesale deals in their self-directed retirement plan. I am not qualified to say if they are or they are not violating the spirit of the IRS rules by using the same resources for doing deals in their self-directed IRA’s and in their regular taxable business. Personally, I would not actively market directly to potential sellers using non-IRA funds for the mailings then allocate a portion of the deals to my self-directed retirement plan. To me, that seems to be too active to be consistent with the intent of the IRS rules and, to me, it would seem worse if a wholesaler was doing many deals per year in an SDIRA or SD Roth IRA since that could potentially be interpreted as “business regularly carried on” in the retirement plan.
According to that thought process, a very conservative approach to assuring total passive ownership of real estate-related investments is to invest self-directed retirement funds in apartment syndications (as passive owner, not a managing member), notes (without prospecting for them) and private lending. My self-directed 401(k) and Roth 401(k) invests in all three of those vehicles.
There are obviously more operational details to investing using self-directed retirement funds and you really do need to consult with a licensed professional for qualified input. Hopefully this article stimulated thought about some of the issues that need to be addressed when asking questions of a licensed tax attorney when considering investing in real estate and real estate-related investments using self-directed retirement funds.